"Good" Debt Versus "Bad" Debt

Yes, good ol' dennis from wall straits.
I find him pretty ok, he dishes out some good advice.
But I think he was a bit too strong in his own views and that caused a lot of unhappiness between him and other folks.

Onto good debts and bad debts.

Good debt :
Money borrowed to generate a higher rate of return.

Bad debt :
Money borrowed to generate zero or negative returns.(think gambling)

On paying down your mortgage.
It's to do with personality. Some people just cant live normally knowing that they are in debt.
For this group, if they do not know where else to put their money, it is best to pay it down.

Others thrive on debts/risks, the more the merrier.
Debts means leverage, the aim of this is to magnify your profits.
For the ambitious folks, there is no other way than to take on more debts
to start/grow a business/make investments.

go to the Greece or ireland or spain and start preaching to people debt is good and see what kind of reaction there will be

{Another investor in the group, Mr B, managed to catch the bottom in the last crisis, when the STI hit 1,500 points. Then, convinced that equities were just too cheap, he mortgaged his properties, paying an interest rate of 2 per cent, and plonked the entire sum into Reits, which were yielding 10-plus per cent at that time.

He has since exited the market completely and is sitting on cash. In addition, he has raised additional cash from banks using his three properties as a pledge. This time, he is paying an even lower rate of 1.5 per cent. And he is looking to get into the market when the STI falls to 2,500 points. Again, he is intending to put his money in Reits which own prime properties.

The group however noted that over-leveraging can wipe out an investor. But they acknowledged the relative soundness of Mr B's strategy of raising cash from his real estate at a cheap rate, and deploying it into the stock market during a crash. This is a far smarter move than taking up share margin financing during a bull market.}

Good debtsLeverage)
The above seems to be very good debt. 10% Reit's yield versus 2 % bank's loan interest rate on pledged properties. This is indeed look quite a sound leverage.
Can some one tell me what are the possible risks or downsides to this leverage?
If properties' prices crash, what happen then?
How much is the damage?

1) Thanks for posting this article Behappyalways!

Learnt a lot and is very much inspired

"So he told the real estate agents who specialised in that project at that time to bring any potential buyers to him first. He'd pay them a commission of 1.5 per cent, instead of the normal one per cent. As such, he was able to offload all four units in a short time."

When I wrote my post: http://singaporemanofleisure.blogspot.co...othes.html

at the back of my mind, I was thinking of a Taiwanese article 5 years ago on how a 35 years old single normal executive salary guy managed to "trade and upgrade" his way from a shoe-box" apartment at age 25 to a landed house in Taipei 10 years later. (When his peers were complaining that Taiper property prices were out-of-reach...)

One of his secret was to pay his property agents well. These property agents know that he will move apartments every 18 to 24 months to "upgrade" - the profits of the previous apartment will pay for the downpayment for the bigger apartment. This young investor gets the first pick of new listings/opportunities since he has made a reputation of paying above market rates to his property agents.


2) Temperament,

I do the leverage method on a much smaller scale than the big guys mentioned in the article; but the principle is the same.

For eg, if I have a fully paid up condo worth 1 million, I can take a home equity loan for 500,000 thousand (if I am conservative) to re-invest into REITS - pay bank interest 2% and get make on the difference on the higher REITs' yields - with bonus on capital gains if the REITS appreciate in value during a recovery.

This way, if my condo halves in value (like in US) in a property crash, I still will not get a cash call from my bank. More aggressive investors may prefer to borrow 1 million from their property. But more gains potential = more risks! I have to get my market timing right!!!

Alternatively, I can also borrow 200,000 or 300,000 thousand instead. Less profit potential; but sleep better. If Singapore property market crash 70 to 80%, we would be worse off than Spain or US!!! Of course technically can happen in a depression.

Nothing is risk free. Nothing ventured; nothing gained.

For me, since HDB does not allow home equity loans, I don't pay up my bank loan 100% when I can afford to. I prefer to have gunpowder when opportunity appears before me

Hi Jared Seah,
What you said about home equity leverage seems workable. Must find out from the horse's mouth though. What is the actual details? i am always amazed by actually how to use "Good Debt" and how to make it less risky? Almost all businesses' capital structure use debt.(OPM). Why can't we ?

