Good debt versus bad debt

How do you approach your clients so they aren’t afraid of leveraging? Can you simply explain the concepts we are taught? Here are some of the ways I clarify the concept of good debt versus bad debt.

As I work with my clients, whether they are business owners or employees, I always try to teach them the six basic steps to growing their own wealth. One of the most important is to understand debt. What matters is not so much how much interest you are paying, although that is a very significant factor. What really, really matters is whether you are paying interest on interest.

The first step in planning is to understand your real cash flow but once you’ve got that part down and are sure what is happening with your money at every point during the year, then we need to look at some of the other basic assumptions. You are the manager of your finances. You get to decide if you buy a sports car or boat. You get to choose to take care of yourself and your family…or not!

We are all told that our aim in life should be to buy a house and pay it off quickly. Then, and only then, will we have the spare cash to start saving for our old age. Assuming we don’t have kids, are never out of work and don’t have health issues, we can all do that. When we are too old to work, we can sell the home we sacrificed so many years for, go pay rent somewhere else and try to live on the equity. That’s the North American ideal.

If you take the traditional route, how many meals will your home equity buy next month if you have no other income and weren’t putting away any savings?

Let’s take a look at a typical mortgage in this day and age. The reason you took out the mortgage is you needed money to buy a home. The bank is happy to lend you the money and allow you to pay back monthly amounts of principal and interest for 20 – 30 years. A fixed rate mortgage runs at bank prime + 2% (approximately 4.25% at this writing). The interest is calculated semi-annually and since payments are balanced over the amortized term you end up paying Compound Semi-Annual Interest. That means interest on interest.

Now, I have a question for you. What does the bank do with that principal that you repay each month? Do they have a drawer with your name on it and put the money there until you finish paying off the loan? Certainly not. They re-invest that money by giving it to someone else and earning more interest on it.

That’s called leveraging money. It’s your money, why can’t you do your own leveraging? Well, it turns out that you can. Have you heard of a self-directed mortgage? There are some conditions around it but here are the specifics. You take out the mortgage for the same reason – you need money. If you are employed you can qualify for up to 80% of your home’s value. If you’re self-employed you can qualify for up to 65%. That means you don’t have to go re-qualify for money again and again as you progress through life. You could eliminate credit cards, car loans, other lines of credit, etc. You would have just one place and one interest rate for all your needs.

The variable line of credit or self-directed mortgage is typically bank prime +1% and you’re obligation is to pay the interest calculated that month. On a $300,000 mortgage over 30 years that reduces the required payment at least $500 per month. You don’t have to pay any more if you hit a bad month with other expenses or are off work for a time. The interest is calculated monthly and you never pay interest on interest.

I know what you are thinking…”I will never pay off my mortgage”. First of all, you would want to pay off any other debts which are at higher rates of interest. Then, you might use the extra cash to start or contribute more to an RRSP and a TFSA. Even if you are taking care of all those things you could put that extra principal into a guaranteed fund or money market fund and earn 2-3% on that money. Periodically you might want to take the principal and pay off some principal on the self-directed mortgage. The great advantage there is that you will be charged less interest the next month and have more to save.

Who is in charge of your financial life and your money? The answer should be – you are. I teach people how to use their resources to their own benefit. We as Advisors should be doing this much more often.

Why doesn’t the bank tell you about this? It’s not in their best interest. If everyone switched to self-directed mortgages they would lose the extra earnings they gain from lending money out many, many times instead of just once. Why not deal with an insurance and investment professional who works in your best interest?

If your not telling people what knowledge you have you are not helping them as much as you could. Every advisor should be out there learning about all the products available in the marketplace and teaching their clients how to use them to their advantage. We have a golden opportunity to be educators while we earn our living. What are you learning?