Wednesday, February 21, 2007

Good debt, Bad debt?

Is debt bad or good? I'm not sure that debt is either bad or good, it is how we manage it that determines whether it has a positive or negative effect on our financial health.

For instance, I mentioned in a previous post that I routinely charge nearly everything I buy to a credit card. If I have rebate cards and pay off the balance on time each month, it has a positive effect on my finances. If I were to miss the payment dates or decide to carry a balance, the costs would quickly eat up the benefits.

The addictive type of spending/debt I mentioned in the previous post certainly is a mistake. It can make it nearly impossible to realize our financial goals, and it can put tremendous stress on us personally as making financial progress becomes more and more difficult.

On the other hand, in certain circumstances, debt can have a positive effect. Borrowing to finance an investment that makes money is one way to make debt work for you. For instance, if you borrow to buy a property which has a positive cash flow the result can be very handsome profits. Keep in mind, though, that this enhanced profit is a result of the leverage resulting from the debt and the leverage works both ways. The same leverage that produces handsome profits can result in devastating losses if your assumptions turn out to be wrong.

Let's take an example. Say you buy a rental house and put $5,ooo down and get a mortgage for $95,000. Assume the value of the house goes up 5% per year and the house rents for $1000/month and your mortgage, taxes, insurance and other expenses come to $800/month. You are making $5000/year in appreciation plus $2400/year in cashflow. That amounts to nearly 150% profit per year on your original investment. In this case, debt is very positive. With these assumptions you can't afford not to buy the house and incurr the debt, right?

But wait, what happens if some of your assumptions are wrong? Let's say the housing market takes a tumble of 10% per year for 2 years. You discover the foundation needs $10,000 in repairs and a hail storm does $5000 damage to your roof. Your deductible is $1000, so you dodge a bullet on the storm, right? But now your insurance goes up $100/month. The tenants move out and it takes 3 months to rent it again at $800/month. The realty company charges a month's rent. After 2 years you realize this house is not the profit machine you had envisioned, so you sell, incurring 10% selling cost. Let's see, that's $21,000 in depreciation, $2,400 in negative month-to-month cash flow, $2,400 lost revenue during the vacancy and over $18,000 in additional expenses. Your $5000 investment has generated about $40,000 in losses over 2 years, or NEGATIVE 400% annual return.

Sounds like an extreme example, right? It is, yet each assumed event can happen. Believe me, they have all happened to me! Again, my point is that debt creates leverage which can work both for or against you and therefore creates additional risk. The two cases above would still generate positive and negative returns respectively without the borrowing, but the debt multiplies the effect. If you had bought the above property with cash, your investment would have yielded about a 9% annual return in the first case and a negative 10% return in the second case. The debt just leveraged both the profit and the risk.

When evaluating an investment, it is always worthwhile to evaluate the investment both with and without the debt. Evaluate with both the best and the worst assumptions. Then you are able to see both the benefits and the risk of the debt.

But, what about other kinds of debt? My rule of thumb is that debt is positive if the after tax interest rate is less than what I could obtain on a similar investment. If you have no investments, it probably means you cannot afford the debt. The result of these two rules is that debt should rarely be used. And then only after careful consideration of both the benefits and the risks using very conservative assumptions.

As an aside, one of the most frequently asked questions is whether it is better to keep your mortgage or pay it off. Since mortgages have one of the lowest after tax interest rates, it may be possible to beat the rate with other investments, depending on your risk profile. When you are young, you can afford more risk in your investments, so a mortgage probably is a good thing. For older folks, a lower risk profile may be in order, meaning it makes sense to pay it off. Either way, make sure you can afford it under conservative assumptions before you take it on.

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