Good debt vs bad debt
There are two types of debt, good and bad. Good debt is borrowed money that, over time, will see an increase in the value of whatever you used it for. For example buying property or shares, investing in a business, buying antiques or just investing the borrowed money in something that returns more than the cost of borrowing the money in the first place.
Bad debt is borrowed money on items that will return you no money, or borrowing for an item that depreciates in value so eventually you have something worth nothing. Examples of these are cars, toys, consumables, and most credit card debt.
Unless you buy classic car that goes up in value, why buy an expensive car if you have little money?
If you are rich and want a $100,000 car then you could probably just pay cash for it anyway, but if you only have, say $20,000, why on earth would you want to sink the whole lot into a car that will eventually be worth nothing in 5 to 10 years time? That's a poor investment.
If instead you bought a car for $2000 and invested the rest ($18,000) wisely over a period of time you may then be able to buy the $100,000 car later in life with the wealth created by this investment alone. To sum up, having lots of bad debt is not good and having good debt is not bad.
The power of leverage to accelerate investment returns
To create wealth you need to use the power of leverage. By this I mean that you have to borrow money to invest (good debt). Consider this example:
Say you gave John and Bob $200,000 each to invest in property. John decided to buy one house for $400k putting in the whole $200k but Bob decided to buy two houses for $400k each putting down $100k on each. On day one (assuming the value of the properties are what they paid) both John and Bob are worth $200k each.
Over the next ten years John’s debt will cost him less as he only has $200k borrowed but Bob has $600k borrowed. If you say that the extra $400k that Bob borrowed was at 7% then over the ten years it would have cost him an extra $280k in interest payments than John. However, after ten years, if property values continue to double every ten years (like they have over the last 50 years) then John’s wealth would be $200k + $400k = 600k, but Bob’s wealth would be $200k +$400k +$400k - $280k = 720k. If Bob bought 4 houses instead of two then his wealth would be closer to $1M. That is the power of leveraging.
Shares v Property
People often wonder whether it is better to invest in property or shares. My answer to that is that they both have their merits and disadvantages. Property, as just discussed, can be leveraged so you can create more wealth over time by using the bank's money to increase you own wealth. Property is something you can see and look after. The downside of property is that you have tenants and tenants can cause you all sorts of issues from not paying the rent to destroying the place. Also if you need the money back in a hurry or have to sell in a downturn then you can lose out.
In the case of shares, generally you put in all the cash to buy them, although you can use margin calling to leverage against them. This could be unwise, because if the share price falls and you are asked for the money back on your margin call and do not have any then you have to sell the shares at a loss. That was one of the reasons the stock market fell so much in 2007-2008 as a lot of greedy people were margin calling and had to sell their shares to pay the margin calls back.
Shares are liquid so on any given market day you can sell them and get your money back. You can also only sell part of an investment too, unlike property. Another advantage of shares is that apart from buying them there is no real cost or time in maintaining them.
I think it is best to have both investments even though the shares will probably yield you less over a long period. It just gives you that flexibility and cash flow when you need it.
Keep your eyes peeled for the next installment in a few months.
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