I’ve been doing some thinking lately about good debt versus bad debt. There are a number of different ways to look at the distinction.
The first is the same view that is shared by a lot of personal finance bloggers, particularly the ones that were once in a heap of debt. They all think it’s terrible, and leads to nothing but shame, despair, and pants wetting, for some reason. Indebted people totally piss themselves all the time.
The most common of these people are the ones that were encumbered by tens of thousands of dollars in student loans. They worked hard to pay off their loans, dammit, and never want to be in debt again. I can at least understand that philosophy, even if I don’t agree with it.
Student loan debt is the greatest investment the average person can make, assuming they do it properly. And this is coming from a guy who thinks the whole world overvalues university. Say the average high school graduate makes $30,000 a year and the average college grad makes $50,000. It costs you $30,000 worth of student loans to make that happen.
This translates into an investment of $30,000 to make an additional $20,000 per year. That’s a 66% return. I would strangle 4,000 hobos for a 66% guaranteed return. You think I’m kidding. I’m not. I would 100% do that. BRING ON THE HOBOS.
There are many other kinds of good debt. If you borrow money at 3% to buy an investment paying you 8%, you’re ahead of the game, provided the value of said asset doesn’t decline. Hell, you can even argue a mortgage on a principal residence is good debt, since a portion of each payment goes towards principal.
Good debt exists. The term is often abused by people with an interest in getting someone to buy property or go to school, but it’s still very much a thing.
Load up on good debt
The goal of many people is to get out of debt. Or if they’re already out of debt, they don’t want to get back in it.
I think they’re looking at the world through their own personal biased lens. They’re letting a sour experience turn them off of one of the easiest way to goose investment returns.
Look at it this way. Say the market returns 8% annually and you have $50,000 to put in it, today. That investment would be worth a million bucks in 40 years, taking off nothing for taxes, fees, etc. Not a bad result.
What if we used a little leverage to add to the original investment? Nothing silly, just 20%. Instead of investing $50,000, we invest $60,000.
The results are striking. An extra $10,000 turns into more than $300,000 extra over the lifetime of the loan. If you borrowed at 4% and never paid a nickel of the loan off, borrowing costs would come out to $16,000, plus the $10,000 originally invested in the first place. It would cost $26,000 to make an extra $300,000. Oh, and the $16,000 would be tax deductible.
Debt is a very good thing if you can leverage it into better earnings. It might not work out in the short-term, which is why you need to keep it a reasonable portion of your portfolio.
How much debt?
That is the question, isn’t it? Just how much debt should you have on your personal balance sheet?
Over the long-term, I think I’d like to see about 20% of my portfolio be encumbered debt. That’s low enough for me to never have to worry about a margin call, but high enough it’s still doing some good.
I’d also like to tie this debt to assets that aren’t in the stock market, ideally. Margin debt forces me to mark to market each day. Debt borrowed against my private mortgage portfolio doesn’t.
You might be comfortable with more, and that’s cool. When I was younger and aggressively buying rental houses, I owed more than I was worth. I had less to lose back then, and was therefore more open to taking larger risks.
Let’s wrap it up
Borrowing money to invest is one of the best ways for average people to supercharge returns. Be smart about it and limit exposure to one asset class, and for the love of God, don’t borrow to buy crap. This is strictly to invest.
If you do it right, you’ll end up with more money without taking on much more risk. Feel free to give me some of it as a thank you. Cheques can be mailed to [Ed. note: Sorry, out of space].