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Good Debt And Bad Debt!
Posted On September 23, 2010
Good Debt And Bad Debt!
If I were to borrow money from a bank to invest in a property, I would incur a debt. Is this debt considered to be a good debt or bad debt? Well that really depends on who is paying off the debt. Based on my understanding of the Rich Dad’s series by Robert Kiyosaki, a good debt is a debt where someone else is paying off for me while a bad debt is a debt where I need to pay off myself.
For example, if I were to rent out my property to someone, then I would be collecting rental income. This collected rental income could be used to pay off my mortgage loan. In this sense, I was the one who had borrowed the money but my tenant would be the one paying off my debt. However, if I had failed to rent out my property to anyone, then I would not be having any rental income. In other words, I would need to pay off the mortgage loan myself. Then this mortgage loan would be considered to be a bad debt.
If my property were rented out, then the debt would be a good debt. If my property failed to rent out, then the debt would be a bad debt. Depending on whether I had any tenant, my debt could be switching to and fro from bad debt to good debt in a given period of time. Thus, a good debt may not stay as a good debt indefinitely while a bad debt may not stay as a bad debt forever.
With this new understanding, there are two things that I can do to strengthen and protect my financial position.
Firstly, I can identify all my bad debts and try to convert them into good debts. For example, if I were to own a car but I rarely used it. I could rent it out to earn rental income. This rental income would be used for covering my car loan. In this way, I had converted a bad debt to a good debt.
If I failed to find someone to rent my car, I would try to settle my bad debt as soon as possible. Using the previous example, my car loan is a bad debt because every month I would need to service the loan repayment. Since I rarely used the car, then it may make sense for me to sell it off and pay off my bad debt.
Secondly, I need to do proper financial planning for all my good debts since there is a danger of a good debt becoming bad debt at any point of time. Based on what I have learned from the Rich Dad’s series by Robert Kiyosaki, it is important to get into good debts to accumulate wealth. But how many or how much good debt should I be taking on?
For example, if I were to borrow from a bank to invest in a property, I would incur a debt. Since my property was rental out and the monthly rental income was more than the monthly mortgage loan repayment, then my debt was essentially a good debt.
Assuming I bought a property valued at 0K and I had loaned at 80% of the valuation price, then my good debt would be 0K. Now there were two possible scenarios that could change my good debt into bad debt.
The first scenario is that my tenant did not continue to lease my property and thus there were no more rental income. Without anymore rental incomes, then my debt would become bad debt. And suddenly, I would need to service my mortgage loan all by myself.
As a precaution based on my financial education, it is necessary for me to set aside 3 to 6 months of expenditure including mortgage loan repayment. If such a scenario were to happen, I would be able survive for at least 3 to 6 months. This period should be long enough for me to find new tenant or sell off my property.
The second scenario is that the valuation price of my property drop to 0K. Assuming that the bank only allowed me to borrow at a maximum limit of 80% of the valuation price, then I could only borrow k. Thus, the bank would have to force me to top up the difference of k. If I had failed to do so, then it would be considered to be a default on mortgage loan. The bank would have the right to sell off my property to reclaim the loss.
If I had more than one property, then I would be a much worst financial situation when the second scenario occurred. This is where financial education can plays an important part as highlighted by the Rich Dad Series by Robert Kiyosaki. With my financial education, I could determine how many and how much debts that I could take on without running into the risk of becoming bankrupt if the situation were to turn against me. That is I would not be overstretching myself with too many good debts. I would borrow within a reasonably safe limit.
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