How many are taught that all debt is bad debt? Don't worry this isn't a Dave Ramsey style rant against having debt. Although there is some debt that is bad, debt can be a good thing when used correctly. In this blog, we will discuss the difference and outline how to utilize debt to your advantage in a business setting.
First, we should begin with what makes debt bad and burdensome. The answer is intuitive, debt that is not being leveraged to use for investments purposes are bad debts, in addition to liabilities that do not provide benefits to exceed the expected returns if invested. For instance, buying a car and getting personal credit cards with 20% interest rates are not helpful in building wealth, but it does help you establishing credit which is needed in some aspects of the business. So, the tradeoff is that you may need to take on bad debt, in the beginning, to leverage good debt in the future. As a result, one must have discipline which is where many of us fail. Finally, the best part about debt is that in a corporate structure it is cheaper to use debt that equity but the ratio must be relevant to the companies specific industry.
Are student loans bad debt? Not entirely, student loans are a result of investing in yourself. However, the debt incurred is only valuable if the degree has value in the marketplace. For instance, many STEM majors provide 6 figure incomes after graduation while education, history, music, and other liberal arts degrees may cost a similar amount and offer much lower rates of pay. Also, trades are not spoken on frequently but some of the quickest and cheapest ways to learn high paying skills because of the massive shortage of trade skilled labor.
Is buying a home a bad investment? It depends on your situation. For instance, if you want mobility, then a single-family home might not be the right decision. However, if you are settled in a career and focused on staying in one location, then it may be beneficial to buy a home if rental rates are higher than a mortgage. When working with residential real estate clients, I always encouraged first-time home buyers to look into duplexes or fourplexes as their first property. The reason for this is because they could obtain the same loan and reap the same benefits from first-time homebuyer programs and down payment assistance while getting three extra units to add to their income and increase the amount of property they can buy. After one year, move out and rent the other unit, then buy the single-family home while the fourplex or duplex pays for both properties.
Are credit cards and lines forms of bad debt? Credit cards are not useful forms of debt because of the high interest rates. If the interest rate is 15%, it is still a very high rate and on a $10,000 loan that is still $1500 in interest annually. Alternatively, credit lines may be attached to a company account or personal account that acts as a liquid asset with a lower interest rate than credit cards; these are useful only if the investment decision yields a higher return than the interest rate or the project has a positive net present value.
Is getting a loan against an investment property a bad debt? In most cases no, unless the income from the property will not offset the debt obligation, then it is a bad investment decision. Also, with all investments, there must be an entry and exit strategy. The reason this is important is that you either will need to pay yourself or other investors and knowing when to capture equity or increase cash flows are crucial in the investment process.
Is debt bad to start a business or do product launches? It depends on the agreement made between the firm and its investors. However, many companies use phase funding to get their products off the ground. For instance, Amazon used phase funding to start the company with the first investors putting $50000 into the business to raise a total of 1 million dollars. An important note is that phase fund utilizes either debt or equity from within corporations.
Similarly, the way payment is given to an investor is dependent on the corporate structure. For instance, will the company give dividend payments to equity investors, and what rate of return will the debt yield to investors. As a result, companies should examine their WACC to help determine the rates to yield on debt and dividends (if any) on equity.
Where can I find good debt? If you have a high enough credit score and a viable investment, then banks, angle investors, or venture capitalist may assist you in the financing process. Alternatively, if you have cash to leverage, then trading in the forex market is another way to get good debt but very risky debt. In the forex market, you can trade on up to 400 times margin depending on the platform you are using. As a result, a $1,000 dollar investment can be traded at $400,000 but the risk of loss is tremendous. Therefore, most hedge funds and professional forex traders keep limits between 4-10 times margin.
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Mark Lester has over 5- years of experience in the real estate industry and is an active employing broker in the state of Colorado that specializes with investment and business real property sales. Prior to a career in real estate, Mark worked over 10-years in the restaurant industry. Recently, he has consulted business owners and real estate investors with helping them solve issues ranging from marketing, operational, financial, or portfolio strategies. Finally, educationally, the author holds a BA in real estate from Ashford University, in addition to an MS in finance and economics, and MBA from West Texas A&M University.