How to know the difference between smart debt and dumb debt
I think it’s safe to say that most people believe that being in debt is a bad thing. The debtor is a slave to the lender and if you’ve ever been in a position where you couldn’t pay your debts, you know exactly how enslaving that feels. Debt has ruined many people’s reputations, marriages, and businesses for as long as people have been willing to lend money. And even though we know that if you spend more than you make and have to rely on debt to make ends meet, eventually your number will be called - unless you make radical changes to get things back in order.
So, if debt is the enemy of prosperity and building wealth, is there a time that someone should consider using debt as a part of their financial game plan? You may be surprised to learn that the answer is actually yes. There are ways you can use debt wisely, but unfortunately, most people don’t understand the difference between smart debt and dumb debt. That’s what I’m going to share with you today, so stick with me and in the next few minutes I’ll show you the difference.
There are three primary areas where I see debt can be used wisely in someone’s financial plan.
1. The first one is with a home mortgage. You have to live somewhere, right? And, if you had to save up the full purchase price of your home before you could buy it, that would severely limit most people’s ability to live the life they desire and have a home they can enjoy. Using a mortgage to pay for that home over time is a smart way to use debt as long as you get a mortgage that you can comfortably afford. It’s no fun to have your possessions possess you, and if you bite off more than you can chew with a mortgage, home sweet home doesn’t always feel so sweet. Nevertheless, using a mortgage to buy home is a smart way to use debt and it can also provide certain tax benefits, plus help you accumulate wealth over time.
2. The second way you can use debt wisely is similar to the first in the sense that it involves real estate, but in this case it’s not your primary home that’s involved. Owning rental real estate that involves debt or a mortgage can also be a smart way to use financial leverage for one very important reason. In this case, smart debt is "smart" because someone else is paying the debt for you. You basically pay the debt off with the rent you receive and/or with the gains you make in the appreciation of your property’s value when you sell it. Plus, there are often many tax advantages with rental real estate that can help you reduce your income tax on other earned income you may have. Although that’s not directly tied to the debt were discussing today, it can amount to a meaningful sum of money over time, which helps you keep more of what you make so you can build wealth faster.
Several of my private clients have built a significant nest egg using this strategy and today many of those properties are completely paid off, so they have a meaningful amount of dependable cash flow they can use to fund their lifestyle, pay for college, save for retirement, or do whatever they like because they planned for it in advance. You can do this too, but you have to educate yourself on how rental real estate works. Don’t just jump into something and put yourself in debt because this strategy falls into the category of smart debt. Think about the term "smart debt." You need both parts in order to be successful.
3. The third place where someone can use debt wisely is through loans inside their cash value life insurance policies. This is something that used to be done quite often, but cash value life insurance as a common savings solution has fallen out of favor in the past couple of decades thanks to the rise in technology that allows us to access financial markets through mutual funds, online trading, and new, easy-to-use financial products, like exchange traded funds. Before all of these options were available, many people saved tons of money in the cash value buckets of their life insurance policies. In fact, if you go all the way back hundred years or so, cash value life insurance was considered one of the safest, most trusted ways to accumulate wealth. They weren’t damaged during the Great Depression when banks failed in the stock market crashed. And even today, they aren’t leveraged from the life insurance company, like banks leverage their deposits to issue loans for 8 to 9 times what they have on hand from their savings customers. Their design is also contractual, so most whole life policies are structured in such a way that they can’t lose value. That makes them a stable source of capital you can use like a line of credit.
In the policies that we use for our private clients, we can use the money in the policy as a loan and still collect the dividends the insurance companies pay each year. Naturally, there’s an interest rate to borrow the money, and the dividend rate that’s paid on the funds that remained in the policy instead of being withdrawn, work to offset that interest rate, making it a very low-cost loan. Also, there aren’t any required payments to make on a monthly, quarterly, or annual basis with a loan from a life insurance policy. In fact, you never actually have to pay the money back. The insurance company will eventually settle up on the loan with the proceeds of the death benefit. That’s a smart way to use debt for a couple of reasons. You’re able to use your money without negatively impacting your cash flow and you can use the insurance company’s money to pay back your loan through the death benefit, which is always more than you’ve put in yourself. Down the road you may not need as much death benefit as you had originally, so using it to cover the loan amount may be an added bonus on how to get the most from your insurance policy.
Using debt to fund a mortgage, purchase rental real estate, or access to living benefits within your cash value life insurance policy are all smart ways to use debt to your advantage. Of course, having a mortgage is the most common of the three, but I want you to be aware of the other two options in case they have the potential to fit into your financial strategy at some point.
Understanding dumb debt So now that you understand smart debt, let’s talk about dumb debt. This is the kind of debt that burns up your cash flow, increases the purchase price of whatever you’re buying due to the interest you’re paying on it over time, and is usually attached to something that has a diminished future value, if any at all. For example, if you buy things like appliances, electronics, or vehicles with debt, the value of those items drop significantly once you’ve purchased them. You have very little hope of ever getting your money back or making a profit should you need to sell those later, yet you're obligated to pay the full amount of your purchase price for however long is needed. That’s dumb.
What’s even worse is when you purchase things you consume using debt, like groceries, gas for your car, and vacations. You may have the intention of paying these things off at the end of the month or with a bonus or tax refund. If that’s the case, and if you actually do pay it off when that money arrives, you can use debt – probably like a credit card like I’m thinking in this case – to earn certain benefits, like points or cash back, and be fine. The problem is sometimes that cash doesn’t always come in. And then you’re stuck with the debt long after the thing you purchased is over or gone. And in other situations, the cash does come in but something else you want meets you at the door and says, "PURCHASE ME NOW!" too. That’s how people live beyond their means and it’s so easy to do.
Building a plan for success You have to set parameters in place to keep you from taking on dumb debt. It’s a mindset that requires discipline and the ability to focus on your goals. The best way to make sure that you have goals that are realistic and compatible based on what’s most important to you in life versus what’s new and popular at the moment is to build a financial game plan with a CERTIFIED FINANCIAL PLANNER™ professional. That person is not emotionally involved in your financial situation and only has your best interest in mind as he or she helps you develop a strategy that meets your needs. If you’re in debt, and dumb debt is eating your lunch, a good planner will show you how to get out of debt and get back on track to living the best life possible. It’s not always easy to turn things around, but it’s not easy being stressed out and drowning in debt either.
Money is a powerful thing only to the extent that we let it control our lives. Having the right mindset and a solid game plan to keep money in its proper perspective can definitely improve the quality of your life. Be smart about how you use debt and educate yourself on how to improve your financial situation with proven strategies that reduce your risks and provide advantages to secure your future. And if you need help with any of this, let me know. I’m happy to answer any questions you have and help in any way I can.