Massive amounts of debt have become a fact of life for many people, especially young people. Therefore, it’s no surprise that the idea of a debt free lifestyle has been gaining traction. Proponents of a debt free lifestyle claim that eliminating all debt leads to more financial freedom and less stress. But all debt is not created equal. Paying off debt certainly has its place, but under the right circumstances, taking on debt, such as in the form of a mortgage, can actually help you make money. Instead of eliminating all debt, a better strategy is to learn the difference between good and bad debt, and limit your exposure to bad debt, while remaining open to opportunities that involve taking on good debt.
Debt to Income Ratio
So, what makes some debt good and other debt bad? The key difference between good and bad debt is all about the debt to income ratio. Meaning, that if you will end up with more money in the long run, thanks to the debt, then it’s good debt. If your debt will not improve your overall income or net worth, then it is bad debt. Though this sounds simple enough, the real-world application can be a bit more complicated. Furthermore, whether debt is good or bad often depends on factors that vary from person to person and situation to situation.
Higher education can be a great example of the variable nature of debt. Maybe in your field a masters is required to move up the corporate ladder and can drastically increase your lifetime earning potential. On the other hand, maybe you’re in a field where a masters has little to no impact on your job prospects or lifetime earning potential. If you’re in the former group, taking out a student loan to pay for a masters would be an example of good debt. If you’re in the latter group, taking out a student loan to pay for a masters would be an example of bad debt.
Though there are some circumstances where it can be harder to tell if debt is good or bad, there are also some clear examples of bad debt that are fairly consistent across the board. When you’re leveraged for items that produce no additional wealth, additional income, or returns; you have bad debt. These circumstances are often what people associate with the term debt.
Examples of bad debt include boats, high end cars, beyond means homes, and of course, the most infamous debt of all – credit card debt. Credit card debt is especially nefarious because it often comes with incredibly high interest rates, and the minor benefits it may offer, such as cash back or travel rewards, rarely even come close to making up the cost of these sky-high interest rates. In certain circumstances, bad debt is unavoidable, but the less bad debt you have, the better. If you must take on bad debt, the sooner you can pay it off, the better.
The term debt often evokes examples of bad debt, but there are also plenty of circumstances in which debt can actually be financially beneficial. When you’re leveraged for good investment purposes you have good debt. But what is a “good” investment purpose?
A good investment is one that produces a sizeable rate of return and/or produces steady cash flow. A sizeable rate of return is usually considered anywhere between six and twelve percent. Why six to twelve percent? In order to truly come out ahead, you can’t just increase your investment, you have to increase your investment while also accounting for inflation. Inflation varies from year to year, but historically, the average annual rate of inflation has been slightly more than 3 percent. Therefore, a rate of return of at least six percent provides a decent cushion, so that you could reasonably expect to make a profit, even when accounting for inflation.
Real Estate as Good and Bad Debt
There are a few examples of debt that often have a good debt to income ratio, including loans for higher education, small businesses, and real estate. Debt taken on to purchase real estate (AKA a mortgage) is one of the best-known examples of good debt. But much like debt itself, taking on debt to invest in real estate is not innately good or bad debt, but instead depends on the circumstances.
If you’re looking to diversify your portfolio in an asset with historically high rates of return, real estate can be a great option. But not all real estate is a good investment. Whether a piece of real estate is a good investment or not will depend on many variables including the location of the property, the appreciation potential of the property, and the current and future state of the housing market. The decisions you make in these areas will affect how risky your investment is, and ultimately, the biggest concern when investing in real estate is the risk involved.
Real Estate Investment Risk
Investing in real estate involves risk, but that isn’t a reason not to do it. All investment involves risk. The key to smart investing is to find the balance of risk and reward that works for you. The right amount of risk varies from person to person, but when you have the ability to do so, you should absolutely take advantage of opportunities to mitigate your exposure to unnecessary risk.
A great example of this concept is diversification, which allows you to reap the rewards of investing, but with significantly less risk. Just as there are ways to mitigate unnecessary risk in your overall portfolio, there are also ways to mitigate unnecessary risk when investing in real estate.
Minimizing Real Estate Risk
There are many ways to help minimize the risk of real estate investments including being familiar with the location (this includes the city, neighborhood, and often even the block), knowledge of rental prices (if the building is a rental property), and familiarity with the real estate market.
Maybe you have all this knowledge but lack either the time or the interest it requires. Or maybe you’re looking to invest in an area of the country with which you’re not familiar. Or maybe this simply isn’t your area of expertise. No matter the reason, you still have options, including investing in turn-key real estate.
Normally, turn-key real estate firms do the due diligence for you, complete any required rehab, and often even find renters for the property. This allows you to leverage your purchasing power while taking on less risk.
Real estate has the potential to be a great investment choice, but it also involves risk. Taking out a mortgage to purchase an investment property is often good debt, that can make you money both through appreciation of the property and income in the form of rental payments. But there is no guarantee. One way to minimize risk and make sure you’re taking on good debt, is to work with a turn-key real estate firm.