August 1, 2011, 6:59 am

Why Debt is a Good Thing

by: The Financial Blogger    Category: Assets and Net Worth,Personal Finance
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 By reading this title, you must think: “man, this guy has guts! He writes about getting out of the rat race and then, he’s telling us that debt is a good thing”. Well… I must admit that at first glance, I don’t make much sense. The whole purpose of reaching financial independence is to generate enough cash flow to sustain your lifestyle. Therefore, the less debt you have, the easier it is to reach financial independence. So tell me, how come borrowing is one of the best moves you could ever make?

 

Why Do You Fear Debt?

I’ve been thinking about why people are so afraid of debt. Here are the possible reasons I have found so far:

a)      Educational background (we have been told by our parents, by school and by the Church that debt is evil and that we should always spend within our means).

b)      Financial Gurus (most “great financial gurus” are literally preaching a frugal lifestyle and to avoid debt at all cost even if it means using half a tissue paper)

c)       Fear of losing (this is more understandable: if you have too much debt, you could eventually default and lose your house/car/lifestyle. Nobody wants that)

d)      Hate to pay interest (that is another good point: when you borrow money, it always costs more to pay it back than paying cash in the first place. Interest sucks!)

I might have forgotten one or two more reasons why people fear debt but in general, you probably fall into one of these 4 categories. When you think about it, they are not dumb reasons. In fact, some of them are easily defendable points. In front of this info, most people would agree that having debt is a bad thing and someone that is debt free is to be considered “rich”.

 

Well, I completely disagree with that. Debt can be so useful that if you are trying to pay them off ASAP, you are missing something.

 

What is the worst that can happen?

If you have too much debt, the very worst thing that can happen is going bankrupt. This is the worst case scenario; losing everything. I might have a different point of view on debt because I have a different background than most people. At the age of 14, my parents went bankrupt. It is important to say that, back in the 90’s, my dad was making over 100K already. My parents were spending their money as it was coming in. While there was lots of money coming in, there was lots of money going out! When my dad lost his contract, it took only 3 months until there was no money left and had to declare bankruptcy. We lost our big house, big cars, no more vacations, we lost everything… in fact, I even remember my mom looking for spare change under the cushions of the couch to buy a pint of milk at one point!

 

However, losing everything is not as bad as it seems. It sucks big time but you just get over it. You learn to live with less money in your pockets and you start working hard again. Surprisingly, 4 years later, my parents had started a new company and were making even more money than back in the 90s! You couldn’t tell they went bankrupt and had lost everything a few years back!

 

What have I learned from this?

 

I’ve learned 2 things from going bankrupt as a teenager:

#1 don’t overspend and make sure you have a backup plan (I have my budget under control and I can always rely on my online company to pay my bills if I lose my job)

 

#2 losing everything is not that bad (so I don’t have to fear debt)

Now, it’s not because I don’t fear debt that I should go to the bank and fill my pockets with loans! In fact, one should only borrow to build assets and avoid consumption related debt. For example, don’t finance your vacation ;-). Make sure you have a budget for it!

 

Where I’m a bit different than others is that I always calculate where my money will generate the most benefits. Then, since my mortgage is at 2% and I can easily generate more than a 2% yield, I invest in the stock market and my company. Therefore, instead of focusing on paying down my debt, I think I should focus on creating more assets.

 

Over the past 3 years, I have noticed that my spending habits have increased significantly. Unfortunately, not all my debts and expenses are related to creating assets. I have also increased my lifestyle a lot. This is why I am now trying to pay down my debt as I consider that if anything happens right now, I will definitely run into a tough time even if I can count on my online company to cope with my salary loss. My other goal is to drop my debts to eventually give me the option of quitting my day job. I really like what I do right now but just having the option possible would make my day!

 

Are you afraid of debt? Do you sleep well at night? As long as my interest rate is low, I do!

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Comments

I’m not afraid of debt. I can see why it can be scary though. Most of us just hate the feeling of owing money to someone. This can easily cause us to feel uncomfortable. How do you deal with this feeling?

