Lee's post yesterday brought up a topic I've heard discussed in GENERAL, but not in DETAIL: good debt vs. bad debt. Depending on whom you ask, the definition appears to vary. Some say "business debt"...."student loans"...."car loans" .

Let's say an investor borrows $100,000 to buy a property with a fair market value of $120,000. Is that good debt or bad debt?

Sid,

13 years ago, I borrowed $100K to buy the house that I live in now. In 2003, my house appraised at $142,500. Now it worth $225K. As long as I can make the monthly payments, I consider this a wise investment or good debt.

Exactly what Jason said. For an investment, you can't just throw out an example with no details except for "you borrow $100k and it is work $120k" and ask if that is good or bad. THAT sort of thinking really IS how so many people got into trouble with debt.

In MY area, I can buy a 2-bedroom for $40k and get $600/month for it. If I put the standard 20% down, I'd have a mortgage for $32k.

After expenses (and allowing for vacancy and my other normal contingencies), that would cashflow over $160/month. I'd have it paid off in 15 years without ever putting another penny into it. (I'd cashflow my $8k deposit back out and have $0 into it in less than 4 years.)

So, after 4 years, I'd have nothing into it. After 15 years, it would be paid off. At that point, it would provide cashflow of around $400.

That's fine cashflow for a small investment and even ignores the fact that I would then own a building worth probably $50k or more at that point.

So, do I consider that system "good" even though debt is involved? Yes, of course I do.

I would be happy to do that over and over again.

- John...

I consider "good debt" debt which improves cash flow. So, if I can borrow $ and my cash flow increases after accounting for the debt service, that is good debt. If my cash flow decreases, that is bad debt. Of course, there are some other factors to be considered, but that is the simplest breakdown.

Note that that is assuming NO RENT INCREASE for the 15 years, which is very unlikely. The reality is that a place that rents for $600/month now is going to be well above that 15 years from now -- growing gradually over the years, of course.

So, that example is more of a "worst case" thing. In "real life", it would actually go much better than that and would likely be cashflowing $550+ once paid off in 15 years. And, again, my out-of-pocket was only $8k.

- John...

Sid I think this is backwards calculating. Your investing isn't for equity but return on investment (can't eat equity). So no matter what it's worth i need to know how much is it returning. ROI

So what you all are writing is a measure of when to commit to borrow.

Good debt starts at "XX" ROI

(You know, some years ago I asked here and people explained how to figure ROI but it went in one ear and out the other. I love math but this just doesn't sink in).

I purposefully went vague because a lot of the answers I saw yesterday were somewhat vague. I tossed in a random bone of market value to get the conversation started, and you all have fleshed it out some. Thank you for that.

Sid too many investors just starting out-- try to figure cash flow at 100%-- that's a big no no. Banks and lenders only allow 75% to figure for unknown's -- I say 50% is a safe bet for cushion.

ROI for me is cost (including fix up) divided by cash flow. Cash flow is not phantom deductions like depreciation either.

The first year you will not have you taxes to guide you so again use the 75% of your estimated annual income.

So ROI first year is purchase+fix up maybe 5K income after expenses and debt service 600.00. 12%

Good debt is

1) secured by a non-depreciating asset

And

As others have said it is all about rate of return. Another part of ROI , is opportunity cost. What other things could be done with the money, what other opportunities are missed if I use the money for X instead of Y. When you can borrow money at say 5% interest rate (or any rate) and invest it and get a 6% (or X+ ) rate of return. Good debt is when you can borrow money at X% and get a rate of return on the borrowed money of X+%.

What is an 'Opportunity Cost'

Opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is, therefore, most relevant for two mutually exclusive events. In investing, it is the difference in return between a chosen investment and one that is necessarily passed up.

BREAKING DOWN 'Opportunity Cost'

What is the Formula for Calculating Opportunity Cost?

When assessing the potential profitability of various investments, businesses look for the option that is likely to yield the greatest return. Often, this can be determined by looking at the expected rate of return for a given investment vehicle. However, businesses must also consider the opportunity cost of each option. Assume that, given a set amount of money for investment, a business must choose between investing funds in securities or using it to purchase new equipment. No matter which option is chosen, the potential profit that is forfeited by not investing in the other option is called the opportunity cost. This is often expressed as the difference between the expected returns of each option:

Opportunity Cost = Return of Most Lucrative Option - Return of Chosen Option

Option A in the above example is to invest in the stock market in hopes of generating returns. Option B is to reinvest the money back into the business with the expectation that newer equipment will increase production efficiency, leading to lower operational expenses and a higher profit margin. Assume the expected return on investment in the stock market is 12%, and the equipment update is expected to generate a 10% return. The opportunity cost of choosing the equipment over the stock market is 12% - 10%, or 2%.

