In America, we are all too familiar with personal debt. This refers to money we borrow to purchase items (assets) that will most likely go down in value (depreciate) over time. It is the most costly type of debt a person can have, because eventually the item purchased will depreciate to $0. Something you purchased five or ten years ago for $50-$100 finds itself front and center at your next garage sale for $5 or worse yet…being donated to the local Goodwill just to clear space for more “stuff”.
- The dreaded auto loan: Talk about investing in an asset that depreciates seemingly by the day! Imagine borrowing $30,000 for that new car, with an interest rate of 6%. Your monthly payment of $580 over five years will pay back the $30,000 you borrowed, along with $4,799 of interest expense. At the end of five years, you might find yourself with a car now worth $10,000. Your payments of $34,799 over the last five years, minus the current value of $10,000, means the net loss of this investment was $24,799.
Other common types of personal debt include most credit card purchases, personal loans, boat loans, and pretty much any unsecured type of debt.
On the other hand, investment debt refers to money borrowed to purchase something that will typically increase in value (appreciate) over time. While this is a form of debt, it often helps increase a person’s net worth. Unlike personal debt, Investment debt is often secured by the asset being borrowed against.
- A home mortgage: One of the most common type of investment debt is a mortgage used to purchase residential real estate. Consider the purchase of a $200,000 house with a 30-year mortgage of $160,000, with a 7% interest rate (yes, I know…much higher than today’s rates…but a much more historically normal interest rate). If the house itself were to appreciate at 4% per year, it would be worth $662,700 in 30 years. The interest you pay over that time would total $223,214. Thus, your initial cost of the house ($200,000) plus the interest expense ($223,214) would total $423,214. However, you would now own a house worth $662,700, resulting in a gain of $239,486 of increased net worth! (No, not adjusted for inflation…but neither is the personal debt example.)
How you borrow, and what types of debt you carry, impacts every aspect of your financial future. For a complete BorrowSMART/RepaySMART Review™, contact us to get scheduled!