Traditionally, when we think about being in debt, more often than not we have negative feelings about it. Our parents would tell us it is unwise to take on debts. And perhaps it is best we pay off our housing loan as soon as possible. Everyone wants to be debt free! But is debt truly all bad?
Good Debt Vs. Bad Debt
Imagine that you are buying a house and you take on a loan of $300k with a loan tenure of 30 years at perhaps 3% interest per annum. Now you are in debt! Let’s see if this is bad or good.
You are going to pay interests over 30 years! That is a lot of money over a long, long time. On top of that, you are still going to pay off the $300k. And perhaps because you did not want to put in too much cash on the house, you kept $100k cash inside the bank, which pays you 1% interest per annum. The worst thing is, the house you bought is not a good asset. It has only 30 years lease left and is depreciating at an average 3% per annum!
This debt is really a bad one.
The house you bought is a good asset and it appreciates on an average of 5% per annum over 30 years. Plus, the $100k cash that you might have initially, you put it into an investment elsewhere and it has appreciated an average of 4% per annum over that 30 years. And, better yet, maybe the house is an investment property, which you have rented out and the rental was able to cover the mortgage!
Now, being in a debt is truly not necessarily bad. It can be bad, yes, but it also can be good! It all depends on some conditions. It depends on the context.
We can do our best to avoid taking on bad debts and take on good debts! We will discuss this in greater details in the next article, so stay tuned! :)
Let’s not forget we have inflation as well. What costs $1 in the past might cost $3 today. Inflation works its magic over time and has a great effect on the value of our money.
Imagine our parents’ HDB flat. It costs… $100k, 30 years ago. Perhaps they took on a $80k loan with loan tenure of 30 years. Ask yourself, what is the value of that $80k today? And what is the worth of that HDB flat now? My friends, that is the effect of inflation over time.
Think about the effect of inflation on both the value of the debt and the value of the asset (the house). It shrinks the value of debt over time (hence, a long loan tenure works well) and rises the value of the asset. Yes, inflation works both ways, and in this case, it works in our parents’ favour!
In conclusion, understanding the concept of debt is very important. With proper use of debt and leverage, it essentially allows us to make more money with the money we don’t currently have. Even billionaires take on debts! Good debts, of course. Perhaps that is how they grew their wealth and became billionaires in the first place.