With all the discussion around the debt ceiling, many residents of Main St are likely wondering: Is debt bad?
The answer isn’t black and white. Debt is good, when used correctly and responsibly. So let’s cover how and when to use it.
Mortgages have gotten a lot of press lately, and not in a good way. Mortgages are a great example of how, when properly used, debt can be good. Few, if any of us, can afford to buy a decent house for cash. If you live in the Los Angeles area, decent is probably greater than $500,000. Most people can’t simply plop that down, let alone have anything for cars, expenses and retirement.
The key here is to take out a mortgage that you can afford. The recent downturn in the economy was spurred on by speculative mortgages. Many people were taking out mortgages based on what they HOPED they would be making in the future.
The deals were structured so that rates increased after several years, meaning that the homeowners were looking to A. Win the Lottery B. Get a Raise or C. Write the next vampire/wizard book franchise. B is the most likely, but still a hard one to judge.
When you stretch yourself so thin to buy a home to the point that you NEED a raise/promotion/rich-aunt-to-die, you’re going to far. Consider renting. Renting a home is not a bad idea, in fact it’s a good one. Here’s a proper checklist for buying a home:
Are the monthly payments within your budget (set a limit, say 60% of your monthly intake).
Consider other expenses associated with home ownership (remember, renting means less here), such as roofs, taxes, kids breaking walls, insurance and a Pottery Barn loving wife.
What is the interest rate? Does it change? What factors make it change?
What do experts think interest rates will do over the next several years? If they are expected to go down, waiting may be a better option? Or at least having a plan in place to refinance.
Home Equity Loans:
A friend of my wife’s told her that she had been advised by her parents to buy a house and “build equity”. Very common phrase in our society, also, a very common mistake. One “builds” equity as the value of the home is greater than the loan. Consider some factors in that:
Home prices decrease (it happens and when it does, it hurts). So that $500k house is now $395k…ouch.
Home Equity Loans – using this can be a good idea, but remember it eats away at your equity. So if your mortgage was $300k and your house is worth $500k, you have $200k in equity. That’s YOURS. Getting a loan based on your equity means it’s not yours, it’s the banks. Always remember that.
Houses are an investment. You wouldn’t just buy a stock because everyone needs to build equity. You buy a stock because you believe it will increase in value. Homes should be thought of in the same way.
I get that we all want to own a piece of land (deep down, we’re still pilgrims looking for some land to call our own), but always remember to do it in the right way and for the right reason.
You’ve always wanted to start up that business, right? Just take a loan! Kinda. Remember, your cash inflows need to cover that loan, in additional to all expenses. One big mistake is people overestimating how much their business will make.
A man opens a restaurant, thinks he’ll make $1 million a year in revenues and ends up making $750k. Problem, he borrowed money based on making $1 million a year. Be smart and be conservative in these cases.
Debt is a great tool, when used wisely. Next time, we’ll talk about using it wisely to help you invest.
Andrew is a corporate finance consultant living in Los Angeles, specializing in distressed and bankrupt consulting. He helps clients review business plans and the general market and decide what steps to take next. He has a masters in finance.
Andrew enjoys running and biking in the San Gabriel mountains, cheering for the San Francisco Giants and eating (but trying not to gain weight).