Opportunity cost analysis also plays a crucial role in determining a business's capital structure. While both debt and equity require some degree of expense to compensate lenders and shareholders for the risk of investment, each also carries an opportunity cost. Funds that are used to make payments on loans, for example, are therefore not being invested in stocks or bonds which offer the potential for investment income. The company must decide if the expansion made possible by the leveraging power of debt will generate greater profits than could be made through investments.

Because opportunity cost is a forward-looking calculation, the actual rate of return for both options is unknown. Assume the company in the above example decides to forgo new equipment and invests in the stock market instead. If the selected securities decrease in value, the company could end up losing money rather than enjoying the anticipated 12% return. For the sake of simplicity, assume the investment simply yields a return of 0%, meaning the company gets out exactly what it put in. The actual opportunity cost of choosing this option is 10% - 0%, or 10%. It is equally possible that, had the company chosen new equipment, there would be no effect on production efficiency and profits would remain stable. The opportunity cost of choosing this option is then 12% rather than the anticipated 2%.

It is important to compare investment options that have a similar degree of risk. Comparing a Treasury bill (T-bill)—which is virtually risk-free—to investment in a highly volatile stock can result in a misleading calculation. Both options may have anticipated returns of 5%, but the rate of return of the T-bill is backed by the U.S. government while there is no such guarantee in the stock market. While the opportunity cost of either option is 0%, the T-bill is clearly the safer bet when the relative risk of each investment is considered.

Using Opportunity Costs in Our Daily Lives

When making big decisions like buying a home or starting a business, you will likely scrupulously research the pros and cons of your financial decision, but most of our day-to-day choices aren't made with a full understanding of the potential opportunity costs. If they're cautious about a purchase, most people just look at their savings account and check their balance before spending money. For the most part, we don't think about the things that we must give up when we make those decisions.

However, that kind of thinking could be dangerous. The problem lies when you never look at what else you could do with your money or buy things blindly without considering the lost opportunities. Buying takeout for lunch occasionally can be a wise decision, especially if it gets you out of the office when your boss is throwing a fit. However, buying one cheeseburger every day for the next 25 years could lead to several missed opportunities. Aside from the potentially harmful health effects of high cholesterol, investing that $4.50 on a burger could add up to just over $52,000 in that time frame, assuming a very doable rate of return of 5%.

This is just one simple example, but the core message holds true for a variety of situations. From choosing whether to invest in "safe" treasury bonds or deciding to attend a public college over a private one in order to get a degree, there are plenty of things to consider when making a decision in your personal finance life.

While it may sound like overkill to have to think about opportunity costs every time you want to buy a candy bar or go on vacation, it's an important tool to use to make the best use of your money.

What is the Difference Between a Sunk Cost and an Opportunity Cost?

The difference between a sunk cost and an opportunity cost is the difference between money already spent and potential returns not earned on an investment because capital was invested elsewhere. Buying 1,000 shares of company A at $10 a share, for instance, represents a sunk cost of $10,000. This is the amount of money paid out to make an investment, and getting that money back requires liquidating stock at or above the purchase price.

Opportunity cost describes the returns that could have been earned if the money was invested in another instrument. Thus, while 1,000 shares in company A might eventually sell for $12 each, netting a profit of $2 a share, or $2,000, during the same period, company B rose in value from $10 a share to $15. In this scenario, investing $10,000 in company A netted a yield of $2,000, while the same amount invested in company B would have netted $5,000. The difference, $3,000, is the opportunity cost of having chosen company A over company B.

The easiest way to remember the difference is to imagine "sinking" money into an investment, which ties up the capital and deprives an investor of the "opportunity" to make more money elsewhere. Investors must take both concepts into account when deciding whether to hold or sell current investments. Money has already been sunk into investments, but if another investment promises greater returns, the opportunity cost of holding the underperforming asset may rise to the point where the rational investment option is to sell and invest in a more promising investment elsewhere.

What is the Difference Between Risk and Opportunity Cost?

In economics, risk describes the possibility that an investment's actual and projected returns are different and that some or all of the principle is lost as a result. Opportunity cost concerns the possibility that the returns of a chosen investment are lower than the returns of a necessarily forgone investment. The key difference is that risk compares the actual performance of an investment against the projected performance of the same investment, while opportunity cost compares the actual performance of an investment against the actual performance of a different investment.

