Debt is a double-edged sword that most people wield without training.
Some figure it out and manage to get through their early encounters with debt unscathed.
Others injure themselves and their loved ones without intending to.
Think of this post as a form of weapons training. We’re going to learn how to handle debt in a way that adds to your power and influence over your financial future.
By the end of this lesson, you’ll understand the difference between useful debt and painful debt. This will help you avoid rookie errors that have the capacity to ruin you financially.
You’ll also learn how to use useful debt as a tool to accelerate the achievement of your financial goals – and when it might be wise to wait (or leave it alone).
Becoming competent with debt is a bit like learning the cheat codes in the game of money. You’ll be a lot less susceptible to danger and possess powers that allow you to do what most can’t.
Most self-made people who are financially successful figured out how to use debt productively to achieve what could not be got alone. If you aim to follow in their footsteps, you need to read this post.
First things first: know thy weapon
Before we get started, it’s critical that we take some time to get the fundamentals right. By sharpening the blade now, later learning will be much easier.
A sharper blade comes out of its sheath much faster. A sharper blade cuts through the air much better, making it easier to manipulate and maneuver.
So, here’s how it’s going to work.
After we take care of the fundamentals, we’ll practice the basic postures and positions.
Once we’ve mastered the critical few, we’ll start linking these positions to create short snappy sequences of movement.
Finally, we’ll put the combinations together to master the most powerful maneuvers.
Before you know it, you’ll be able to wield the sword of debt with precision and poise.
Ready to get started? Good, let’s get after it
Level 1: The Fundamentals
Let’s start with a simple question most people don’t really think about.
What is debt?
Most of us see debt as a tool for getting us what we want, which is true – but grossly oversimplifies the truth.
This shallow thinking leads to predictable yet preventable mistakes.
Some people take out a lot more than they need.
Others fail to fully understand and adhere to their obligations, which gets them into serious financial trouble.
These mistakes and other variations can cripple us financially – often for quite a long time too.
So, let’s stop and meditate on the answer to that question for a second: what is debt?
Debt is an obligation to others.
You acquire financial debt when you use other people’s money to buy things you couldn’t otherwise buy on your own.
Put this way, debt sounds kind of awesome right? (who doesn’t want more than they can’t currently afford), BUT, there’s a little more to it.
Debt (like any deal) comes with terms, conditions and consequences.
The terms are, you’ll pay interest regularly until you pay it back. Think of interest like rent on the sum of money you’ve borrowed. The more money and the longer you borrow it for, the more you’ll pay in interest.
The conditions are, you’ll repay the debt and interest according to a set schedule – or incur additional penalties. This could be additional costs that compound your problems, or the repossession of the thing you bought, and other things you might own.
Most people know the terms and conditions but downplay or ignore the consequences.
The consequences are, a portion of every dollar you make in the future is now spoken for. These dollars are now allocated to paying off the interest and or the principle (which is geek speak for the amount you borrowed).
So, debt creates a high level of commitment and comes with ongoing financial obligations and consequences.
If you’re the kind of person who values flexibility – then debt might pose a real threat to the quality of your life.
Put this way, debt sounds kind of dangerous right?
The truth is, that’s another half-truth.
For some people, debt is dangerous, but for others who know how to use it the right way, debt can be an accelerator of our financial goals.
The key is knowing which person you are, knowing which type you are using, and using it the right way.
We’re going to cover all of this, but the best place to start is knowing the different types of debt.
Level 2: The two types of debt
Entering into a relationship with someone you are attracted to can be a rewarding experience that changes you for the better.
Or it can blow up your life.
It all depends on what type of person your partner is. Attraction is not enough; we need a little more information to make good decisions.
If your spouse is a loyal life partner who complements you, and loves you unconditionally, then chances are this will be a fruitful relationship that adds priceless value to your life.
On the other hand, if your significant other is a superficial, narcissistic energy vampire who isolates you from your support networks and makes unrealistic demands, you’re in for quite a ride – and probably not the fun type.
It’s the same with debt.
Knowing what type of debt you are dealing with is crucial to the outcome and your experience along the way. When it comes to debt, there are two main types.
There’s consumer debt, and there’s investor debt.
Consumer debt is baggage: like the toxic partner it drags you down and mires you in misery.
Investor debt is leverage: like the lifelong lover it can add immense value to your life.
Knowing how to tell one from the other is a core posture. When you master this position, you’ll be better able to defend yourself against the dangers of consumer debt, while intelligently engaging with investor debt.
To be able to instantly recognise each when you see it, we need to delve a little deeper into a description of each type.
