Debt Free

It's true! Debt is not always bad. Debt can be your friend if it's used correctly. The problem for most people is that they don't do so. For the majority of people, debt is a mortal enemy to be slain like a medieval dragon. It's either your financial health or your debt, only one can survive. The key to making debt your ally instead of your enemy is proper debt management. Your debt must be working for you. Used correctly, debt can indeed make you wealthy and financially secure.

It comes down to one of the three financial principles I referenced in my post on August 23^rd about strategies for financial success. That principle is leverage. You must use your debt to control appreciating assets that generate a return greater than the interest you pay on your debt. This can be used for something as simple as using 0% interest credit cards to put money in an interest bearing savings account, or as complex as using the equity in your real estate to finance other investment projects. The beauty of debt when used in combination with leverage is that the the amount of money you are paying interest on is hopefully far smaller than the amount of money that is generating a return for you.

In order for this to work successfully you must do two things. The first is to get financing with an attractive interest rate. The lower the interest rate on your debt, the easier it will be to generate value and a positive return. The second item is to put the debt into a vehicle that generates a consistently high return. I'm not talking about a new BMW, either, although they do have great resale. Typically you'll need to some sort of secured debt to accomplish this, because the interest rate on a secured debt is usually much more attractive than unsecured debt, for obvious reasons.

Clearly, the greater the asset you control, the lower the return must be in order for you to generate a positive result. The reason is simple. A small percentage increase in a large asset will be greater than a small percentage increase in a small asset. You can use your debt to generate additional net assets for you with no leverage, if you are consistently earning a greater return than the interest on the debt. However, the use of leverage will allow you to realize a substantial return even if you are paying, in some cases, a greater interest rate than you're receiving.

This can be true if:

1. You are getting substantial tax benefits from your investment. If the tax benefits are great enough, they may outweigh the additional interest you're paying on the debt.

2. The levered investment allowed you to generate additional income in addition to the investment return. This can be true for real estate or other investments, although for most people, real estate is the most like investment to allow this. Another example would be a collector car that was appreciating and also generating prize money from winning car shows (this is the definition of very risky, however). Another example would be financing a successful business. The business, if successful, would appreciate, in addition to generating a positive cash flow.

3. The amount of the levered investment is large enough. To use the real estate example again, you could pay 9% on $20,000 on order to control a $200,000 piece of real estate that the balance of $180,000 was financed at 6.7%. If, the real estate generated a 7% appreciation return, you would be generating a positive return, even though you were paying 9% on the down payment. This is because the weighted average interest rate you're paying on the property, 6.95%, is less than the appreciation of 7%. You would probably want to have a greater safety margin than in this example, however. If you combined the appreciation with a monthly positive cash flow from rental income, and some tax benefits, you'd come out way ahead.
   

So, it's possible to use debt as your friend. It can generate substantial wealth for you. You must, however, be prudent and manage your debt successfully. The key is paying the lowest possible interest on your debts and generating the best possible return from your investments. It's pretty basic, but is the proven recipe for success.