Read more: Opportunity Cost Definition | Investopedia http://www.investopedia.com/terms/o/opportunitycost.asp#ixzz4VTjWsFB1

Follow us: Investopedia on Facebook

In the example of a homes market value of 120K but can purchase for 100K with a loan would not be a good debt for me, as an investor.

Now if I could buy that same home for 75k as an investor with debt that would be good debt.

Take that same home, and I could purchase it for the 100K but its's market value is 120k for my personal residence and have debt, all things equal. Good debt.

Sid, I think theres a small part of you that wants to take a few small mortgages on some properties to increase your portfolio. If you do end up going that route, buy the properties and get them fixed up with a refinance that is so cheap and leaves so much equity in the house that if you have to walk away and underprice that house to sell it, that it will be a screaming deal and sell quickly. That's only thing I can say about taking out a mortgage on the property.

I would love to hear Dave Ramsey and Robert Kiyosaki debate this. I have heard they are friends. What a discussion it would be.

Lee, I did hear Dave Ramsey say once that he really respected Robert Kiyosaki's approach to things, he just didn't do debt.

Debt in cash flowing real estate is good providing its not overly leveraged.

Unsecured debt is rarely good.

Ray, you made the same error as David in saying that unsecured debt is rarely good. You are confusing the issue as to whether or not the debt is secured with what the debt is used for. All other things (interest rate, terms) being equal, unsecured debt is better for the borrower. What you are trying to say, I believe, is that debt used to acquire appreciating assets like real estate is good and debt used for other purposes is usually bad.

Sid,

The parts most casual investors leave out is

1. Risk. Stuff happens. Stuff happens to our health and we cannot manage the debt effectively or any more. How about the stress from rentals that splits up marriages?

2. Time. I'm at 39 years in the biz BECAUSE we have debt. We bought houses with 20 year debt, we refi'd because that was trendy into 30 year debt, so I have sweat, teared, stressed, rehabbed, repaired, evicted, threatened by free attys, shelled out more and more cash to keep the houses repaired for 39!!!! years and those house are STILL encumbered with debt, will be til I'm 89 IF I make it that long.

I make a handsome income. Half comes from a handfull of paid houses (from when I stopped using the banks) and the other half comes from A BUNCH of rentals that I share with the bank.

It does not take many paid houses to replace a job income.

BRAD

Don,

Because I care, I am willing to give my unsecured credit card debt away. Wouldn't that be a "Good" gift to someone.

I started out with debt. In less than 2 months I will be debt free!

Without debt, I could not have retired at 58.

Is debt a risk? Of course. Calculated risk. Count the cost...that's biblical.

My long departed Dad taught me a few very simple rules of finance:

1. The first 10% belongs to our heavenly Father.

2. The second 10% is for long term savings (retirement)

3. Live on LESS than the remaining 80%

4. Never borrow against anything that loses value (cars, vacations, luxury items, etc.)

5. Use a sharp pencil and good math skills before making a purchase.

If you could borrow 100K and buy and sell the same day and make 20K why wouldn't you. That's a great use of short term, low cost money.

Mike, I have to disagree a little. If it's worth 120k and I paid $100, it's worth 120k. Congratulations to whoever negotiates that deal.

The full value will be realized at resale. I'd say these numbers are too tight for that type of turnaround, though.

I agree with NE's "Minimal to no personal debt, and conservative debt on rentals" balance -- and with gevans' entire post where he says it well.

My personal home will be paid off this year. We have been paying extra on it for years now to get the 15 year mortgage done early. (This is not usually the best move from a purely financial standpoint since it is such a low-interest loan -- but I like the feel of being debt-free in my personal residence, so that is our goal and we'll accomplish that by the end of this year.)

I buy used cars with cash. I pay off credit cards monthly (but use them regularly to maximum points as I have mentioned elsewhere on this forum before).

But I use debt for rentals to my advantage when it is a great deal and worth it. We have reserves for emergencies. We have some that are very close to paid off in case of a BIG emergency. There is backup money there to ride out issues. So, that debt does not scare me.

Like gevans said... Debt is going to allow me to reach the freedom that I otherwise either could not have -- or could not have nearly as quickly.

Call it "good" or "bad" debt all you want. Debt is a tool that I have used to accomplish my FREEDOM (as some of you like to put it). Debt has not made me a "slave" -- instead, the tool of leverage has helped to set me free.

- John...

I am a true believer in real estate debt ... not so much personal debt.

This post has accomplished exactly what I was hoping for...getting folks debating the terms. I see them tossed around too casually, which is a mistake. Even among those who use debt and/or believe it is a tool, there appears to be disagreement in some areas. Fleshing it out was the goal: mission accomplished.

