Chapter 1
Good Debt and Bad Debt
Most of us think we know what debt is all about. All we have to do is check out the bills we receive and our credit-card balances.
We borrowed, and we owe more than we borrowed because of interest charges. So we have to pay it back.
What else is there to know?
A lot, as it turns out. When I was in college, I bought a book with an odd, counterintuitive title:
How to Borrow Your Way to a Great Fortune.
The author, Tyler Hicks, sang the praises of OPM, which stands for Other Peopleâs Money. His thesis is if you can put other peopleâs money to better use than they can, then borrow it.
Pay them interest, of course, which theyâll be happy to view as the highest and best use of their funds. But youâll know better, because youâll be bringing in a much better return on their money than they are receiving.
This may seem abstract, but it isnât. It is the age-old capitalistic concept of buying low and selling high. In this case youâre buying, or, if you like, renting money.
And then youâre reselling the same money you have been loaned, but at a higher rate.
Technically and quite practically, youâre going into debt for the purpose of turning a profit, or in some cases with the idea of building long-term wealth.
Seen this way, incurring debt is not only OK and not to be avoided, but it is something to purposely acquire, because if you use it in the right way, debt becomes an asset.
Just as you need steel, plastic, and increasingly today aluminum, to build cars, you need debtâand the more the merrierâto create wealth. Thatâs what Hicks is saying.
This is good debt. Debt that puts you in a better position tomorrow than youâre in today is actually positive.
If thereâs good debt, there must be the other kind, correct? Yes, it is bad debt. And weâll get to that in a minute.
But letâs start with an example. If you buy a house, as a general rule you are taking on good debt. Why is this? As you know, homes usually appreciate in value.
Theyâll sell for more in the future than they do today. And despite tax reform, which has limited the amount you can write off of your property taxes, there are still advantages to home ownership.
For one thing, as long as you pay your mortgage, taxes, and insurance, and the state doesnât forcibly buy your home to blow it up for a new highway, you can live there, uninterrupted, for the remainder of your days. That confers serenity, which is an antidote to the other stresses of modern life.
This peace of mind and ability to plan where you will be in the long term delivers âpsychic income.â You canât cash it in at the bank, but it is meaningful.
If you contrast it with the insecurity renters can feel, being subject to big price increases and the whims of owners, who can sell your home out from under you, there is much to be said for home ownership, if only because of the feeling of control it confers.
Of course, one of the downsides of stiffing themâwalking away from your billsâis that it can make qualifying for a home loan later on more difficult. However, there are various workarounds.
You can get owner financing, if the people that are selling have the deed to the place and are willing to carry back all or part of the mortgage amount. This is a smart strategy even if you have sterling credit, because you can avoid paying high loan fees to conventional mortgage lenders.
Of course, even with bad credit, if your down payment is sufficient, you can find lenders that are willing to take the risk. They know that in case they have to foreclose, they will receive their entire investment back.
Iâm getting afield here. Suffice it to say that home ownership is mostly a good idea, and the debt it requires you to take on is good debt. It positions you well for the future, because it is an appreciating asset.
In How to Borrow Your Way to a Great Fortune, Tyler Hicks recommends buying a lot of houses and renting them out. If your rents cover your expenses, youâre in good shape. And he is very high on the idea of getting owner financing.
The key to real-estate investing is leverage. Basically this means that the less you need to put down in cash to buy a property, the better your gains will be.
Letâs say you purchase a home for $400,000, and it appreciates in value by 3% per year on average. After youâve owned it for a year, it is valued at $412,000. On paper, you have âmadeâ a gain of $12,000.
If you made an initial down payment of $80,000, your âreturnâ on that investment is NOT $80,000 times 3%. That would be $2400. A decent stock could pay you that amount in dividends.
Your return is actually 3% times $400,000, or, as I said before, $12,000. Youâve made a nifty 15% return on your $80,000 down-payment money in a single year.
Letâs say, instead of $80,000, which is 20% of the purchase price, you could buy for only 10% down, that is, by investing only $40,000. Then that $12,000 gain would represent an astonishing return of 30% to you.
Thatâs just year one. Through what is often called âthe miracle of compounding,â your home, now valued at $412,000 will appreciate by 3% in year number two. That means it will increase by $12,360, and will be worth $424,360.
If you put down $40,000, you will have already realized a payback of 60.9% of it after 24 months. After your year three, the home will be valued at $437,090.
By that time, your payback on your down payment will be almost complete: youâll be looking at a return of 92.7% of what you originally put in.
The miracle is that your 90% of debt on the property is earning you money at compounding rates of return, while you are repaying your mortgage at simple interestâ while you are mowing the lawn and eating breakfast and sleeping soundly at night.