Let’s start with consumer debt…
Consumer Debt: The Cancer that Cripples Your Cashflow
You’ll accumulate consumer debt when you use other people’s money to buy things that cost you money when you buy them, as well as afterwards.
The fancy financial term for these money sucking possessions is ‘liabilities’.
When you buy a new car using a car loan, you’re incurring consumer debt. The upfront cost is the purchase price, the ongoing costs are registration, insurance, maintenance, fuel and tolls for parking and freeways.
Acquiring consumer debt is like digging yourself a hole. While it’s only knee-deep things seem more than manageable. But once you’re in over your head, getting yourself out can be damn near impossible.
Like the dirt you throw out of the hole as you dig, the interest on consumer debt piles up quick. The costs compound fast, and pretty soon you’ll find yourself trapped in a financial prison of your own making.
So, why and how do we get themselves into these positions?
Consumer debt allows us to buy those shiny symbols (like fancy cars, clothing etc which are actually liabilities) that we associate with wealth and success-even when we don’t have the money for them.
The road to financial ruin is paved with souls who mistook the trappings of wealth, for wealth itself.
The highway to hell was built by those who used consumer debt to acquire these things.
Bottom line here?
Stay the hell away from consumer debt at all costs. It’s a cancer that will constrict your cashflow and cripple you for life.
Ok good, let’s move onto the other type of debt: investor debt.
Investor Debt: A Tool to Be Treated with Care
When you use other people’s money to buy things that make you money, you’ll incur investor debt.
The catch all term for these money-making things is ‘assets’.
To be an asset, a thing must do two things:
- It must put money in your pocket regularly.
- It must trend toward growth in value over time.
Under this definition, things like investment property, stocks, bonds and businesses are assets.
The more assets you have, and the longer you have them for – the more wealth you’ll build.
Investor debt is leverage, because it allows you to do more with less. Without investor debt, it would be impossible for most people to do things like buy an investment property or expand their business.
It would take most people decades to save the 553k it costs the buy the average Aussie property. Most might never get there.
Over that time, investment properties would continue to grow in value and pay their owners an income.
Taking out an investment loan allows you to gain control and legal ownership of a money-making asset – even though you can’t pay for it in full.
Now, you get to enjoy all the growth, and income from this asset – despite the fact that you only paid a fraction of the full cost upfront.
That’s a bloody good deal, and it’s why investor debt is leverage: it allows you to do more with less.
So, how do you tell the difference between consumer debt and investor debt?
It’s relatively simple. Just ask yourself if the thing you’re buying with debt is an asset or a liability.
Does it grow over time and put money in your pocket? If yes, you’re using the leverage of investor debt.
If no, you’re digging a financial hole for yourself. Pay that thing down. Fast.
If you’re still not sure how to tell the difference between consumer and investor debt, there’s another way to figure it out.
Find out whether you can claim a tax deduction (geek speak for ‘a discount on your tax bill’) for the interest cost of the loan.
If you’re using consumer debt, the interest you’ve paid has zero effect on the tax you pay.
If you’re using investor debt, you’ll be entitled to reduce your tax bill by the same amount you payed in interest for your investment loan.
Why is this the case?
Well, the rule makers obviously want to encourage more investment. More investment equals a stronger economy most of the time. So, you’ll get rewarded for using debt productively.
There are a bunch of other ways to know whether your debt is baggage or leverage. The most obvious and salient differences can be found on the post below…
It’s important for me to point out that I am not making the distinction that consumer debt is ‘bad’ and investor debt is ‘good’. That could be a bit misleading.
The words ‘good’ and ‘bad’ are categorical and polarising, and in this case can be unhelpful for guiding decisions and actions.
It’s not as simple as ‘good’ or ‘bad’, it’s probably better to think about them as useful and ‘not useful’
Consumer debt is not useful
Investor debt can be useful.
In the case of investor debt, useful is a much better word because it invites a more measured approach – which is what is needed when dealing with leverage.
Let’s take a look at why that is now…
Level 3: The two sides of investor debt
In a world without investor debt, only those who are born into money can be wealthy. The rest are of us are destined to strive and struggle to survive.
Investor debt is leverage that helps you do more with less, but as with most good deals in life – there’s always a catch.
Leverage cuts both ways.
Leverage is a force multiplier, so it magnifies both gains and losses.
Being highly leveraged can be a death trap. Being optimally leveraged can be a pivotal path to wealth.
Let’s take a simple example to see how this works in the real world.
Say you saved 10k and secured a 90k loan to buy an investment property worth 100k. You’d have a 90% loan to value ratio (or LVR in geek speak).
LVR is a just a fancy way of determining and describing how leveraged you are, which can be a quick way to see how much risk you’re taking with debt.
