Having a huge amount of debt forces you to be a slave to your money. Bogged down with repayments, you will not be able to achieve what you want in life. What’s more, the possibility of you losing your job – and hence be unable to service your debts – will constantly weigh on your mind. With proper financial planning, however, you can avoid taking up excessive debt to help reach your financial goals.
There is a psychological aspect to borrowing money that you must be aware of. When you fund a goal through debt for the first time, it gives you a false sense of confidence that you can keep borrowing money to achieve your future goals.
But as your debt levels builds up, you will soon realise that this is not a sustainable way of managing your money. At some point, most of your income will go towards servicing your borrowings rather than chasing your dreams and goals.
Being free of debt also means being able to take advantage of opportunities when they come up. This could be starting or investing in a business, or taking a sabbatical from your job to avoid burn-out. You will be unable to pursues such opportunities if your money is tied up paying off loans.
Having said that, is there a situation when taking on debt makes sense? The answer is a resounding “Yes!”. There is a positive side of debt known as leverage. One good example of leverage is when you buy a property.
Say you pay a 20% down payment for a $1 million property (which works out to $200,000 in cash) and borrow the remaining 80% (or $800,000). If your property’s value increases by 20% to $1.2 million, your actual gain from this investment is almost 100%, because you had only used $200,000 of your own cash.
So in this case, borrowing the $800,000 to help finance the purchase of the property makes sense because you are able to make a profit that you would not have been able to if you didn’t take on this debt.
So how do you decide if you are in a debt trap or if you are leveraging effectively?
To help you along, here are my three golden rules to ensure you leverage effectively with good debt and stay away from harmful bad debt.
1. Never borrow money to spend it on something that you can live without
Before you consider a debt option, explore other alternatives first. Do you really need the item that you are borrowing money to purchase? If it’s not that urgent, it is probably better to save up for it and avoid taking a loan.
2. Differentiate between Good Debt and Bad Debt
Good and Bad Debt is differentiated by what your savings are doing for you.
Let’s say you keep all your money in a normal savings account at an interest rate of 0.05% per annum (p.a.), any debt that has an interest rate higher than 0.05% p.a. is considered a Bad Debt. However, if you have invested your money into a dividend portfolio that pays 4% p.a., taking a loan that charges of 2% p.a. can be considered to be a Good Debt.
To put it another way; assume you have $100,000 in excess cash and you can choose to either clear an outstanding loan or to invest the funds. Following the concept of Good Debt, Bad Debt, you will only pay off the loan if the interest rate you are being charged is higher than the interest that the investment is offering.
In most cases, you will usually not pay off your home loan early even if you have excess cash as the interest rate is low, and you should be able to invest the money in a security that can give you a higher return.
Do take note also that if the interest rate on a loan goes up (for example, if it is based on a floating rate), a Good Debt can become a Bad Debt.
3. The asset you purchase should have a good chance of appreciating in value
Leveraging only works if the asset you are buying with borrowed funds goes up in value. A smart investor only borrows if they can make enough returns to more than cover the loan and interest payments; leaving them with a profit.
However, you need to be mindful that there is no such thing as a sure thing investment, and there is always a risk that the asset doesn’t appreciate in value.
Higher risk investments have the potential to offer high returns, but the opposite can also hold true. The higher risk means there is a greater chance that you might make a loss. As such, you have to be careful in selecting the assets that you are leveraging to invest in.
Using debt wisely will help you achieve many more things in life.
Speak with a GoalsMapper consultant to find out more about how leveraging can help you.