When I was growing up, my poor dad said, “Debt is bad.” He spent most of his life avoiding debt, taking it on only in emergencies. “That’s what credit cards are for,” he said. He also worked hard to pay off his mortgage and saved money to buy things cash whenever possible.
My rich dad, agreed with my poor dad—to a point. “Some debt is bad,” my rich dad said. “But some debt is good too,” he added. To my rich dad, taking on debt only in emergencies was the worst debt of all.
He believed taking on debt in emergencies was a sign of poor financial intelligence. It showed that you were living paycheck to paycheck, which meant you probably didn’t have many assets and probably had many liabilities.
My rich dad also believed it was good to only buy liabilities like cars, televisions, and more with cash rather than financing them. He agreed debt was bad when used for luxury items that lost value over time. But he differed from my poor dad because he believed in using good debt to create cash for those things and more, while my poor dad believed in saving and spending.
My poor dad would save money and then spend it. My rich dad would borrow money that made money for him to spend many times over.
Though I didn’t know it at the time, my rich dad was teaching me a fundamental lesson that the rich know about money—debt can make you richer, if it’s good debt.
Good Debt vs. Bad Debt
Today, many people are living by the old rules of money, the rules of the poor and the middle class. Facing uncertainty, people are saving money, sitting on piles of cash hoping things will settle down. The problem with this strategy is that savers are losers because as the Fed prints record amounts of money—the base money supply has risen three times over since 2008—savings lose value, especially as inflation kicks in and grows faster than the interest paid on savings.
Others, the financially intelligent, are making a lot of money and borrowing more of it. Why? Interest rates are at the lowest in history and many assets are priced at bargain bin prices.
The financially intelligent understand they can borrow money at cheap interest rates and use that money to buy assets that provide cash flow that covers their debt payment and expenses while putting money in their pocket every month.
Both individual investors and large companies are growing their good debt as I write. As The Wall Street Journal reports, “Banks have lent $66.6 billion this year in five-year U.S. corporate investment-grade loans, some of the longest available, almost 25 times the amount for the same time last year, according to Dealogic. Investment-grade loans to U.S. companies have more than doubled so far this year compared to the same period in 2010. Junk-rated companies have also been able to raise debt at a record pace.”
Translation: Money is cheap so companies are stocking up on it.
The power of good debt
My simple definition of good debt is debt that puts money into your pocket rather than takes money out. For instance, if I’m using debt for a business deal, I won’t do the deal unless the cash flow from the deal pays for my debt payment and expenses while providing a good return.
This assures that cash comes into my pocket each month, providing a continual income that allows me to enjoy liabilities.
The great thing about debt is it allows me to leverage my existing cash into many assets.
For example, in real estate, I can buy investment properties with debt. The bank will give me a loan for 80 percent of the purchase price while I only have to use my money—or someone else’s—for 20 percent of the purchase price. My job is to find a deal that pays the bank the interest on the 80 percent while still providing a decent return on my 20 percent.
So, using simple math, if I have $100,000 in cash, I could buy one property for $100,000 that gives off $800 a month in cash flow—a little over 9 percent annual return.
Or I could use good debt to buy five $100,000 properties. The bank would lend me $80,000 for each property and I would divide my $100,000 into five $20,000 down payments. At 5 percent interest, the payment on the loans would be around $500. So, my cash flow on each property would be $300 a month ($800 in rent – $500 in debt payment = $300 per month) for a total of $1,500 ($300 x 5 = $1,500) per month—an 18 percent annual return.
I can then use the income from my properties to either invest in more assets or I can buy something nice for myself or for Kim knowing that more cash will come next month from my investments. Rather than save and spend like my poor dad, I invest and spend like my rich dad.
That’s the power of good debt. And for that lesson, I owe my rich dad a debt of gratitude.