A Lesson on “Good Debt” Vs. “Bad Debt”

“Good debt” is defined as debt incurred to finance something that goes up in value over time, produces positive cash flow, or contributes to your overall financial health. Examples of good debt would be an investment in your primary residence or rental income property. In some cases, student loans can be considered good debt if it allows you to earn more over your working lifetime. Simply put, good debt should produce positive cash flow after all debt service.

“Bad debt” is debt incurred to finance things that go down in value after purchase, such as cars, boats, or motor homes. Consumable items, such as food and clothes if financed, are also considered bad debt. Credit card debt if not paid off each month is the worst form of bad debt because of the high-interest rates charged by banks, typically 18 to 28%.

Wealth can be accumulated when you use good debt wisely. By definition, your investment must produce positive cash flow after the underlying debt service is paid. Using leverage to purchase a property at today’s low-interest rates should produce a positive cash flow after all debt service. For example, if you were to purchase a $100,000 home with $25,000 down, your leverage would be 4 to 1. That means you control 4 times as much value as your cash out of pocket. This could allow you to buy 4 times as many properties as you could by using all cash. With the potential for appreciation combined with monthly positive cash flow, this formula can make you rich over time if used correctly.

It’s important to note if improperly structured, even good debt can be bad. I recommend 20% or more on the down payment, and 30-year fixed-rate loans. I don't recommend variable rate loans on an investment property and strongly suggest a 6-month mortgage reserve be maintained at all times for each of your investment properties.

There is an expression: “Your real estate debt today can be your net worth tomorrow.” In explanation, property values in many parts of the country have shown to double in value over a 10 year period. This has proven itself to be true by studying over 60 years of real estate appreciation cycles.

Properly structured to ensure positive cash flow after all expenses, and with an allowance for vacancy factor and repairs, real estate debt can make you rich!