Using debt to get rich

I often hear that debt is bad, and actually I spent most of my life desperately avoiding all forms of debt. I never borrowed money, I just hated the skin crawling feeling I got when I owed someone something. When I finished school and got a job, I drove a ten year old car because I didn’t want a car loan, and I wouldn’t even entertain the thought of a credit card.

When I discovered FI, and the FIRE community, this reinforced that debt was bad. Reading the Barefoot Investor and Rave Ramsays Total Money makeover hammered the points of how bad debt is. Debt is like anti investing, or anti dividends. Money you have to pay each week, and get nothing for. Or is it?

As it turns out, I’ve learned that there are two kinds of debt – Productive debt or Good debt, and Destructive debt or bad debt. Whilst desperately trying to avoid destructive debt, I also inadvertently made myself abstain from good or productive debt, like a mortgage.

Productive (good) debt

Good debt is debt that is used to buy an asset. A smart investor can use good debt to put more money into their pocket than it costs them. Essentially you use someone else’s money to buy an asset that produces an income or goes up in value. You need to be savvy, and a smart investor always looks at the cashflow on good debt.

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Cheers to Good Debt!

A Mortgage

The best example I can think of is a mortgage or a business start up loan. If you have a stable job, a good savings history and a decent deposit you can approach a lender and apply for a loan to buy a house. The most common type of mortgage would be a principle plus interest for an owner occupier loan for 80% of the property cost (80LVR) over a 25 year time frame.

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If your mortgage payments and combined holding costs (insurance, utilities, council rates etc) are less than what you were paying in rent – congrats, that debt is putting money back in your pocket every week!

Interest only loans

Even better are a form of mortgage called interest only loans. These loans as the name suggests have interest repayments only, rather than a traditional mortgage which is principle and interest (where you gradually pay down the value of the loan over the loan period). An interest only loan is never paid off, and at the end of the term you have to refinance or pay off the debt in total.

These are usually favoured by property investors that hold rental investment properties; because the interest only payments are lower, you end up with a much better cash flow or positive gearing putting money in your pocket from day one. A principle plus interest loan would mean you are gradually paying off the loan and generating equity in the property. Equity (or your percentage of ownership) is good, and you could even refinance down the track to pull out this equity for a future purchase deposit (called debt repurposing or recycling), but its not doing anything for you at the start.

Negative gearing a loan

Some people chose to negatively gear their properties, which means the cost of their loan and management costs are higher than the rent they receive. Usually people are sacrificing cash flow today in the hopes of capital gains tomorrow. Its a tax effective strategy for those on top tiers of the income tax rate, and has worked for thousands of property investors in a property boom. In a declining market negative gearing is just as dangerous as it is beneficial in a rising market. Personally negative gearing is not for me, but you get the idea.

Starting a business

Other ways debt could be good for you is a small business loan – if you desperately need capital to launch your business then you could consider a small business loan from a lender such as a bank.

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This could really accelerate your business allowing you to produce an income sooner. If you were an Uber driver, then a low interest rate car loan could also be considered a form of business loan as you are then deriving an income from it. But these do have their risks, and you are locked into needing to make repayments which is a source of stress on a new business owner.

Credit cards

Credit cards are not always a form of bad debt – spoofing credit cards for sign up bonuses (called credit card or travel hacking) can be a very lucrative source of free travel or cash bonuses, as well as using the credit cards on everyday purchases for their cash back offers.

Destructive (bad) debt

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Bad debt is debt that takes money out of your pocket. This is dumb debt. Debt that was used to buy liabilities, or was otherwise wasted. There are countless examples of bad debt being used in our society, but it essentially all boils down to living above your means.

Credit cards with outstanding balances

Using credit cards to buy things you cant afford is a seriously dangerous practice, which can destroy your wealth and lock you into a debt cycle. The incredible interest rates charged on outstanding balances mean you pay a hefty premium if you cant pay it off. To the tune of 20%! There are a number of other ‘synthetic’ credit cards or payment plans like Zip or Afterpay, where you can ‘Buy now – bleed later’, but I think its worth steering clear of these unless you have a tangible business case use for them.

Personal car loans

Another bad example of debt that I see is personal car loans. I look at the carpark at my airport and I usually look out to a sea of big 4WDs and other luxury cars. I wonder how many of these cars were purchased for cash, versus how many are on payment plans. All for a big car which from what I can see spends most of its time depreciating out in the weather (Sun and Hail).

The irony is that buying an expensive car using finance might make you look wealthy on the outside, but its a surefire way to keep you poor. Those expensive interest repayments are destroying your wealth, whilst the liability itself (the thing that the loan is secured against) the car just continues to drop in Value – on average by up to 20% per year over the first 5 years.

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5 years is the most common car loan period, although people are increasingly taking out 6 and 7 year car loans to get lower monthly repayments or afford a higher loan amount (but costs them more in the long term).

