Unless you were born a trust fund baby, it is virtually impossible to go through life without borrowing money. The decisions you make when taking on debt will have a deciding factor on how much gold, if any, is waiting for you at the end of your rainbow. Every loan consideration should be treated as a business decision that fits in with your long term goals, and needs to include weighing the pros and cons, a cost/benefit analysis, and identifying the impact it may have on your financial well-being.
Do you know the difference between good debt and bad debt?
Unfortunately, bad debt is often recognized in hindsight. Making payments on a ‘new’ car for so long that its now worth less that what you still owe, revolving credit card debt, borrowing for things that aren’t necessary, failing to interest-rate shop or negotiate loan terms, and high-interest loans (payday loans, in-store credit, etc) all make the list. A commonality with all bad debt is the total amount paid including interest, is always significantly more than the item is worth. In many cases the item is worthless at the end of its short 5 to 7 year life.
Good debt tends to provide longer term benefits that outweigh the cost of the loan. These loans come with lower interest rates, and have either been used to generate income, purchase assets that increase in value, or in some other way benefit you financially. Good debt falls within your affordability range, allowing you to pay it off in a manner that is prudent, but not burdensome. There will always be emergencies, or larger purchases such as a practical, well priced family vehicle (not the sports car) that will require borrowing, but there are general guidelines for what constitutes good debt.
Good Debt – What should you borrow for?
Home Ownership (with exceptions)
Owning a home is a common goal for most people, and makes a lot of sense during this era of low interest rates. We all need a place to live, so if you have done your homework, have a healthy down payment, and are ready for the responsibility of home ownership/maintenance, buying is a great option. It can also have tax perks – Some countries such as Belgium, Ireland, Netherlands, Sweden, Switzerland, and the United States allow for the deduction of principle residence mortgage interest against income taxes (deduction varies by country).
Home ownership is isn’t always a better financial option and you need to weigh the pros and cons. There are a lot of things to consider including costs of renting vs buying, is your (or your spouse’s) job secure, can you still make payments if one of you loses your job, etc. While renting doesn’t build any home equity, neither does over-paying at the peak of an inflated housing market. Market timing and ‘fear of missing out’ (FOMO) when buying a home can destroy you financially. Everyone has heard of housing bubbles, but very few realize they are in one until it is to late. When the housing bubble leading up to the financial crisis in 2008 finally popped, $trillions of American home-equity wealth evaporated.
If you have what it takes to be a landlord, and I can assure you it isn’t easy, buying an investment property can be a lucrative opportunity. If you are earning rental income, all expenses including mortgage interest are deductible from income tax. If you are living on the property, the personal residence portion may not be deductible. There are different tax laws in various countries regarding rental income and allowable expenses, so do your homework before buying. If you buy and borrow wisely, the rent will help cover the mortgage payment, property taxes, and other expenses, as you build equity in what could be a valuable property in the future.
Targeted Home Improvements
If you have to borrow money for home improvements, it should be done based on needs not wants, and always with resale in mind. A roof that is worn and leaking needs to be replaced, but replacing a perfectly good roof with the latest overpriced designer roofing material, is a foolish want. Safety needs to be a top priority, and upgrades to things such as electrical and plumbing are often necessary in older homes. If your house is in good shape, and you are not stretched financially, there are improvements that can add value to your house and increase its chances of a quicker sale. In real estate, it is said “location is everything”, followed closely by “kitchens and bathrooms sell homes”. Check with any local real estate company and they will provide you with a list of return on investment for home improvements in your area. Ideally, to get the most financial gain, your house should fit the neighborhood, so avoid overspending on home improvements that will never pay off.
Education (choose carefully)
Taking out a student loan to pursue post secondary education at a university or a trades/technical college, can be a very wise use of debt. Post secondary graduates generally receive much higher rates of pay than those with only a high school diploma. Things can go very wrong however, if a student takes on a huge debt to earn a degree in which there is no employment opportunity. Reputable trades and technical colleges, provide students with more real world exposure, hands on training, and apprenticeship opportunities compacted into shorter programs (1 – 2 years), and can make a smarter debt choice. There are shortages of skilled trades in many countries, and if there are no jobs, you have the skills to start your own business.
Borrowing to invest is not a good idea at the height of a bull market or real estate bubble, but can provide the money needed if you come across a great investment opportunity. Do your homework – Is the loan interest deductible or are there other tax advantages on this particular investment? Will investment income cover the loan payment? How long before you plan to sell? How risky is it and how much can you afford to lose? Borrowing at the height of a bull market frenzy isn’t going to make the loan go away if the market crashes.
Not everyone possesses the discipline to be self-employed. If you are hard working, and have a sensible business plan, borrowing money to start, or grow your business can make for a very smart use of debt. There are many tax advantages to business ownership, including the income tax deductibility of loan interest, home use of office, or a portion of all home expenses if your business operates from your residence. Since business expenses are deductible, one should always pay off non-deductible personal loans and credit cards first.
Recommended reading – If you think you have what it takes to start a small business – The Four Pillars of Business Success