There are so many reasons why people have gotten into debt. I remember my first time was when I had to take a student loan. Since it was on low interest, I took the chance, feeling comfortable that I made the right move. Even if I had a valid reason to pursue such debt, it took months before I finally considered it. I had to do rigid budgeting, so I can keep my lifestyle even if it was a good decision. After paying off that first debt, it gave me confidence that I can manage my finances. Then I knew I was ready to make another purchase.
You see, when we fully pay what we owe, it builds our self-reliance that we can manage another one. There are these huge, important purchases too, such as a home, or college education, like paying for medical school. We can’t deny that not all of us have enough money to make one-time-big-time payments. What is most important though is, we incur debts that we can benefit from.
Let’s say there’s news circulating in the office that there would be a salary increase, or if we are expecting a Christmas bonus or a work incentive. Can you imagine yourself at one of these peak times if you will likely have a plan to swipe that credit card for a shopping spree or sign a payday loan?
What kind of debt would you choose? Are these the kind of debts that can potentially increase your net worth and can eventually be converted to assets?
What is good debt and bad debt?
Good debt is an investment that will increase in value or generate income in the long-term.
A student loan is an example of good debt. A college education will increase your value as an employee and will potentially grant you a stable, future income. A college degree must be carefully chosen though, to ensure that you can easily find opportunities and that your career path will lead you to maximize earning potential.
A mortgage to buy a home is also a good debt. Since mortgages are payable long-term, you can set aside some money for savings and emergencies. Over time, your home will increase in market value making it an asset.
Bad debt is a purchase of items that will lose value and will not generate long-term income, like our necessities which are clothes, shoes, and other goods and services. Credit card debt, payday loans, and automobile loans are some examples of bad debts too.
How do you calculate debt to assets?
A debt-to-assets ratio is a formula that takes all your debt and divides it by all the assets you have to give you a number. Ideally the lower the number the better.
For businesses, the debt to asset ratio represents the total amount of debt owed compared to the total amount of assets.
For individuals, it is the debt to income ratio. The number represents the total amount of debt owed compared to income.
The debt to asset/income ratio will help the creditors determine how much they would be willing to lend.
How to use debt to build long-term wealth?
If we have a plan and objective towards making a debt, we can effectively utilize it to create wealth. Here are different ways on how to do it.
1. Remove bad, inefficient debt
Associated interest and fees from your credit card can reduce your wealth. Focusing on which debt to pay off first will give you a hand in achieving progress until you pay it off.
2. Borrowing to invest
Borrowing money to invest in a property, stocks or shares, or gearing, can help build your wealth over time.
If your investments achieve higher value over time, it can result in a higher overall return, even if the interest and the other costs will be included. The income generated from these assets and the capital increase, can be used to pay the debt and even the interest and other fees.
There is still a risk though those investments may decrease in value. This will result in an outstanding balance that could be more than the loan value of the investment. The lender may have the right to take ownership of the investment in such case where, the dues won’t be paid, due to certain unwanted circumstances like an increase in the interest rate or unemployment.
3. Debt recycling
How about using home equity to invest in income-producing assets?
According to National Australia Bank, “Debt recycling is the process of replacing mortgage debt (non-tax deductible), with investment debt (tax deductible). This strategy may enable you to start building wealth while you are still paying off your home mortgage. You effectively take out equity from your home and invest somewhere else, where you may potentially increase income and growth. Income from these new investments can be used to further reduce the mortgage balance, while the growth component contributes to wealth accumulation”.
Though this may be a good option, it may not be fitted for everyone. One must consider and understand the risks involved before choosing this strategy, as you may put your home at risk or just fall to a deeper financial crisis.
4. Leveraging your assets
You can make extra money out of your borrowed capital or assets too! If you’re paying for a house but is living on your own, you may consider renting out a part of it that is not in use. This can be a helpful option to pay off your monthly mortgage.
There’s nothing wrong with having debt. But we must carefully determine if such debt will help us or hurt us. The problem only arises when one gets too overwhelmed with too much debt and becomes unable to manage the finances.
Worse, some people don’t have spending money anymore because their credit cards or their loans take over their income.
If we borrow money and choose depreciating assets, then we shouldn’t go into debt, agree? But of course, we are still in control of our own finances.
We make decisions according to what allows us to feel accomplished and happy. We have to consider that if ever we will incur debt, may it be good or bad, that it would be something we can comfortably afford and payback.