Chapter 7 - Debt

Good Debt - Bad Debt

If you need will power to save and managing savings, you will need it in larger measures to manage debt. The simplistic view of debt is that it is compound interest working the other way. That is true if you do not pay debt down.

Debt also has a positive side that it multiplies your investment power. This is called leverage. Both have to be managed very carefully.

Who doesn’t have credit cards? You have to have at least one or two just for identification purposes. With so much counterfeiting of bank notes, some businesses would rather take a chance on your credit card than on taking higher denomination bills. Once you have them it is so easy to use these cards. There are so many sales and so little time. You can save 20% to 70% at those very special “sales events”. The only thing is that credit card interest rates for the majority of people start at 18% per annum. If you buy something on a 20% off sales event and don’t pay it off for a year, you are paying full price. By the time you pay for it, is it still even in your closet or garage?

I cannot stress the point enough that this 18% interest rate that you pay is out of your take home income.

In most cases, credit card companies want you to pay at least 5% of the outstanding balance each month as a payment. That is pretty easy at the start when the balance is low. However, if you let this balance grow and grow, pretty soon you are paying 5% of the maximum balance that you are allowed. So you make your payment, but you spend it right back up to the maximum balance again each month. If this strategy works, often the credit card company will bump up your maximum balance. I know this is good for the credit card company but is it really good for you? The other thing that will happen if you are able to keep up on your payments is that other credit card companies monitor information banks for customers who pay on time. If they can get a new customer to pay 18% to 20% interest, they will offer you all kinds of deals. They may offer that you can pay 3% instead of 5% of the balance as a monthly payment. They will offer you a “special reduced interest rate for 3 or 6 months on transferred balances”. Wow, it’s pre-approved as well! That’s great isn’t it? Now you have 2 credit cards. This cycle can continue until you have 3, 4 or 10 credit cards. By that time you are robbing Peter to pay Paul. You take a cash advance from one credit card to pay the payments on the others. A worst-case scenario is that you buy merchandise on one credit card, take it back and return the merchandise for cash and use that money to spend or pay off the other credit cards. This is called the “SPIRAL OF DEATH”. Everyone has seen a picture of an airplane spiralling into the ground after the pilot hopefully has ejected. This is a great analogy except imagine that your finances are the airplane with no parachute.

It is amazing how many people end up in this spiral. To get out of it, just like big companies, you have to restructure your personal finances. The easiest way is to have a windfall drop into your wallet. However, betting the milk money on the ponies is just not a high ratio success strategy. Waiting for that rich aunt to die is another of those strategies that just does not work for so many reasons. In both these cases, you are not dealing with the root problem, which is your own attitude toward yourself and your take home income. If you get into this kind of predicament, you must learn to manage your money properly. A lot of people who get into the “spiral of death” still manage the rest of their finances well enough that they have some assets. Many own a house. One way to restructure is to consolidate your loans using home equity as collateral. This gives the lender security and reduces the interest rate and the monthly payment as well. The lesson is that you have to be wise enough to learn to manage your credit cards properly so that you exercise this option only once. Your house is supposed to be a way to save for your long term goals. Another way to manage house equity is to sell and buy a smaller house or move further from the centre of town. In the first case your mortgage cash draw can stay the same. The equity that you cash in can be used to reduce or pay off all credit card debt. To move further from town, you can usually get a similar house for less money. Here again, you keep your mortgage the same and use the equity to reduce or eliminate your unsecured debts. The problem is that your mortgage is back to the full amortization period.

These situations have costs. You only want to do them once because these costs are not recoverable. You get nothing for that money except access to your own equity. Some people will take their mortgage right up to 90% or more of the house value every time it is up for renewal and then spend their equity. Sooner or later, any real estate market takes a downturn. Now you have a negative equity position, have spent what they thought they could refinance for and are now painted into a financial corner. This was originally written in 2006. I feel almost prophetic. The only thing to do is start over from the beginning.

