(The difference between Good Debt and Bad Debt)
Can debt be good? The answer is yes, as long as it is leveraged and makes you money. That is the difference between good debt and bad debt. Bad debt costs you money, and good debt makes you money. Let me explain with an example of two applications using one item of purchase…a house.
Buying your own home is a form of bad debt since it costs you money and makes you no money. Now, before you say “what about the equity?”, I will tell you that equity is not money. Equity isn’t even virtual money. It does has an equivalent monetary value, but only when you use it. Since you can’t spend equity, it has no physical monetary value. It’s a trophy. It’s a good trophy though in this case since it means you have that much less bad debt to pay off on your home. Paying off your own home is a good thing.
Having said this, I am NOT a fan of 15 year amortization, or accelerated payoffs using a structured (by the lender) payoff with 13 payments a year or bi-monthly payments. The only person this helps is the lender. The gain you make from all of this, while having the privilege of making higher payments per year, is achieved at the END of the mortgage period…which most people never reach. Why don’t we reach it? We usually either refinance or sell our homes long before that time. In fact, I’ve been informed that the average time from the start of a mortgage to the time we refinance or sell is about 7 years. During the first 60-70% of a mortgage, most of the monthly payment is for the interest charge. Can you say “huge profits for the lender”? Then, we refinance or sell, and start the clock all over again. I like to call it the “30 year mortgage for life”.
Making added payments, when you can, on the principle each month…not as part of a structured accelerated payment schedule…will add to your equity and be a much better solution to a faster payoff. Also, since it isn’t part of the structured payment schedule, if you have a bad month and can’t afford to make the payment, it doesn’t count against your credit…but I digress. Now back to the reason we are here.
Good debt. Leveraging money, through investment real estate, is a form of good debt. Why? It makes you money. How? There are a number of ways.
First, when the tenant’s rent is higher than your expenses, such as insurance, property taxes, and the good debt of mortgage with interest, you have positive cash flow. The positive cash flow is income and thus this type of investment makes you money…and therefor is a form of good debt.
Second, when the tenant’s rent payments are paying off your good debt, as in your mortgage with interest, they are building up equity on the investment home. OK. I did read the above statement and explanation regarding equity. I wrote it. This isn’t the same thing. Why? This equity you can access and use. As your tenant pays their rent, paying off you mortgage and building up your equity, you can refinance the equity out and then use it. This works as long as the resulting new mortgage payment, when added to the other monthly expenses still is less than the rent per month. Your cash flow may go down, but you are trading in smaller incremental income (cash flow) for a one time lump sum. It gets better. The cash flow is income…and taxable. The refinanced cash looks just like income, it spends just like income, it adds up just like income, but it isn’t taxed. Why? The IRS doesn’t tax a loan.
Third, even though the property appreciates…as in goes up in value, the IRS assumes, through wear and tear, it depreciates…it goes down in value, and, you can thus deduct the depreciated value as a loss (prorated over time) on your taxes. I will explain how this works in a later chapter. This has been explained many times, and I’m sure many of you are nodding your head right now and saying you know all about depreciation. I will, however, take what you know and apply it as part of my system and show how it is possible to use the concept of depreciation and turn even the taxable cash flow into a tax neutral situation.
Sorry, but you’ll need to read the book for more. The next part is based on parts before this chapter, so I chose to stop right here. You can take a look at the Table of Contents to see what else I discuss.