Debt: Debt: The good, the bad, and the ugly

 

The faces of debt: The good, the bad and the ugly
It is almost impossible to live totally debt-free; most people will borrow money at some stage in their lives. Borrowing can be a useful way to help spread out the cost of large purchases or expenses that we could perhaps not otherwise afford. It can also help us through difficult times or periods when there just isn’t enough cash. By borrowing to invest it is possible to attain greater levels of financial success than if one depended solely on ones own resources. Debt is often regarded as “bad” often ignoring the difference between "good debt" and "bad debt".
“Good Debt” versus “Bad Debt”
“Bad debt” is where you borrow to finance lifestyle purchases, such as clothes, jewelry, expensive cars, holidays or just to have a good time; these are things that should ideally be paid for in cash and not with credit cards and personal loans. Bad debt does not usually generate income or wealth. Resist borrowing to buy things that will quickly depreciate or lose value. Using credit responsibly can help grow our wealth; yet if not carefully managed, debt can have dire consequences.
“Good debt” is debt that creates value and can help to build wealth and generate income. This includes borrowing to buy property, to finance an education, for a business or for investment purposes such as for the purchase of property or shares.
Borrowing to buy a home
For many people a home will be the single largest investment they will ever make. A mortgage makes good sense provided you are able to comfortably handle the monthly payments over what may be a considerable period of time. Usually the value of the property, if in the right location, will appreciate over time and should more than make up for the financing costs that you would have incurred.
A home equity loan allows you to borrow using the equity in your home as collateral. If you have equity in your home, you may be able to use your home as security for a loan that you can use to invest in other assets. Your equity in the property is the difference between how much the home is worth and how much you owe on the mortgage.
Borrowing to finance an education
Higher education comes with huge financial value and usually increases earning potential thus making a difference to one’s future. Student loans are commonplace in developed markets. It is expected that once the students have completed their studies, they should be gainfully employed or at least have an enhanced ability to earn a living and attain financial independence and security.
Borrowing for a business
Businesses often require a credit line in place to be able to operate efficiently. Others need to borrow to expand their facilities or to take advantage of short-term opportunities. Other forms of debt financing include vehicle and asset financing which may be considered especially for big-ticket items such as computers, generators, and motor vehicles.
Borrowing to invest
Borrowing to invest in good quality assets that grow in value can build one’s wealth substantially. In general, it is a strategy best suited for investors who have a greater than average tolerance for risk. Experienced investors often borrow to take advantage of short-term market opportunities. If interest rates are low and the prices of assets such as shares and property are rising or the expectation is that you will be able to get a higher return from investing than you will pay in interest on a loan, then it makes sense to borrow.
Buying stocks on “margin” or margin trading is where one borrows money to invest in shares and/or managed funds using an existing investment portfolio or cash as security. Borrowing additional money to invest provides the means to build a more diversified portfolio; with more funds available to invest, you can spread your investments across more asset classes thus reducing your risk. There may also be tax advantages where there is a tax deduction for the interest costs paid on an investment loan.
Is margin borrowing for you?
Unfortunately, the ugly side of a leverage strategy is too often ignored in the face of the prospect of magnified returns with exponential investment portfolio growth. Investors particularly the inexperienced, uninformed investors are enticed into taking margin loans with the expectation of inevitable and imminent prosperity with little regard for the accompanying risk; indeed, some of the most devastating debt has come from people borrowing to invest.
A loan must be repaid, regardless of how investments perform. The worst-case scenario comes where the cost of borrowing is climbing while investment values are falling. If the investment value goes down, a margin call, or requirement to provide additional collateral may occur. Even as investments are being sold at a loss, the investor must still cover the difference between the outstanding loan and the investment proceeds out of their own pocket. If cash isn't available and the loan has been secured using stocks or their home as collateral, they risk losing these assets.
Sometimes it makes sense to borrow - sometimes it doesn't. It is important to understand your money personality, how much risk you are prepared to take, and how you feel about debt. Debt should be viewed as a tool to get you further along the path towards your financial goals.  Do give yourself some credit, but be careful.

source:moneymatterswithnimi.com