Advanced Debt

Getting to grips with debt

In previous posts I have almost always made reference to debt as burden and to be avoided as much as possible. I wrote of the perils of debt and how to try to begin to tackle it. The following ideas should be considered carefully. I am not advocating taking on debt generally, especially if you have a poor history in controlling your personal finances. The following is an idea as to how to use debt to your advantage.

Using debt to your advantage

Let's consider what is debt? Debt is a liability. This means that it takes money out of your pocket. For example, If you take out a loan to purchase a car you will pay back the amount borrowed over time plus interest. So for debt to be good, are there any ways that you could borrow money such that each month you are better off having borrowed that money?

Good debt versus bad debt

Good debt should increase your cash inflow each month, whereas bad debt will increase your net cash outflow each month.

An example of good debt might be the mortgage on an investment property that is producing cash positive returns. Let's use an example to consider how this might work:

Good Debt Example

You find a 2 bed flat worth £200,000. You have £50,000 as a deposit and borrow £150,000 from the bank. At 4% mortgage rates, the house costs you £500 per month. However, you have been able to find two tenants each willing to pay £400 each for the flat. Assuming that maintenance and insurance costs you about £200 per month, you find that you are actually cash positive each month by £100:

Income (2X£400): £800
Mortgage: (£500)
Maintenance and insurance: (£200)
Total: £100

As you can see, even though you have £150,000 of debt, cash-flow-wise you are actually £100 better off each month.

Additionally, assuming this is not an interest only mortgage, the mortgage is actually being paid off by your tenants over time. The debt will reduce each year such that in 20-30 years it is all paid off.

Warning: Taking on an investment property should only be done if you have your personal finances in check and under control. Make sure all the maths checks out before buying an investment property. Make sure you will be cash positive each month and that you have stress tested for increased interest rates.

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Anonymous said...

I agree with this post but should we not also consider the income which the £ 50,000 would have generated anyway. So for example it could be invested at 3% fairly easily in relatively risk free dividend producing shares to give an annual positive cash flow of £ 1,500. In the example above taking on all that debt reduces the annual cash flow to £ 1,200.
Also you say "assuming this is not an interest only mortgage" but if £ 150,000 @ 4% is to cost £ 500 per month is it not interest only by definition?

Mr. Moneybanks said...

Hi there Anon. Your dividend example is a good argument and as someone who would prefer to take the safer road in investing, I'd be very tempted. However, you ignore the leverage that you get through taking on a mortgage via any capital gains. For example, if the house price increases by £10,000 over one year, that's only an increase in 5%. However, due to leverage on your £50,000, this is a 20% return on your investment.

In your second point we would simply be arguing as to whether it is possible to get a buy to let mortgage at 4% or whether it would be more. Of course this would differ for different people based on income, credit score etc.

Of course, both points that you have made are important as it identifies the assumptions that I have made. The calculations prior to any investment should be done carefully and stressed tested for changes in interest rates to check that you can still afford the investment.