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Leverage is possible, but what will you be using as a pledge?

1. Your paid up or nearly paid up private/commercial property?
2. You company? (and of course it must have a track record of profitability/etc) and interest rates aren't exactly low, in the region of 5-7% currently.

The deal is this, banks will borrow to those who want the money but don't need the money.

Hi,
If interest rate is 5-7% then it's a different kettle of fish, altogether. The risk is different again.

(21-11-2011, 12:22 AM)hmwes Wrote:

My 2cents. Personally believe that "good" leverage for personal invesmtent is possible but the conditions are stringent:

(i) leverage is for investment and not speculation or consumption and the chances of success are good,

(iii) financing costs are very much lower than the expected returns, leveraging to boost a 1-2% spread is akin to the LTCM model,

(iii) borrower is effectively debt free and the amount of leverage is limited to wiping out only a fraction of surplus assets,

(iv) borrower have other sources of income or reserves in place to meet ongoing interest obligations as a backup to prevent liquidation of the leveraged investment while it is being played out,

(v) if collateral is used or required, then the collateral posted should be of stable value with low volatility to prevent temporal fluctuations from resulting in margin call, hence shares are poor collateral due to volatiliy,

(vi) there should be considerations on how/when to throw in the towel and liquidate the leveraged investment and manage the outstanding debt should things fail

Hence, my view is that leverage by most individual retail investor cannot be "good" debt even for investment purpose because of inadequate risk capacity like being effectively debt free, having sufficient and stable collateral etc. . This is especially true for working class individuals who still have a residential mortgage loan to service. In the event of investment failure, he will have "bet the ranch" and the debt will erode not surplus assets but rather throw up livelihood issues like personal bankruptcy, downgrading to a smaller home etc.

PS: Leverage for starting a business is different as the borrower will have much higher degree of control and the advantage of limited liability barring personal guarantees.

Hi hmwes,
Super, duper, solid, practical principles on "Good Debts"(Leverage). The best i learn so far. Actually i am allergic to debts but at the same time amaze. Amaze how some people can use "Good Debts". You have definitely enlightened me. Your article is a GEM for me to collect and never to forget. i also hope one day i have what you say, so that i can put it into practice.

" leveraging to boost a 1-2% spread is akin to the LTCM model,"

May i known on how many % spread is then worth to consider using "Good Debts"? (if all your advices are met).
(Me think you are "Master GOOD of DEBTS").
Thank you very much.

(21-11-2011, 12:22 AM)hmwes Wrote:

(iii) borrower is effectively debt free and the amount of leverage is limited to wiping out only a fraction of surplus assets,

(iv) borrower have other sources of income or reserves in place to meet ongoing interest obligations as a backup to prevent liquidation of the leveraged investment while it is being played out,

Hence, my view is that leverage by most individual retail investor cannot be "good" debt even for investment purpose because of inadequate risk capacity like being effectively debt free, having sufficient and stable collateral etc. . This is especially true for working class individuals who still have a residential mortgage loan to service. In the event of investment failure, he will have "bet the ranch" and the debt will erode not surplus assets but rather throw up livelihood issues like personal bankruptcy, downgrading to a smaller home etc.

Hi. Good post!

So is it your recommendation that only those who are debt-free (i.e. paid off their housing cum car loans) take up "safe" leverage? That would ensure these people don't crash and burn should something bad happen.

I think most people have day-jobs (those I know at least), so effectively that provides a consistent income stream. My question is should one still take up leverage as an economic downturn may still cause sudden loss of jobs or result in a pay cut. The problem with leveraged instruments is that it is not so easy to just liquidate and take profit/loss, especially if the bet has gone the wrong way. So even though one may be assessed to be "safe", how safe is a salaried job these days?

All in one, I do agree that most salaried employees are ill-equipped to use leverage wisely. Businesses and companies are in a much better position to do this due to the corporate veil which protects the shareholders from litigation and complete asset wipeout!