I think the perfect example of not being afraid of debt, and using it to your advantage is using the Smith Manoeuvre, which I plan to begin soon (selfishly loving this dip in the stock market).

Be careful on the math for a mortgage comparison for evaluating paying it faster or investing.

First of, a 2% rate today is not guaranteed for tomorrow when you renew which means that your interest payment grow and so do your interest. It’s also a loan with a compounding factor. Making extra payments will certainly payoff when you renew at a higher rate. Especially true early in a 25 year term as oppose to being 5 years away.

When comparing the best use of your immediate cash flow, it’s probably good to also have a goal in mind for your mortgage over time. Basically, how much do you want to pay in interest in the end? The way I look at it is that one has a fixed cost whereas the other has a potential earning. Your math accuracy when extrapolating for years down the road diminishes with time.

I think there is a difference between saying debt is good vs saying that I am not afraid of debt. I am certainly not afraid of debt and probably have more debt than most. At the same time, there are times when debt can limit choices and others when it can expand horizons. The prudent use of debt can be a powerful tool. But even bankruptcy while possible for the debtor to bounce back is not good for the lender. Sometimes, it all depends upon perspective.

by: The Financial Blogger | August 2nd, 2011 (11:04 am)

@MD,
I got used to it pretty fast. I think it depends if you see that you are able to pay back your debts or no. If you have a good income stream, having debts is less stressful.

@Teacher Man,
I would LOVE to have more liquidity at the moment. the stock market is definitely offering great investment opportunities!

@Passive Income,
Math accuracy diminishes in both scenarios (investing vs paying off your mortgage). If interest rate goes up, it would be because economy is going well. If economy goes well, your investment yield during those year will also be good ;-). Technically, if your interest is tax deductible when you invest instead of paying of your mortgage, you just have to average a return equal to your mortgage interest rate to be a winner. The tax deduction will do the magic for you. If you can beat your mortgage rate, then you are in serious business. Considering you can easily build a 4% dividend portfolio, you can just pay your interest from your dividend payouts and leave the capital grow over time. no cashflow required ;-D

@Cashflowmantra,
Debt is good as long as you use your money efficiently. a Car debt is definitely not a good debt and in all cases, a bad debt. this is always a tough concept to define!

@TFB
I still think it’s a slippery slope to compare with the mortgage. (Mind you that I am dealing with large mortgage amounts in Vancouver :( ) A co-worker made the same comment as you did at the office. Why pay more when I can borrow at a very low cost. Except he just spend the extra money rather than save it … When the interest rate kick up, he is in no better place. The compound growth interest is going to kick in.

Just like you went through, many rack up debt on lifestyle inflation and letting large loan like a mortgage may not be the best move even if the math works.

But on the simple fact that you can borrow cheaply and pay it back at a lower interest, it’s easy math but you need to be able to service the extra debt because the benefits for the tax deduction come in later. It also require diligence to not have spent the tax return on something not financially related. Many spend their tax return before they already have it. The math is sometimes awfully simple but the human behavior is not :)

You are perfectly right, I can build a dividend portfolio paying 6% no problem but I also have a mortgage and car loans and a family to support. Extra debt is not always transparent on cash flow. Dividends don’t pay at the same time.

Here is a hypothetical question:
Would you recommend someone who has 10 year left on their mortgage to refinance for 25 years to have lower payments and invest the difference because the interest rates are low? (Note that it won’t be an investment loan so you don’t get the tax credit)

Note that you brought up a point that I review almost every year for the past 3 years. I do the math and I even get setup but in the end, I still prefer to lower my debt. Layoffs from 3 years ago brought a reality check on how unsecured employment can be at times. No employment and debt don’t go so well together.

Well that was a downright liberating read, and it jibes with my personal experience: Debt has made it possible for my husband and I to have our own businesses. Now, they are successful enterprises, but they wouldn’t have gotten started at all without credit cards.

Our story – is, so far, a happy one, with that debt paid off, but we all know that anything can happen and it’s great to hear your perspective: the world won’t stop spinning on its axis if the worst happens and you have to start all over again.

I keep trying to remind myself that the real currency is experience and knowledge and ability – to do it all again if you have to.

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