Good debt, bad debt

Not all debt is bad. People can even become richer thanks to debt. How you can take advantage of opportunities and minimize risks and what leverage is. That and more in this contribution.

Financing a home that you are not going to live in

Suppose you are young, dynamic and just graduated. You have your diploma in your pocket and already a good job in a renowned company. What else do you want? Well, having your own home, that wouldn’t be bad. You have already looked at some real estate properties in the area and an apartment has caught your attention:

  • the sales price is 120,000 euros;
  • the apartment is still rented;
  • the net rental income is 750 euros per month.

You wonder what it would be like if you bought the house and continued to rent it out? You make a quick calculation and you come to the conclusion that the apartment gives you a positive cash flow of approximately 160 euros per month after deduction of mortgage payments and other costs.

Will the housing market ever pick up again?

You also assume that the value of your property will increase in the future. The housing market will pick up again someday, right? But you don’t want to decide alone and you have asked your parents for financial advice. But they advise you against the purchase: “What? You have only just started your career and you are already starting to borrow? And that too for a house where someone else will live? ” You decide to follow your parents’ advice and cancel your purchase. But could they be right?

Good and bad debts

Your parents assumed that all debt is bad. But it is not that simple, because there are good and bad debts. Not every debt obligation is bad. It would be a bad idea to take out financing for a very expensive car or an expensive mortgage to purchase a spacious villa at the start of your career.

What distinguishes consumer credit from investment credit?

Well, the purchase of that very expensive car that is financed by a bank loan will only take money out of your pocket:

  • on the one hand, you have to pay the credit terms, which can be quite high, depending on the car brand and the term;
  • on the other hand, you also pay for petrol, insurance, maintenance and repairs, etc.

And the same more or less applies to that financed spacious villa.

The decisive factor is the way in which debt is deployed

Bad debts only create double obligations: in addition to the mortgage’s burden on your budget (after all, it costs you money in the form of interest and repayments), the object itself also creates financial obligations because it entails additional costs for operation and maintenance . Obligations that only cost you money are bad obligations. They make you poorer. But besides bad debts, there are also good debts. These are obligations that earn you money month after month. Good debt is distinguished from bad debt by the way you use that debt.

How does good debt function?

Good debt can therefore be taken on to generate positive cash flows. They are intended to finance investments and are not entered into to finance consumption purposes.

The leverage effect

There is a rule of thumb, also known as leverage effect, which states that debt financing is only worthwhile if the return on the assets involved is higher than the interest on the loan. In other words, you should not want to use the leverage too intensively, because then the return could be counterproductive. And that is precisely why good debt is important: in addition to the use of own capital, financing in the form of debt capital is also used. If the profitability (profitability) of the total capital employed is higher than the interest on the loan, the return on equity also multiplies. And so good debt makes you richer, because it will generate positive cash flows.

Effective risk management: don’t miss opportunities but be aware of the risks!

However, one must keep in mind that every investment entails risks as well as opportunities. Also when financing with foreign capital, one must take into account a “worst-case scenario” in which the above theory does not apply. Such as, for example, financing the apartment if the rental income unexpectedly disappears, for whatever reason.