This may involve declaring personal bankruptcy. Though the stigma of it is gone and it is so much easier to rise from bankruptcy these days, most folks still do not find it easy to choose this option. If you are in the spiral of death, you do yourself a great favour by having the courage to make this decision. In a lot of cases people feel like the weight of the world is lifted off of their shoulders.

There is good debt and there is bad debt. Bad debt works to overwhelm your finances and put you into the “spiral of death”. Up to this point we have covered bad debt.

Good debt is used to “lever” your savings into situations where you can buy assets far larger than you could ever save for in a much shorter time. It also allows you to acquire more appreciating assets that will add to your net worth far faster than you could by saving. A mortgage is by far the most common of good ways to owe. To get a mortgage you have to save up enough to put a “down payment” on a property. Then the bank will loan you the rest of the cost of the house. You make monthly payments to the bank to pay down the mortgage for an “amortization period” of 10 to 30 years. This means you are gradually paying off the loan. This is especially good if your mortgage payment plus taxes is very close to or lower than what you would pay for rent for similar accommodation. At the very beginning very little goes towards your principal but each month a higher and higher percentage of your payment becomes equity. If you rent, your rent money is gone forever. With a mortgage, your house turns into a savings account that you live in. Choosing which house to buy makes a big difference because there is a second way that you can gain by using a mortgage to own a house. In the long term, houses almost always increase in value over time. If you stay in a house or in a successful housing economy for decades, the value of your house increases in value. Over that amount of time there will be peaks and valleys in the rate of price increase but let us assume that it appreciates 60% over 10 years. If you bought a house for $200,000, it would now be worth $320,000. The gain is $120,000. You put in $40,000 of your own money. You would have paid rent anyway. So what you have here is a 300% return on your $40,000 investment. You also have managed to pay down your mortgage by about $40,000, so you have also saved that amount. Let’s add this up. You have your down payment $40M plus you have paid down the mortgage by $40M plus you have gained $120M in market value increase. That means that your $40M down payment has grown into $200M of house equity in 10 years. Due to inflation your cash flow is the same or better than if you had rented. You can see now why it is worth it.

Look at the progression we have made. First we took Benjamin Franklin’s “a penny saved is a penny earned” and modernized it that a penny saved is now worth two cents earned. If you put this to work in your house for a decade you can earn 5 more cents on each of those 2-cent pennies. That means that for you a penny saved is 10 cents earned. Can you feel the power? You know you can do this!

Not only is this a nice way to build financial security but also in most countries, the governments do not tax a financial gain on your principle residence. Some even let you reduce your income tax by a percentage of how much interest you pay on your mortgage.

However, please be careful. There are exceptions to the rule that the value of property will go up over time. 2008 showed us what a house price market crash is all about. Industries move and ghost towns are created when a town’s main employer closes the plant. Interest rates can climb to the point that when you renew your mortgage, the cash draw takes too much of your monthly income. This will probably be the next big problem that will develop in the housing market. Don’t buy any bridges or beachfront property in the dessert. And keep your property insured.

All good debt is similar to the mortgage scenario. There are many possibilities come to mind. Retirement savings plans are another example of using good debt to improve your financial security. In most cases money put in a Registered Savings Plan is tax deductible. If you can borrow money to put in your plan, assume 30% will come back as a tax refund; the first fact you have to appreciate is that you just got a 30% return on your investment in yourself. It will still earn interest all year and compound year after year. If you pay off that loan in 1 year, you are ready to do it again the next year. You can even take an extra year or two to pay it off and still be ahead. You can do a similar exercise to the mortgage calculation we did earlier. Imagine yourself borrowing $3000 at 6% to put in a Retirement savings plan. Pay off the loan in 2 years at $93 per month and put your $900 tax refund toward the loan. You invest your savings at 6% compounded return. After 2 years you have no debt and have $3370.80 saved. It cost you $2225.00. You gained $1155.80 over and above what you put in. That is over a 50% return in 2 years. You have got to like that.

You don’t have to gamble to make big money. You just have to THINK YOUR MONEY especially when it comes to debt. It is always a similar calculation. You can apply it to so many things in life when you have the patience to stay within the confines of your cash flow.