5/27/2017

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Financial Leverage--Good Debt vs. Bad Debt

There is Good Debt and there is Bad Debt. The characteristics of Good Debt might include a low interest rate, desirable terms without excessive or unexpected fees, an ability to prepay without penalty and interest that is tax deductible.

Another example of Good Debt could include debt incurred to acquire an income-generating asset that serves as collateral and helps offset or cover the payments for the debt. Examples of Good Debt might include mortgage financing and home equity loans (essentially a second mortgage on your home).

Bad Debt shares many of the opposite characteristics of Good Debt. Features of Bad Debt could include high rates of interest, a penalty to prepay and the inability to deduct interest payments for tax purposes. Examples of Bad Debt include credit cards and high interest bearing consumer product loans.

A perfect example of Good Debt could be a home mortgage loan. One advantage to this type of debt is the available tax deduction. The federal government is willing to give you free money as an incentive to purchase a home with the use of debt.

Also, mortgage financing is usually an inexpensive form of debt with minimal transaction costs. Another reason why mortgage financing is beneficial pertains to the Power of Leverage. We will further discuss the benefits of financial leverage and the use of Other People's Money.

When I talk about Good Debt versus Bad Debt, one must realize that Good Debt can become Bad Debt if abused. I am not suggesting that you take out a mortgage on your home and use the proceeds to go to Las Vegas and bet the bundle at the craps table. Nor am I suggesting that you borrow as much money as possible when there is likelihood that you will not be able to make the payments.

Good Debt is on Good Debt when the proceeds are invested wisely, the terms of the debt are attractive, and you feel comfortable that you can make the required payments under conservative scenarios.

For example, suppose you buy a house that you plan to manage as a rental property. Let's also assume that your salary from your job just barely allows you to pay your own monthly household expenses. If your rental property were to remain vacant for several months or if an unexpectedly large repair were to arise, you would be unable to make the mortgage payments on the property.

This is a realistic scenario that must be considered before you buy the house. If you miss a couple mortgage payments and are unable to catch up, your lender is going to take the property away from you through foreclosure and sell it in order to repay its loans. In addition, if the bank does not recover your full loan amount from the sale of the house, it is going to come after you and your remaining assets for any leftover loan balance.

It is imperative that people do not abuse Good Debt and turn it into Bad Debt. Always plan for the unexpected and remain confident that you can stay ahead and avoid any adverse consequences.

It will always be safer to have less debt than more debt and as mentioned earlier, everyone needs to develop their own risk parameters and comfort levels. Just like riding a bicycle, each rider can choose where they want to go and how fast they want to get there. A greater amount of debt, if invested wisely, should get you to retirement faster than having no debt. However, with a faster ride often comes more risk.

From the book Retire Richer And Faster by Robert E. Lawless

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