You will run into a lot of personal finance websites that will give you advice about debt. Most of this advice will be about how to reduce it since consumer debt in the US averages $132,086 per household that carries debt. $15,310 of that is credit card debt according to www.nerdwallet.com. There are many articles to help you get rid of that debt but I would like to look a little closer into how you may be able to use debt to your advantage while also explaining the risks of doing so and how you can take a measured approach to these risks.
Good Debt Vs, Bad Debt
You may have heard that there is good debt and there is bad debt. Usually the bad debt is considered consumer debt like credit cards and auto loans and the good debt is the mortgage on your home. What is the difference between them? Well first is the interest rate, usually credit cards carry very high interest rates. Rates can be as high as 20-26% for some balances on credits cards, even if you have a good credit score. Even on the lowest rate cards I can find through places like www.usaa.com are at their lowest about 10%. Don’t forget that these are also adjustable rates so the bank can increase your rate in any given month. The reason they are so high is because they are what is called unsecured debt, if you decide to stop paying that credit card, the bank has no assets of yours that it can seize right away to try to make up for its loss. It’s risk vs. reward for the bank and even with a high credit score this is a riskier bet for the bank so you end up paying for it through the interest rate.
This is not the case with auto loans and homes. You pledge your car or your home as collateral to the bank and they can seize either of these assets after a period if you stop paying your loan against them. This is what keeps the interest rate much lower for buying these types of assets. However there is an important difference between a house vs. a car and that is something called depreciation. A house can easily increase in value (appreciate) in many places, while, with the exception of some collectible cars, all cars start to depreciate in value as soon as you take them off the lot. Usually what happens is the car starts to depreciate at a similar rate to that which you pay down your loan balance, hence giving you a negative return over time. Combine that with the fact that you borrowed to pay for that asset and are paying interest on top of the shrinking value and you can start to understand why people will tell you auto loans are bad debt. Here are some facts about the average depreciation of autos from Edmunds.com
Based on the data provided by www.edmunds.com for the hypothetical purchase of a new Nissan 370z I charted the value of the car vs. the loan balance of a typical 5 year and 7 year amortizing car loan here:
The equity you have is the difference between the value of what you own and the amount you owe. You can see above that the purchase of a car loan with debt doesn’t leave you with very much equity even over time. Now contrast that with a 30 year mortgage and the price of a home over the same period. I assumed here that the value grew 4% annually over the life of the loan. I got this number from the higher end of the average annual growth rate of home values in the US since 1980. The average for the whole country was 3.6%, if you were in a place like San Francisco or New York it was more like 5% so just for fun, let’s assume you are on the luckier side here.
So now you see the argument for using debt to buy a home vs. using debt to buy a car or just buy things that don’t appreciate in value in general.
Of course this is all due to what housing market you choose, as you can see below, those in Detroit and Houston were not as lucky as those in New York or San Francisco.
If you go by the above, after 30 years if you lived in Detroit and assuming you lived in a neighborhood that remains decent to this day, your home value still increased at around 2.9% annually (Q2 1986 to Q2 2016) whereas in New York City the annual increase in housing prices over the same period was 11.9%. A big difference to be sure, but still positive which still makes borrowing feasible in either place in the long run as opposed to what we saw with auto loans.
Hence the Good Debt vs. Bad Debt Argument
So why do we care about this? The point of the good debt vs. bad debt argument essentially says that mortgage debt is god because you invest the proceeds in an asset that increases in value while loans for things like cars or consumer goods (pretty much everything you buy for consumption, new shoes, a bag, eating out etc.) either lose value quickly or in the case of a nice dinner, immediately go to $0 in value after you have eaten it, but what about if you used your money wisely and could use debt to purchase other assets that increase in value besides just a home? In the finance world, another name for this is leverage, and it is essentially what a bank uses to make money.
How a Bank Works – A Ton of Debt (Leverage)
So essentially a bank works in this same way, they borrow a ton of money (in the form of deposits, bonds loans etc.) at one interest rate and they then lend that money out at a higher interest rate. After the costs of doing business, the difference the bank makes and what it costs to borrow all that money is called the net interest margin. Why is this relevant to you? Because you can essentially do what a bank does, the key difference is that the cost of borrowing for most of us is a bit higher than a bank so you have to choose the investments you make wisely.
How You Can Start Acting Like the Bank
The first thing you have to do is determine is how much it costs you to borrow money. Let’s say you have $420,000 and you want to buy a house and the house you like just so happens to cost $400,000. After transaction costs you have nothing left, but over the years your home will grow in value, maybe by say 3.5%. That 3.5% or $14,000 in the first year is the return on your investment. But what if you only had to pay for a portion of the house and were able to use the rest of the money to invest in something else? Here is where it gets interesting.
Let’s assume instead that you get a typical 30 year, fixed rate mortgage in which you pay 4.0% at today’s rates. Your down payment and transaction costs bring your savings down to $300,000, but now you have a house, so you decide to take this $300,000 and invest it in the stock market instead. Let’s also assume that you are able to let that money sit and do not have to touch it for a very long time, let’s say 10 years. Many assume a 7% long term annual return on a broad based stock index which I will do here as well (take a look at an explanation for it here. Let’s see how these decisions will play out over time assuming a 3.5% growth rate in the value of your home, a 7% growth rate in your stock market investment and you keep your day job in order to keep on paying the mortgage of your home.
As you can see above, after only about 10 years, you can have a net worth of almost $1 million. These results come from understanding long term growth (i.e. you are not checking the stock market every day in this hypothetical example) and the use of leverage to increase your return (i.e. using debt to help your money grow faster). This is a well-known phenomenon used by corporations, who try to find the right balance between taking on debt to fuel growth and not taking on too much debt that you sink the company if things go bad, like for example in the case of an individual if you lose your job and have to live off your savings for a stretch of time. It is better illustrated in here where we can compare 3 different scenarios of decisions played out over 10 years.
The first is where you take the mortgage and invest your $380k in the stock market and you get the benefit of the home value growth and the growth in the stock market (the leverage option). The 2nd is where you simply buy the house all cash down and the third is where you don’t buy a home at all, you continue to rent and you simply put all the cash you have in the stock market.
As you can see the option that uses leverage produces the fastest growth in your net worth even with the slow 3.5% growth in the home. Interesting enough, the outcome that produces the lowest net worth is the one where you pay all cash for your home, and this is due to the fact that the investment in the home has the slowest growth rate. But what is it about the option with the mortgage that makes your net worth grow faster? Because leverage is like rocket fuel to growth rates. If we break it down even further and look at the growth rate of just the home equity investment with the mortgage, you start to see why this option produces a higher return over time.
So here you can see that due to using the mortgage, the debt actually increases your rate of return on the home although the growth rate falls over time as you pay down your mortgage as you can see to the right. This is why people tend to refinance their homes when the price rises. They can “tap into their equity” and go back to an 80% debt to value ratio, by taking out a new loan and paying the old one off. In my example above though we are assuming you did not do this and just continued to pay down your mortgage over time.
In essence this takes us back to what a bank does and how it makes money. In this case you are the bank, you borrowed and you invested the balance of those borrowings in an asset that grew over time. A bank does the same, it borrows in the form of deposits and issuing bonds and takes the proceeds and invests those in assets that produce income like auto loans home loans and commercial. The key is the difference in the rate of return vs. what you are paying to borrow those funds.
This is a great example of how you don’t have to be a financial wizard to use debt to increase your net worth over time. In part II of this I topic, I will show you how you can use leverage for things other than a home to produce hedge fund like growth rates and why the interest rate that you pay becomes even more important when using leverage.
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