Busy, busy, busy made a great point: how can you KNOW it's good or bad until the deal is done? The house that cash flows today may become an alligator tomorrow. Worth keeping in mind, for certain.

I've also seen reiterated in several posts that cash flow must cover debt service and expenses. And several folks ASSUME that real estate always appreciates...at least, that's how their posts are worded. Is that enough, or must we assume a healthy profit margin/appreciation of X% before we call it good? Is there such a thing as "marginally good/bad debt"?

Anyway, it's been a great learning experience. Thank you all for participating.

I disagree any goal was accomplished there. Part of the problem is people calling debt "good" or "bad" really. And we're likely still in the same place as we all started with that. It's just a semantics issue.

The real issue is whether or not using debt as leverage to invest makes sense. And, well, I think we're all still on the same page there too.

We didn't resolve any "debate" over the terms, sorry. :)

- John...

Also, there seems to be some confusion about people posting actual numbers and cashflow covering all of the expenses. You seem to think that that has a built-in NEED for real estate to appreciation in value. That isn't the case at all.

The goal is to have enough cashflow to cover expenses AND PAY OFF THE MORTGAGE over the next 15-20 years. Once that happens, then there is cashflow that is SIGNIFICANT INCOME.

It simply DOES NOT MATTER at that point if the real estate appreciated in value during that time. Not one bit really. If it does (and it LIKELY will), then so be it -- it is a nice bonus.

But if I buy a place that is 50,000 and rent it out for $600/month for 15 years -- and that rent covers all of my expenses including the mortgage itself -- then, after 15 years, I own it free and clear. It can still be worth only $50,000. Doesn't matter. It could go DOWN in value and be worth only $40,000. Still doesn't matter. I'm still going to continue to rent it for $600/month (or, that COULD be less but is much more likely to be significantly MORE after 15 years). That is all great cashflow now to use as income.

So, based on what you've said several times, Sid, you seem to have this idea that using a mortgage to buy a place means that we're assuming appreciation. I don't see that as a necessary assumption AT ALL. It doesn't HAVE to go up -- and I still come out way ahead. The fact that it very often DOES go up is simply a bonus.

- John...

That's fine. What I said in the last two posts still applies, I think.

I don't think anyone changed much of anything in their way of thinking. I'm not sure we "fleshed out" much. :)

- John...

Also, to be clear, I did not say nor mean that I think "this post accomplished nothing." I said that I didn't think it accomplished the "goal" that you seemed to be going for.

I think it was a great discussion about how debt can be used as a valuable tool in real estate investing.

I never said that it accomplished nothing. Only you said that I said that.

I thought it was a great post/thread. I just said I didn't think it accomplished your goal. (Unless your goal was to confirm that using debt as leverage can be a great tool to freedom -- but that seems unlikely to me. :)

In any case, no offense intended. It was a fine thread with lots of good discussion.

- John...

"I disagree any goal was accomplished there" posted at 11:39 AM.

Okay. Well, I guess I misread that.

The goal of the post was, as repeatedly stated, to "flesh out" the terms good debt and bad debt which people seem to use far too casually. That goal of fleshing out (i.e. what IS "good debt"...does it ever change? do we define it differently?) was accomplished, in my mind at least.

I tried not to offer any judgment as to whether or not it should or shouldn't be used. I did reiterate what some folks said, and perhaps that sounded like a judgment vs. just attempting to restate for clarity. You all know my stance; it hasn't changed. I just like to know what it is people are talking about and what--to them--those terms mean. I think most people I see use them, even here, do not clearly define them. That much is apparent as several posters responded back and forth saying, "what about X, Y, Z?"

Correct -- you misread that. "I disagree any goal was accomplished here" is not the same thing as "this post accomplished nothing."

As I said, I don't think your "goal" was really accomplished. Although, based on how you worded it, it sounds a bit like you were trying to manipulate us. Since you asked a question, but had a different "goal" in mind than really answering it. But, in any case, as I said, I think things WERE accomplished in this thread. I just don't think the "goal" you mentioned was. Because I don't think anyone changed anything or really "fleshed out" the terms "good" or "bad" debt.

Sure, people gave some input there -- but it still seems to vary widely depending on their views. And, in the end, the opposite happened for me: I came to the conclusion that labels of "good debt" and "bad debt" are just not a good idea because they miss the point.

That's why I said I don't think the "goal" of "fleshing out the terms of good vs bad debt" was really accomplished.

But, it's just semantics. We can agree to disagree on whether or not that was accomplished.

I think the better "accomplishment" was some good feedback from people about seeing it as a tool instead of a black-and-white "good vs bad" thing.

- John...