If you purchase a $60,000 vehicle on a 6% finance over 5 years, you would end up paying 60 monthly repayments of $1160 (before any additional fees or charges) which adds up to almost $10,000 extra over the life of that loan! At the end of the period, you would be left with a car worth less than $20,000 – meaning you had spent $10,000 and lost $40,000 for a total loss of $50,000 over 5 years – $10,000 per year is VERY expensive motoring, and we haven’t even insured, maintained or put petrol in the thing yet! In contrast, I spend on average approx $3,000 on TOTAL vehicle costs for an entire year, with maybe $500 or so of depreciation (the car is currently 14 years old but drives like brand new!).

5 year tax depreciation schedule for an automobile

I’m not always against car loans, and there might be circumstances where using a 0% interest rate finance (or delayed payment plan) on a sensible ex demonstrator (show vehicle) or second hand small car might be a smart choice if you need a reliable vehicle for work. But your generally always going to get a cheaper option buying second hand for cash, so there isn’t really any excuse to end up saddled with a loan.

Personal holiday loans

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Ugh. If you can’t afford to pay for a holiday, you probably shouldn’t go. Maybe check out something cheaper – I love doing road trip holidays and camping or hanging out at the beach or river, which is nearly completely free (other than the cost of some fuel, beer and food). Racking up thousands of dollars on a personal loan because your scared you wont have another opportunity to go on a Contiki tour is not a sensible choice.

Pay day loans

Pay day loans are some of the shonkiest practices I have ever heard of. The sad thing is this kind of predatory lending takes advantage of some of our most vulnerable people in our society; statistics show the highest percentage of pay day loan users are single mothers, struggling to make ends meet. Pay day lenders gouge exorbitant fee’s and interest rates, and you want to stay as far away from this destructive debt as you can.

Summary

In conclusion, debt isn’t always a bad thing, and used effectively it can make you money. But having any form of debt does present you with a level of risk that needs to be managed – economic circumstances can change and you want to make sure you aren’t going to be left drowning in debt unable to make your repayments. But I will leave you with something from one of the worlds greatest investors, Warren Buffet

‘You don’t need to use debt to make money, and someone who doesn’t understand debt certainly has no place getting into it”

Warren Buffet, CEO Berkshire Hathaway

If you enjoyed the article or have something interesting to share about debt, why not leave a comment below and join the FIREstarter community

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6 thoughts on “Using debt to get rich

  1. I don’t necessarily agree with you that a car loan is a ‘bad’ debt. Consider that most people actually need a car to go to work, and if they drive an unreliable car that breaks down that may seriously impact their performance at work which leads to a loss of income or a loss of confidence in them at work and maybe even missed promotions. I actually know a girl who was fired from her job because she was always late and then her car broke down and it was the final straw. Personally I also drive long hours for work (2 hour commute) and I also need a car to tow my boat so I am comfortable having a debt for a newer and better car

    1. Hi Ben,
      It sounds like you consider your car as a work expense. Do you claim distance travelled / fuel usage and the interest on the loan as tax deductible expenses? Personally I looked into salary sacrificing and also novated leasing of a vehicle to try and get tax savings, but no matter which way I looked at it I was much better off driving my current (14 year old) station wagon. Whilst it doesn’t have all the bells and whistles of a modern car (like reversing cameras etc) it is still incredibly feature packed and a very comfortable drive. I bought the car 6 years ago for $17K and after all was said and done (giving it a complete strip down service myself and new tyres etc) it cost me $20K. Since then, I have spent approx $3400 per year in Fuel, maintenance, registration and third party property insurance. I estimate the vehicle is worth $10K now (maybe thats a bit optimistic) so the depreciation has been about $1600 a year. So in total, thats about $4000 a year (or $77 per week) for just under 20,000kms per year (380 kms per week) – fairly cheap motoring I would say given the fuel alone is almost $40 of that. This kind of shows how poor the fuel efficiency of my car is – but its just not economical for me to trade it in for a newer model with better mileage, and I use the stationwagon for camping and transporting large and bulky objects (kind of like how you said you need to tow). How much does your vehicle cost you per year?

  2. I always get to listen that debt is a bad thing. So I never go on for of debt. But However, there is good debt also available. Good debt is debt that is used to buy an asset. A smart investor can use good debt to put more money into their pocket than it costs them. I learnt a lot from this article. Thanks a lot. This is an incredible site having lots of ideas and tips that can be handy.

  3. I took a business loan to get my company going. I didn’t have the cash myself and figured even with the fairly high 7% interest repayments I could still make it work. I ended up paying it off last year and my business is still going strong, wouldn’t have been able to grow it as fast without It

  4. I’m trying to get a loan for a car despite my bad credit. It’s good to know that you can still get access to certain kinds of loans for this kind of thing! I’ll have to see if I can find a good lender who can provide this kind of loan for me.

    1. Hi Braden, just make sure your very sure about the terms and conditions of the loan. I would advise you avoid getting a loan of a depreciating liability like a car and instead check out the second hand market. Its your decision but just understand the ramifications and true cost of that loan. Cheers

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