How to Leverage Debt to Earn Money
People often talk about good debt and bad debt, so what’s the difference?
Good debt is debt on an asset that appreciates in value and has a cashflow coming in that helps service that debt. The greatest example of this is property.
Say you buy a property for $200,000, with a 4% interest rate on your loan. That’s around $8000 a year that it will cost you to hold that debt. But if you rent it out for $300 a week, you have $15,600 a year coming in. That’s a $7600 buffer to pay holding costs and then the remainder goes into your pocket as extra income.
Bad debt is something that depreciates in value and you are paying it off yourself because it is not bringing in an income. A car is a perfect example of bad debt.
Debt traps to avoid
There are two common mistakes you can make with leveraging debt. You can become over-leveraged, meaning your cashflow won’t keep up with the debt and the debt grows quicker than your assets can appreciate in value. That can cause a debt trap for you.
The flipside is that if you have too much cash, you may be under-leveraged and your money is actually losing its purchasing power when it could be better put to use being invested elsewhere.
What’s the best way to pay off my debt?
It’s important to have a debt strategy; a clear strategy for how you want to acquire the debt, but also a strategy for how you want to pay it off.
Binvested founder Nathan Birch sees inflation as his biggest friend, because it will help him pay off today’s debt with tomorrow’s dollar.
Say you had 10 investment properties that you’d bought for $100,000 each and one day they increase in value to $1 million each. You could then basically sell off one of those properties and use the money to pay out the other nine loans that you’re holding.
Close to home
Nathan’s parents bought their house 52 years ago for $13,000 in Sydney. It’s now worth about $1.2 million. If someone bought that today, the stamp duty would be double what they paid for it originally. If they never paid off the $13,000 but wanted to do so now, they could have done it with 6 months’ worth of rent. This is an example of how debt becomes irrelevant with inflation.
If you’ve got cashflow coming in to service the debt, and then inflation pushes the value of the asset up, and also boosts the value of the cashflow coming in, it gives you more options to pay off that debt.
What if Nathan was different?
Nathan has 200 properties. He built his portfolio by hanging onto debt and leveraging equity to acquire more debt.
If he had instead bought his first property for $200,000 and then spent five years paying off that loan, he’d then own that one property. If that property went from $200,000 to $400,000 in that time, he may go and buy a second property, pay that off, maybe get a third… and that’s where he’d be today.
However, he understood the value of attaching debt to assets which would be inflated forever.
Debt experience is a wealth of experience
Everyone is different and this is not financial advice, but Nathan’s experience with debt was crucial in him being able to build such a large property portfolio.
If you were looking to buy a $500,000 property and your wage was $50,000 a year, it would take 10 years of saving money just to buy that property and that’s without paying taxes, eating, driving a car, and so on. It would be impossible to get that property without using debt.
But use debt to get in and when that property goes from $500,000 to $1 million, you’ve just made half a million dollars.