In the related post Be Uncomfortable With Debt, we promoted the idea that you should approach borrowing carefully, not casually. Treat debt with respect and agonize over having to borrow. When making an informed decision if new debt is right for you, a major consideration would be the impact of new debt on your net worth: does it add or erode?
Generally, all debt erodes your net worth because of the associated interest cost. Interest is an expense like any other living cost (rent, food, etc.) and it reduces your savings. But beyond this, depending on the purpose of the loan, you can have either “good” debt or “bad” debt. Good debt or “Investment” debt creates more wealth in the long run, and in this post we examine the borrowing purposes that could be considered good debt. The upcoming related post Bad Debt & Wealth Erosion examines borrowing that could be considered bad debt.
Buying a home
In the Caribbean, buying a home is generally considered a good long-term investment (not to mention peace of mind and stability for your family) because prices have steadily and reliably increased over time. Of course, no investment is 100% safe, and housing market crashes do occur e.g. in the United States in recent years. But Caribbean housing markets are structurally different and although real estate goes through cycles like any other investment, we tend to experience stagnation in prices for a period rather than significant downward re-pricing.
As a result, taking a loan to purchase a home is generally regarded as good debt because the long-run appreciation in house values has the potential to exceed the interest cost on the mortgage and other homeownership expenses. As a result, it could increase your net worth.
Home improvements (Renos)
Let’s add a few comments about home renovations. Some renos can be considered investments, as they could add to the value of your home e.g. kitchen remodelling, adding new rooms, or installing a pool. But take care that the cost of your renos do not exceed the realistic valuations of properties in your neighbourhood (you’ll never recover the cost of a palace if you build it in a slum).
Other renovations simply maintain the property in acceptable working order e.g. upgrades to electrical or plumbing.
If you must take additional debt for renovations, then make sure it’s for investment-type renos that appreciate the value of your home.
Any invested funds that potentially earns a higher return than its associated loan interest cost, is potentially good debt because it adds to your net worth. Investment options could range from financial investments e.g. bonds or stocks, to funds to start or buy a business.
Obviously, starting or buying a business involves various risks and uncertainties that are beyond the scope of this article to evaluate, but if successful, the business will grow profitably over time, and by extension, your wealth and net worth will increase.
Persons sometimes take a home equity loan to finance a new business venture. A home equity loan is one in which the borrower uses the “equity value” of their home as collateral. The equity value is the difference between your home’s market value and the sum of all outstanding liens on the property. The equity in your home increases as you pay your mortgage, or as the property value appreciates. The risk involved with using a home equity loan for a potentially risky investment is fairly obvious, so evaluate the pros and cons carefully.
Related to making investments is buying an asset with a long useful life that could earn income. The upfront cost of such an asset may be prohibitive, so financing the purchase makes sense because you are essentially matching the asset’s future income with future loan payments. Of course, you still have to ensure future income will exceed the asset’s total costs.
Further or higher education is usually one way to earn a higher income (and potentially grow your net worth); therefore, borrowing to fund your education is generally regarded as good debt. Often education loans can be obtained on favourable terms e.g. student loans usually have lower interest rates than most other consumer loans, or flexible repayment arrangements.
Protect your net worth: Repay early
You can use our Cari$ Loan Calculators to help you with your repayment strategy.
The amounts involved can be substantial. For example, we know someone who took a $550,000.00 mortgage at 8.75% for 25 years (a few years ago). Ignoring interest rate changes, and assuming they took the 25 years to pay it off, they would have paid $806,000 in interest, so the total cost of the house would have been $1,356,000.
Instead, they paid down the mortgage whenever they had spare cash (excluding Emergency Fund, etc.) and extra cash from a second job. After a few years they successfully paid it off and ended up saving approximately $650,000 in future interest (surplus cash was not earning much interest). This meant over time, their net worth will be higher by this amount because they no longer need to pay it to a lender.
Good debt = buying a home (for example). Better debt = early repaid debt!
We’ll contrast the above with examples of debt that reduce your net worth in the upcoming post Bad Debt & Wealth Erosion. In the meantime, we hope you found this post useful, and if you have thoughts or experiences to share, we’d love to hear from you in the comments below!