I was chatting with a friend the other day, discussing money matters and the idea of winning the lottery came up. When I asked what she’d do if she won a million dollars, she immediately blurted out: “I would pay off all my credit card debt, student loans and mortgage then invest the rest…$1 million will just about make me debt free”. I told her that won’t be a smart move and she looked at me as if I had a third eye smack in the middle of my face.
Some people avoid debt like a plague. From my experience and training, debt or OPM – other people’s money as I call it, if used wisely, is a great way of attaining your long-term financial goals and can be used to leverage one’s finances. Companies use leverage (if managed appropriately) to shore up their enterprise value and high net worth individuals leverage debt to boost their cash flow for investment opportunities.
GOOD DEBT: any debt that is used to invest in assets that typically appreciates in value is good debt. For example, in an expansionary economy, a mortgage taken on a principal place of residence or business is a wise move i.e. as long as the asset is poised to increase in value, this equity can be tapped into in the form of a home equity line of credit or in the event of a sale of the property, the proceeds from the sale will more than offset any remaining mortgage principal left at the time of the sale. Furthermore, all things being equal, mortgages are typically the cheapest form of debt due to their low interest rates.
BAD DEBT: good debt turns bad when the debtor is out of his/her depth and has allowed the debt to spiral out of control and/or the current income cannot cover expenses and debt repayment. High interest rate credit card balances or high interest personal loans are bad, bad debt.
Below are 3 ways to make debt work for you:
- Own only a couple credit cards: Choose credit cards that come with perks and opportunities to earn points and take advantage of those perks. The key is to pay off the credit card balance every month and not let it build i.e. zero interest financing. That way, you earn points by using the card but do not incur any interest if you pay off the balances every billing cycle. At some point, you can then redeem your points for perks. Stay off store-branded credit cards as these come with very punitive interest rates, north of 20%. If you must have a store-branded credit card, maybe for earning points, ensure you pay off the balance every billing cycle.
- Student loans: In the final analysis, obtaining a student loan for the purpose of getting a good education is a great idea but you must do the homework i.e. ensure that the career prospects in the field of training is excellent, you graduate with honors and can secure a good job upon graduation to enable you pay back the student loan in a short space of time. Be smart about your career prospects and invest wisely in studies that will put you in demand and increase your earnings potential.
- Never convert unsecured financing to secured financing: Sometimes when one applies for a home equity line of credit, the lender often times will request that part of the proceeds be used to pay off credit card balances (maybe in an attempt to reduce the debt-to-income ratio). This effectively converts unsecured debt to secured debt which, inadvertently, increases the likelihood of the lender foreclosing on your property in the event of a payment default. If you have high-interest unsecured debt e.g. credit card debt, seek out credit card deals that offer zero-interest on balance transfers for a specified period and transfer the balance from the high interest rate card.
Back to my lottery scenario, I would offer the following advice:
- do not pay off the mortgage since it is the cheapest form of debt
- pay off the credit card balances
- if the student loan interest is low e.g. below 5%, do not pay it off just yet
- invest the remaining lottery win proceeds i.e. after paying off credit cards balances in a high yielding investment portfolio or in the stock market with a medium term horizon say 3 – 5 years. Historically the stock market goes up over time and at end of year 5, those investments would have appreciated in value and the profits from such investments can then be used to pay off the mortgage and/or student loans while the original principal investment remains primarily intact.
Drop me your comments, I’d like to know of other ways you have made OPM work for you (or not). If you also won the lottery, I would love to know, maybe you can blow some luck my way 🙂