Tuesday, March 20, 2012

How to Deal With Debt - Make it Work For You

Debt is a very ugly and scary word for many individuals.

As mentioned in a previous post, there is good debt, bad debt and really ugly debt. Review my previous post "How to Deal with Debt- - The Good The Bad and the Ugly" to refresh your memory.

This post will concentrate on the Good Debt, the debt that can be used to help accelerate your building of wealth.

Good Debt

My definition of Good Debt is simply a form of debt that allows you to deduct the interest on your income tax. Most commonly this is debt that is used in order to purchase an investment that earns you an income.

Some jurisdictions allow you to deduct the interest on your mortgage for your principle residence. This is still good debt, but not as good as debt used for investment purposes, because it discourages you from building equity in your principle residence.

Building Good Debt

The first step for most individuals is to pay off all debt that you cannot use as a deduction on your income tax. Next would be to pay off the mortgage on your principal residence.

Once all the above debt is taken care of, now is the time to start accelerating your wealth using other peoples money (good debt). Once all other debt is retired, open yourself a line of credit at your bank or credit union. To keep your interest rate low, you can secure your line of credit with your principal residence ( once your mortgage is paid for ). This is by far the best option.

Now you can borrow money on your line of credit to purchase investments that will pay you an income. Examples of investments are high yielding stocks, royalty trusts, real estate investment trusts (REIT's), individual revenue properties, etc.

The key here is to ensure that the net income from your investment after taxes will be more than the interest costs on your debt after taxes. The income from your investment can then be used to pay your interest costs as well as to pay down a portion of the debt itself. You will essentially be using other peoples money to increase your own net worth.

What the Wealthy Do

Many wealthy individuals use the above strategy to propel their wealth. The above strategy is called financial leverage. It allows you to use good debt to accelerate the rate of growth in your assets.

A Word of Caution 

It should be noted that this strategy is not the starting point for building wealth. This is a strategy that should only be used once you have a regular savings and investment plan in place using your own income. You should already be in a comfortable financial position and not be worried about paying your everyday expenses. This includes having an adequate emergency reserve and proper insurance in place.

As in all investments, there is always a potential for loss. You should only be considering this strategy if you have the financial cushion to absorb any potential losses.

As always, I welcome your comments and suggestions for future topics.

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