To determine LVR just divide the value of the loan owing by the value of the asset.
In this case the math looks like this.
A high LVR indicates a lot of leverage, which often means a lot of risk.
Most people think the relationship between risk and reward is linear, so basically the more risk you take the more reward you’ll make.
Once again, this is but a half truth.
The reality is, the more risk you take, the higher the variability of outcomes. In the case of leverage, this works both ways. You can win big or lose big depending on different circumstances.
Let’s see how this works.
Let’s say the value of our property increased to 110k after 6 months. Then you’ve made a 100% return on investment. This is because you’ve turned your original 10k into 20k (on paper at least).
This is an example of how leverage can magnify gains.
Without leverage, you wouldn’t be able to afford the 100k home (you were 90k short). This makes it highly unlikely you could have doubled your money so quickly, without doing anything.
Sounds kind of awesome right? It can be, but there’s something else you need to know.
It doesn’t always go this way.
Let’s look at the shadow side of leverage. The part that most people are unaware of or ignore.
Say the value of our property suddenly fell 10% to 90k over the same six-month period. In this example, things are not so rosy.
You now hold an asset worth 90k, that you owe 90k on.
That 10k of your hard earned that you fronted up as a deposit?
That’s all gone now.
Now you’d have to wait until the property recovered its value to regain your lost money. You’ll have to wait even longer to get back in front.
If that 10k you ponied up was all you had, then you lost everything you had.
This is what happened to a lot of people in the US during the global financial crisis.
Highly leveraged home owners who’s entire capital base was tied up in their home quickly learned about the dark side of leverage.
Being highly leveraged, with all your cash in one asset is the financial equivalent of going all in on a what you believe to be a winner and then betting on that bet – with other people’s money.
This is why describing investor debt as ‘good’ can be misleading. It is useful, the same way a sword can be useful in persuading others to do what you want, but it can also slice you open if you’re not careful.
So, how do we use leverage carefully?
Level 4: The four principles of proper lending
So far, we’ve looked mostly at increasing your financial intelligence, but being smart with debt is about coupling that know how with emotional intelligence.
When you can combine these two skills, you’ll be devastatingly good at making financial decisions where debt is involved.
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You’ll be able to make the kind of gains others only dream of, while taking a lot less risk. Mastering this combination will supercharge your progress and success.
So, how do you do it?
To master the combination of financial intelligence and emotional intelligence, you need to consider two key dimensions when making decisions about leverage.
First, you need to consider how manageable the obligation is. This is the financial element.
Then you need to consider how tolerable the obligation is. This is the emotional element.
Let’s start with understanding how manageable your debt might be.
Smart money managers like to bake a ‘margin of safety’ into every deal they do. This just means that they structure things so that they are taking no more risk than they absolutely need to, and only pulling the trigger when the odds are stacked in their favour.
To assess how manageable a potential debt may be, ensure you have an adequate margin of safety. To do this, analyse two main variables:
- Your loan to value ratio.
- Your income security.
If you are highly leveraged (85% LVR or more) and have serious doubts in your ability to pay back the loan over time (because your job is uncertain for example) then you’re margin of safety is severely limited and the debt should be classified as unmanageable.
If you are moderately leveraged (70% LVR or less) and are confident in your ability to pay back the loan, you’ve got a good margin of safety and the debt would be quite manageable.
Got it? Ok good, let’s keep moving.
Now, that we’ve understood how manageable the debt is likely to be, we’ve understood the financial component.
Next, we need to understand the emotional component.
This is where we consider how tolerable any potential debt might be.
The way to assess how tolerable a given debt might be is to consider two things:
- The degree to which you value or require flexibility in your life.
- How you typically respond to pressure.
If you like the luxury of changing your mind, making impulsive moves with your life and career, then no matter how manageable a debt might be – it might tend toward the intolerable end of the spectrum.
If you find that pressure crowds your thinking and impacts the quality of your life and work in negative ways, this might push the debt into the intolerable zone.
In contrast, if you are happy to commit to big things and see them through, and you find you generally rise to the occasion when under pressure (financial or otherwise) – then debt is likely to be tolerable, hell maybe even desirable for some.
If we plot the two dimensions of manageable and tolerable on a classic quadrant style matrix, we can quickly recognise when and how to make wise decisions with debt.
Obviously, we want to be dealing with debt in a way that is both manageable financially, and tolerable emotionally. This could be described as ‘taking a calculated risk’.
Taking a calculated risk on a deal with downside protection and big upside potential is the ultimate power move when it comes to smart money management.
This is how you level up in the game of finance.
