Teh Chad

The debate on how any debt can be good is as old as currency. I’d like to talk about how debt can be good and how most debt is bad.

The true financial definition of good debt is debt that pays for itself. An example of this is a rental property where the tenants pay for the property loan, the taxes, upkeep, and all other expenses. The owner is paid a small sum after all of the expenses are paid for holding the full liability of the property loan.

Are the past two financial market implosions (housing and credit) making more sense now?

When someone mentions debt, most people think of their mortgage or their credit cards or their car payment. These are bad debts. They don’t pay for themselves. With those images in mind, it’s easy to see why nearly everyone thinks that all debt is bad.

Earlier in this blog, I posted a pretty long piece on the sides of the interest rate. This blog was very focused on getting out from behind the interest rate, or debt, and getting ahead of it, or investing.

The housing implosion was a result of a few things. People had become a bit too aggressive in their real estate investing. Many people were taking a small monthly hit to make sure they covered their expenses. In contrast, they could have been a bit more conservative and made sure that their loans would be covered by the value of the property.

Around this time, property values were going up and not slowly. When people bought property, they were paying a lot versus the true value of the property. This was coupled with the fact that banks were offering loans with relatively small down payments. These down payments are normally designed to offset any variance in prices for the given property. When prices blew up, initial principals, or down payments, should have followed.

As the bubble worked itself bigger, more and more loans were utilized with less protection. More people were vulnerable.

Then a few people lost their jobs as big companies turned out to be corrupt. All of the sudden, people could no longer take that small hit on their income properties since they didn’t have jobs. Their debt was bad. It was about to get worse. The housing market came full swing.

After a while, the banks put properties into foreclosure and sold them off where they could. However, there was a problem. The bank could not sell the property at a price to cover the loan. The borrowers still owed on a loan that was backed by a property that they didn’t own any more.

Property values dropped out of the sky. They reverted back to prices closer to their true value. Some might argue that property values have dropped below their true value. In places like Detroit and Las Vegas, I would certainly agree with that argument.

This, in turn, caused the credit crisis. Banks were seeing loans defaulted constantly. They were no longer making money. They called on the government. And the government can really only pull money out of the taxpayer pockets.

So, how do I find good debt? I don’t want to go broke and then be poor all of my life!

Finding good debt requires understanding of bad debt, ergo my discussion above. Then we must see that good debt pays for itself. I like the real estate example because it is so readily available in our society.

We have found a house that we think tenants will enjoy occupying. We must first make sure that we are not paying too much overall for the property. Then we must put an adequate down payment.

I keep reading about people who just put the minimum down. This is financial stupidity in my opinion. Not only will a solid down payment give a cushion against a downswing in property value, it will increase a property’s cash flow. This is very important as random expenses happen. Stoves fail and water pipes freeze. Properties need solid financing. Once that is done, tenants are happy to live in the property and pay you consistently for that privilege.

As owners and investors, it is important that we protect ourselves against these financial vulnerabilities.