Whether you blame peer pressure or clever marketing campaigns, I think we can all agree that the pursuit of status symbols and instant gratification has come to define our modern culture. When we want something, we want it NOW. And we don’t just want it, we NEED it.
Something about the phrase “low monthly payments” has a tendency to overwhelm logic and reason. Our rational, objective side gets trampled by emotion as we thumb passed the cash in our wallet in search of plastic. Out comes the credit card.
Debt represents an interest-bearing liability on a balance sheet. Some party has loaned you money, and now they’re charging you interest for providing that service. Trillions of dollars are built on this simple model. This is how your bank works, this is why Macy’s offers a store card, and this is how American Express has generated billions of dollars in profit since its inception back in the 1800s. Our entire financial sector is centered around this concept.
In my years as an investor, I’ve come to realize that not all debt is created equal. And to properly evaluate debt, we need to break it into two distinct categories: consumer debt and investment debt.
To briefly summarize, consumer debt is a financial burden, while investment debt, when used correctly, yields income and profits. I’ll give you a couple examples of this dichotomy in my personal life to help you understand the concept.
UNDERSTANDING CONSUMER DEBT
Consumer debt is created when you purchase something using debt, you personally pay for that debt, and the transaction provides minimal or no financial return.
It often takes the form of a car loan, furniture payment plan, or an outstanding balance on a credit card. Because you’re personally responsible for this debt, it requires an outflow of cash from your bank account on a consistent basis. It’s like having little income vampires that are constantly draining money out of your checkbook. As a result, you can only afford a limited amount of consumer debt before it starts having an adverse effect on your financial standing.
I used to have a car payment, which means I borrowed money from a lender in order to finance the purchase of my vehicle. Every month, I’d send a check to the credit union. It shouldn’t come as a shock that the money I borrowed for the car came with a catch – it was an interest-bearing loan.
Once I had paid off the auto loan, I ran the numbers and realized that I had paid over 30% more for that car as a result of my consumer debt obligation. Hmmmm… not good. That $16,000 car ended up costing me nearly $21,000. If that was the price on the windshield at the dealership, there’s no way I would have bought that thing.
Same story with credit cards. Visa loved me. I paid the minimum balance every month just to keep the wolves at bay. Little did I realize, that’s a guaranteed recipe for lining Visa’s pockets with your hard-earned money. Credit card companies absolutely love when people do this. It’s how they maximize the profits they extract from interest charges.
Since those experiences many years ago, I’ve vowed to always minimize my consumer debt. I now pay cash for my cars and I pay off my credit card balance at the end of every month. Those two simple decisions have allowed me to avoid paying thousands of dollars in interest charges over the years.
My advice to you is this: whenever possible, avoid consumer debt.
UNDERSTANDING INVESTMENT DEBT
Investment debt is a different story. It’s created when you use debt as leverage to acquire an investment, someone else pays for that debt, and the transaction provides a financial return. The appeal to using debt to acquire investments is that it amplifies your investment returns.
For example, if you invest $100 and earn $8 from that investment, your return is 8% ($8 in income / $100 of invested capital). Now let’s say you use $50 of your own dollars and borrow $50 (a total of $100) to purchase that same investment that earns you $8. Now your return is 16% ($8 in income / $50 of invested capital). See the benefits? Your rate of return just doubled. That’s why investment debt can be a powerful tool when used correctly.
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Several years ago, I used a bank line of credit to build an online business. The payment for that line of credit was covered by the cash flow from the business through customer transactions – someone else was paying for the debt. Moreover, that prudent use of leverage increased the rate of return I received from the business.
Currently, I use investment debt in the form of a mortgage on my rental properties. The payment for that debt is outsourced to my tenants. And much like the business line of credit, the use of leverage to acquire the rental properties enhances the return I receive.
Please understand that there’s nothing wrong with investment debt as long as it’s managed well and used conservatively. That means you do NOT overextend yourself. Use investment debt wisely. Running out and buying properties with your credit card is a highly leveraged approach and can lead to disaster – that’s not using investment debt wisely.
In my personal portfolio, any investment debt I have is tied to an asset (rental property, business, etc.) and the debt payments are well covered by the asset’s operating income. Moreover, I keep ample cash reserves in place to cover any debt obligations in case of emergencies or a challenging environment.
So, do you see the difference? Consumer debt – bad. Investment debt – good. It’s okay to use debt as a tool, just use it conservatively, make sure someone else is paying for it, and be sure that the investment is providing a positive return.
As we approach the end of 2012, I’d like to propose a key question to you:
“If you could live this year over again, knowing what you know now, what would you do differently?”
This can be a very introspective and thought-provoking question. It forces you to evaluate your reasoning and your decision process. This is your opportunity for reflection. Go for it.
Those are my thoughts. Feel free to share some of yours below. Thanks for reading and as always, make it a great day.
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