This isnât just good debt, itâs GREAT debt!
I should point out that if you sold your home after one year, using a realtor, your gain would probably be eaten up by his or her fees, which typically run 5%. But youâre not going to cash out that soon.
Plus, you can always take a short course and get your own real-estate sales license. This could be used to negotiate a split of commissions with the listing realtor. Iâve done this, and I currently have a California brokerâs license, entitling me to a bigger slice of the pie.
Once more, good debt positions you for a better future. Bad debt does the opposite. It mires you in the past, paying for trifles that depreciate in value or have been completely consumed.
Buying clothing on a department storeâs credit card is an example of bad debt. Typically clothes are fashion items, designed to become obsolete after a season or two. They are poorly made and wear out easily. And they cost too much.
Now on top of these faults, youâre borrowing to finance these flimsies. Thatâs just all kinds of stupid. Over time, my philosophy has become, âBetter to wear it out than to throw it out!â
When we were playing tennis the other day, my wife noticed my shirt was becoming more holes than shirt, so we tossed that one away at the park. I kid you not. Iâve extended the life of so many things that when I do buy a half-dozen new socks, as I did yesterday, itâs time to break out the champagne!
I would also classify some student-loan debts as good ones. You might expect a guy with five earned degrees to say as much, but I mean it. As Plato reportedly said, âEducation is the one good thing we canât get too much of,â and I agree with him.
But there are smart ways to take on student-loan debt.
For example, as a general rule, federally insured student loans are not dischargeable in bankruptcy, with a few exceptions that I cover in another section. But as I write this, I can tell you many PRIVATE student loans can be wiped in a Chapter 7 liquidation case.
That is something to remember if you believe there are three immutable forces, death, taxes, and student-loan repayments!
I have to say you need to attend an accredited institution of higher learning or a trade school that has a solid track record of placing its graduates in paying jobs.
Donât kid yourself that a buy-your-degree-mill that is in the printing business and not in the education field will do anything for you except take your dough and put you into debt.
I appeared on the same dais as a prominent speaker and up-and-coming author. He called himself Dr. So and So, and he referred to himself that way throughout his talk.
We got to know each other, and I had a client who was seeking another speaker for an annual sales meeting. I thought this fellow would be perfect. But that âdoctorâ title didnât quite seem right. Dynamic as he was in speaking to audiences, he didnât strike me as the type that would really develop new knowledge, as legitimate PhDs like me are trained to do.
So before putting his name into play for the occasion, I looked up the school that granted his doctorate. Actually, I asked the research librarian at the University of Southern California, from which I graduated, to do it for me.
He reported that it was a diploma mill. If you paid enough money, you could use your life experiences as substitutes for attending classes. And you could tender a simple research paper and call it your âdoctoral dissertation.â
Long story short, my new pal was a phony. Well, at least his degree and his claim to being an intellectual were fraudulent.
I called him and urged him to drop the âdoctorâ title. âYou donât need it,â I said.
He did exactly that. He was a smash hit at my clientâs event, and this same fellow went on to become a coeditor of one of the best selling self-help books of all time.
His phony degree was a time bomb. Sooner or later, he would have been unmasked as an impostor.
Donât go into debt to get that kind of pretend education.
That said, there are some other things to avoid. Paying out-of-state tuition, which is about the same as private university prices, is dumb. If youâre going to attend a state school, go to your own.
Also, community colleges can be a tremendous bargain for the first two years, even at todayâs prices. When I went, I paid the grand sum of $7.50 to take up to 18 semester units.
Thatâs not a misprint. Seven dollars and fifty cents is all I paid for that virtually limitless buffet of classes, all of which counted toward my degree, which I completed at a state university. Then I went on to get my MA at State and my PhD on a partial scholarship for year one, and then on a fully paid assistantship for years two and three.
My MBA and JD were earned at expensive private schools. By the time I attended, I made enough income to pay for these out of pocket as I went.
To pay my living expenses, I took out federally insured student loans, which I paid back with ease after they became due. But they were deferred for years while I earned the MA and PhD.
This is worth a comment. Remember my economics professors at community college, who looked at us straight in the eye and made this suggestion:
Borrow heavily when youâre young, because youâll be paying back in cheaper dollars!
What did he mean? For one thing, we can (almost) always count on a certain amount of inflation to make our currency worth less and less. When I did repay my loans, I was paying 7% interest on top of the principal I borrowed.
But the cumulative amount of inflation between the years I borrowed and when I repaid vastly exceeded 7%. Ultimately, I paid back in 25% cheaper dollars.
Plus my degrees became worth more and more as time passed because there was infla...