Any conversation about debt always carries with it some extreme and highly charged personal opinions about how to use it, and what role it should play in our lives. With experts on both sides of the aisle making different claims, (Like Dave Ramsey saying all debt is bad, or Grant Cardone, saying debt is your best friend) it can become really confusing to form your own opinion. Today, I am going to break down two basic forms of debt, and outline a few scenarios in which debt can be extremely lucrative, and some in which debt can become shackles dragging down your growth.
What if you want to avoid debt all together? Here is a real life example of why in some situations, debt will make you way more money than cash will.
Let's say our friend Greg just inherited $100,000, and wants to put it to work for him. He's done his research, and decided that he wants to invest in some rental properties. He's found a triplex he likes, and want's to figure out whether he should take a loan out, or buy it in cash. Here is the scenario:
Scenario A: Cash
Purchase Price: $100,000
Interest Rate: 0%
Rents: $1,600/month
Amount Owed: $0
Monthly Payment: $0
Cash Spent: $100,000
Cashflow: $1,600/month
Total ROI: 19.2%/annually
Scenario A really isn't that bad. Greg is making almost an awesome return on his money, and he owes nothing on the property. However, he has used up all of his cash, and can only purchase this one property. If he has a vacancy, or major repair, this may hurt a little bit. Let's look at Scenario B.
Scenario B: Debt
Purchase Price: $100,000
Interest Rate: 4.5%
Rents: $1,600/month
Amount Owed: $75,000
Monthly Payment: $380/month
Cash Spent: $25,000
Cashflow: $1,220/month
Total ROI: 58.5%/annually
In Scenario B, Greg took an investment loan out and put 25% down on the property, which equaled $25,000 here. He financed the other $75,000, and every month, he had to make a payment of $380 per month to the bank. However, because he had only 1/4 of the money into the deal that he had used in Scenario A, his return on investment was nearly four times higher, and he still had $75,000 of his own cash left in his account.
Scenario C: Portfolio Debt
Let's say that Greg wanted to use his full $100,000, and purchase as many properties as possible leveraging debt.
Purchase Price: $400,000
Interest Rate: 4.5%
Rents: $6,400/month
Amount Owed: $300,000
Monthly Payment: $1,520/month
Cash Spent: $100,000
Casflow: $4,880/month
Total ROI: 58.5%
The important thing to note in Scenario C, is that for the same amount of cash Greg used in Scenario A, he is making $3,280 more, each month. That's a 39.3% higher return on his money.
How does it make sense that taking out debt makes more money than avoiding it? The answer is simple. Right now, the cost of money is very cheap. The interest rates, which are very low right now, determine the percentage of money you have to pay in exchange for taking out that low. When the interest rate is very low, the cost of borrowing money is very low. If you were to change the interest rate in those scenarios to 16%, all of the sudden, the return on investment you get from purchasing with cash looks WAY better.
There are essentially two categories of debt that you can separate everything into. There is:
Personal Debt: This is money that you've spent on things you want, but don't quite need. The key thing that defines personal debt is: Does it make you money? If the answer is no, and it cost you money each month/year, it's personal debt. Some common examples of this are auto loans, credit cards, and home mortgages.
The reason these things can be tricky is because they often disguise themselves as things we need. For example, we all need a car for transportation, but do we need a sports car? We all need shelter, but is it cheaper to rent? Taking on personal debt and buying yourself nice things isn't bad, if you can't do this, then what's the point of working hard? However, it is important to be able distinguish a need from a want, and make sure that you can afford what you're purchasing
Asset Debt: This is money you've spent on things you need, or things that are going to make you money. For example, you purchase a beater truck that you use to make money at work, or you take out a loan to purchase a rental property that is going to pay you every month and generate it's own income.
Taking asset debt out is almost always a good thing, but it's hard because it almost always will come at the expense of something that you would like to have in your personal life. If you purchase a rental property, it may be harder to purchase your own home right away. If you buy that work truck, you may have to wait for the sports car. The difference being that these assets will pay for themselves, and then pay you, eventually putting you in a position to buy the personal things you want, and still have the assets at the end of the day.
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