What exactly is a debt? A debt, in financial terms, is an obligatory payment commitment between two people, two entities or one person with one entity.
And how can it be that a payment commitment along with implicit interest on it can become a good debt? I’m going to try to explain it to you…
There are many people who go into debt for everything and there are people who have never gone into debt for anything. As they always say, the ideal is in the middle.
✅ What is a BAD DEBT?
A bad debt is the debt that you incur for the purchase of an object, good or property that does not generate any type of income, moreover, that only generates expense and limited profit. For example, the purchase of a car, a last generation mobile phone, new furniture for the terrace, for travelling, etc.
It is clear that we may all need a new car or a new washing machine, but we must always try to acquire this type of objects and goods without debts, thus avoiding the interest and expenses generated by the loan in question.
For this type of expenses you can pull the savings fund that you will have generated with the passage of months and years, but … do not abuse that fund! Only use it when you need it, not for whims. If you can’t make the trip of a lifetime this summer or you can’t have the last iPhone you want on launch day, keep saving and run that expense the day you have 100% of the amount.
It is clear that a car is not an item that costs hundreds of euros but thousands, but in this case if it is very necessary to change the car because the previous one has stopped working or because the family has increased and you have become too small, try to provide the maximum amount to start the loan is as small as possible and its share is affordable.
Many people think that you always have to buy a car on credit even if you have the cash to buy it, because while you pay the installment of the loan, the rest of the money can be invested in order to grow your money.
This is a good way to look at it but if your investments rent you 6% per year and the personal loan to pay for the car is 8% per year you are losing money.
Here everyone decides how to carry out the purchase of a car and whether it is a good or bad debt, but in my opinion a car is a good that loses value from the first day of purchase and we should never pay more for it than it is really worth, so I would always try to pay it once or with a loan of very little amount if my savings fund does not allow me to buy directly.
✅ What is a GOOD DEBT?
A good debt is one you acquire to generate extra income from it. For example, you find an apartment in the center of your city that is at a price below market and you have the possibility that the bank gives you a mortgage at an acceptable interest rate and you buy it to rent for days in vacation and tourism plan or for long term rental getting an annual income higher than what you get the payment of the mortgage debt and the costs of the apartment.
In this way you are getting into debt, but it is to get an income higher than the expense while your assets increase.
An important note: before buying any home in order to get a passive income, either through long-term rental or vacation rental through platforms such as AirBnb, make good calculations.
Buying a home as an example of possible good debt.
Bearing in mind that each case is a world and that in each country or state the tax scales may vary, I am going to make some quick calculations with data as close as possible to the reality of a city like Valencia and what we could do acquiring a good debt.
It is easy to find 2 bedroom apartments between $100 and $125,000 for different areas of the city that are to enter to live doing some minor repairs and could be offered for long term rent for about $650 a month.
If we go to the bank to ask for a mortgage we will be given a maximum between 70 and 80% of the value of it:
- 125.000$ * 80% = 100.000$ of mortgage
- Mortgage rate: fixed at 2.25% per annum for 30 years.
- Mortgage installment: $381.08 per month leaving a total of $2,203.03 in interest amortized the first year.
- Rental income: $7,800 per year ($650 per month).
That $7,800 a year that we would pay for the rent would be the yield obtained by our investment from which we would have to deduct all the annual expenses generated by the housing and that would make our taxable base in the IRPF not increase as it should. Within those deductible expenses we have the following:
- Interest generated by the mortgage: $2,203.03 the first year (as I have indicated above)
- Housing Continent Insurance: 150$ / year (approx.)
- Taxes: 250$ / year (approx.)
- Community expenses: 480$ / year (approx.)
As time goes by, the property suffers an effective depreciation that is carried out by means of the calculation of the Amortization of the property and that is the result of applying the percentage of 3% on the greater of the following values: acquisition cost or cadastral value without taking into account the land. In the case of this example we would speak of about $3,750 (which is 3% of $125,000).
In this example, the income from renting the dwelling amounts to $7,800 from which the expenses indicated above must be deducted, $6,833.03, so that for our income tax return we obtain a net return of $966.97 (which is not the same as the actual profit for renting the property).
The Taxes establishes that in the cases of lease of real estate destined for housing, the positive net yield is reduced by 60%.
In the example, the reduction would amount to $580.18 (which is the result of applying 60% to the $966.97) and the final yield obtained by renting the house to the Treasury would be $386.7 ($966.97 minus $580.18).
Thanks to the tax advantages of cost reduction, the effective depreciation of the property and the reduction of the positive net by 60% we will practically pay no taxes for having the rented property under the assumption of the example and our patrimony will rise year after year thanks to the rent income and the revaluation of the property.
Beware, however, because a good debt can turn into a bad debt if you have an empty property that you acquired to rent or if unfortunately you have a tenant who becomes delinquent.
MY TIP: If the passive income does not rent you a minimum of 6% a year on the value of the purchase after deducting expenses of the new home (taxes, community, etc.), mortgage interest, possible reforms and inflation, do not consider buying it. It will always be better to allocate that money to your investment portfolio.
Summarizing in a single sentence:
“A good debt is one that “others” pay and a bad debt is one that only you or your family unit pays.”