This is how you go from amateur to pro.
The key to taking calculated risks comes down to two things:
- Having a margin of safety
- Doing your homework.
Remember, leverage cuts both ways, and if you’re going to wield the weapon, you need to make sure you’re moving and acting with precision.
To take calculated risks with debt observe the first principle of proper lending:
Always borrow less than you can afford and never skimp on due diligence
Borrowing less than you can afford should automatically bake in a margin of safety. If less than you can afford means you can’t afford anything – then you’re not in a position to be dealing with debt.
Do your time, pay your dues and you’ll be much better off for it in the long run.
If you do your homework, you’ll be a lot less likely to make mistakes while identifying and purchasing your asset. Most of the time, the time when you buy is the time you make or lose money.
If you’re not willing to do your due diligence or don’t know how, take step back and make some space for clearer thinking. At this point, you have two choices: either get professional help, or find another game to play that won’t blow your life up.
Now that we know what to do. Let’s look at what not to do.
Leverage that is unmanageable, yet tolerable.
If a given debt is unmanageable but tolerable, it’s a Hail Mary.
In this situation, you’ve pulled the trigger, have little margin for safety, and you’re scraping by, hoping like hell thing work out as you need them to.
This is a dangerous place to be and believe it or not most people live here without even really knowing it.
They buy as much debt as lenders will sell them, often because they’ve fallen in love with the idea of owning some asset (usually property) and refuse to wait until it makes more sense.
To avoid winding up in quadrant one, follow the second principle of proper lending:
Got it? Good. Cause we’re done.
Never let your ambition cloud your reason
As humans, we tend to think of ourselves as rational creatures, but we’re not.
The part of our brain that deals with decision making, is the part that deals with emotion.
This creates the tendency to make an emotional decision, and then use logical reasons to support it, rather than reasoning with logical comparisons to come to a decision, and then using emotional intelligence to enact it.
If you feel like you’re bending reality to make the deal make sense, instead of making sense of the deal, it’s time to stop and think.
Walking a financial tight rope causes insane stress and anxiety, which can really strain relationships.
When you consider that financial stress is one of the biggest factors in divorce, living large on high leverage is hardly worth the cost.
Leverage that is Manageable but Intolerable
If a debt is manageable, but intolerable you’ll be dragging a ball and chain.
This is what happens when someone who value’s flexibility and simplicity in their life signs a thirty-year million-dollar obligation.
Even though you can manage the financial side of the equation, emotionally it’s going to be a drain.
If you’re a free spirit, having a huge debt hanging over your head can feel like you’ve sold your soul for someone else’s dream.
To avoid this quandary, follow the third principle of proper lending:
Be honest with yourself and what you really want out of life.
Herding (which is the human tendency to follow the crowd) is a real thing. It’s an inbuilt evolutionary instinct to keep us (meaning the human race) safe.
That’s great for humans on the whole over time, but it can be terrible for you in the moment you sign on for a thirty-year mortgage.
Remember, you’re not going to die by going against the grain.
Be less like a lemming, and more like Sinatra: when it comes to the crunch be strong enough to say ‘I did it my way’.
Leverage that is Unmanageable and Intolerable.
You never want to find yourself in this quadrant. This is committing financial suicide.
If you’re struggling to manage debt and you can’t deal with it, things are probably not going to end well.
If lenders do their jobs responsibly, this should never happen. But the reality is it can and it does. Just google ‘global financial crisis’.
To avoid drinking a poison chalice, observe the fourth principle:
Invest in educating yourself and developing your self awareness
This one is tough because if you don’t know what you don’t know, you’re not likely to recognise when you might be about to make a big mistake.
The way around this is to surround yourself with people and professionals you know and trust. Then, put your ego aside and take their guidance and counsel.
If you let them, others who care about you and want you to succeed can help you. They can point out your blind spots, which will help you learn faster and avoid disaster.
Debt is a Double Edged Sword.
Congratulations, you made the grade
If you’ve made it this far, you’re a rare breed.
While the rest of the world was watching Netflix and or skimming social feeds on their smart phone, you just invested time and energy to genuinely improve yourself.
Take comfort in knowing that if you’re the kind of person who reads a meaty blog post like this, you’re probably not going to make any fatal mistakes.
Now, if I did my job right as your sensei, you should now also be able to:
Recognise that debt is a serious obligation, with serious implications.
Spot the difference between consumer debt and investor debt.
Use a combination of financial and emotional intelligence to make smart decisions about how and when to use leverage.
If you apply these lessons and observe the principles of proper lending, you’ll be much better prepared to deal with debt in a way that empowers you, rather than enslaving you.