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Debt is a Tool (that You’re Probably Not Skilled Enough to Use)

December 11, 2015

As long as I can remember, I’ve been fed the idea that debt is a tool. This rationale is typically given as an excuse for us to use debt to buy the things we want. Want a new TV? Debt! Want a new car? Debt! Want a house that’s far above your means? It’s called debt, and it’s a tool!

After much thought and research into the topic, I can confidently say that yes, debt is a tool. It can be extremely useful for various financial ventures which I will describe later in this article; however, the vast majority of the population is far too dimwitted to utilize debt in an effective way. Instead, they see debt as a way to simply buy things they can’t afford and doom themselves to paying heavy amounts of interest. In fact, the average American pays over $600,000 in interest over the course of their lifetime.

Like any tool, debt requires vast amounts of knowledge and expertise to use effectively. Otherwise, you’ll easily smash your nest egg or drill holes into your carefully crafted lifestyle. Before you can even consider taking it on for the purposes of building wealth, you must first understand a few commonly overlooked truths about debt.

Debt is designed to make lenders rich

Let’s get one thing out of the way. Banks are not charities. As I’m sure you know, when you take out a loan, you get charged interest on the money that you borrowed. This interest ensures that your lenders are seeing a return on the investment that they made when they loaned you money.

In fact, making a return on loaned money is the defining characteristic of one of the most common investments — bonds! You probably have a healthy portion of bonds in your own retirement portfolio, and in that case, you get to attain the spoils of being a lender. Isn’t it nice?

Sadly, most people sit on the other side of that transaction. Long ago, lenders realized, “hey, these schmucks want us to lend them money so they can buy things they can’t afford. We’re going to make a fortune off of that interest!” And that, friends, is how banks were born. (Surprise! A bank isn’t just a place to store your money. That feature actually came much later.)

Until you realize that lenders aren’t your friends and your consumer debt is making you filthy poor, you’ll never be able to utilize debt in an effective, wealth-building way.

Side note – want to actually become a lender of personal loans and make an investment that could lead to a healthy return? Try Lending Club.

Debt crushes those who can’t live without it

Take a look at the common American household’s spending, and it’s likely that you’ll see a disturbing trend. For most people, debt is an ongoing cycle throughout their entire lives. Finance a new car, buy a new house, make payments every month, trade in car when it’s not cool anymore, sell house when it’s not big enough, finance a new car/house, make payments every month, repeat until death. Most people never learn to live debt free. It’s simply not in their brain space. (In fact, there are many young people who consider credit card debt to be the mark of “adulthood”!)

These aren’t the people who retire at 30. These aren’t the people who abandon the 9-to-5 and travel the world. There is no life beyond debt and rat races for these people, and they continually doom themselves to endless outflows of interest payments.

If a person ever hopes to find out what all this “debt as a tool” stuff really means, they need to be looking at it from the other side of the fence. You can never see debt for what it really is, both the good and the bad, without first learning to live without it.

Becoming debt free is a crucial step to take in our financial lives, and it requires two things:

  1. Hard work
  2. Awesome money management skills

These two things are also the ingredients for other awesome pursuits — staring a business, setting up rental properties, becoming a hardcore investor, etc. Basically, working towards debt freedom will unlock financial power that you perhaps never thought possible. However, if you insist on continuing the cycle of endless debt, then building wealth may never be within your grasp. For you, debt is not a tool. It’s a handicap.

Debt is a tool when you can minimize its impact

There’s one key component in making debt useful for your financial path – leverage. If you ever hope to build wealth in a venture that requires debt, you simply won’t get anywhere without something of value that can be leveraged in order to generate returns that outweigh the debt.

Let’s take houses for example. Since houses are often cited as being a good investment (ugh), let’s first ask how the house is being used. Are you taking on a 30 year mortgage in order to live in a fancy house? In this case, what you’re leveraging in this transaction is your home — where you live, raise your family, and make memories. Is that something you really want to leverage in a transaction that makes up one of the biggest purchases you’ll make in your life? From this thinking, it’s perhaps best to consider purchasing a house that’s within (or even below) your means to improve your chances of paying off the house quickly and with minimal impact from interest payments.

However, consider someone who uses a house as a rental property. Though they may take on a mortgage to pay for this house, what are they really leveraging? An empty house that also happens to be a valuable asset. Through proper rental property management, they’re able to make an investment that will often see a great return. More importantly, there’s minimal impact from the debt used to purchase the house since the renters are making those payments.

Let’s also briefly consider those who make a living buying and selling businesses. They often require financing to make such large purchases, but the trick is that the businesses they’re purchasing are expected to provide a steady stream of revenue. From there, that revenue is utilized to minimize the debt used to purchase the business. Even better, that revenue stream may even provide income for the business owner. Cha-ching.

As a unique example, I recently listened to a remarkable podcast featuring a man named Adam Carroll who utilized a Home Equity Line of Credit to pay off his home mortgage in under ten years. How did he do this? By tapping into his HELOC, he was able to make significant payments on his mortgage using HELOC loans. From there, by continually living below his means, he was able to quickly pay back each loan in full in a matter of months (or even weeks) thanks to his excess cash flow. Once the HELOC was paid back down to $0, he’d repeat the process. This cycle of leveraging a lower-interest debt in the form of his HELOC, he dramatically cut down the interest being charged by his mortgage (it was a rather complex and magical balancing act that he performed with this system, and I’d highly recommend you listen to the full podcast).

This is an extreme example, but during the podcast, Adam makes a very firm point — techniques such as this can never be used by those who are careless with their money (see the previous section).

In short, debt is only a tool when it’s being used on a venture that generates revenue that can then be used to pay back that debt while also providing a healthy stream of income. If it’s your revenue being used to pay down debt, then frankly, you’re on the wrong end of that transaction.

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  • Mrs. Groovy

    Mr S, I like that you dive deeply into what it means to use debt as a tool. So often we hear about “Good debt” from people who don’t know what they’re talking about. Real estate is tricky.There’s money to be made for sure on rental properties but you really need to buy at a discount and have the temperament for being a landlord, or hire a management company. It’s not as easy as Carlton Sheets will lead us to believe in hs late night infomercials (where is he now, anyway?)

    • Save Money, Dammit!

      Hey Mrs. Groovy. Those are some good points! It’s true that I hear “Good Debt” far too many times these days and people often don’t understand it. I’ve definitely gotten my fair share of “just use debt” advice in the past.

      Thanks for stopping by!