Self Made: NASE's Blog

Good debt ... Bad debt! [NASE Experts]

Thursday, August 02, 2012

Posted by Gene Fairbrother - Contrary to what you hear or read, debt is not always bad! Especially for entrepreneurs, debt is almost unavoidable and making all debt one bad bogeyman is bad financial thinking. The secret is to control debt and use good debt as an investment tool.

If all debt were bad few people would own their own home or live in a 750 square feet adobe. As for starting or expanding a business ... without debt, that would be nothing more than a great American dream.

The real issue is whether your debt is controlled or uncontrolled. And that is where most people go astray, by ending up with more uncontrolled debt than controlled debt.

Granted, if you have more month than you have money and it's difficult to meet even the minimum payments on your debt you have a problem. But, if your financial picture is more comfortable and you think you’ll be better off paying off all debt ... you might be making a poor investment decision. Here's an example related to personal debt, but the same philosophy applies to business finances. On the personal side, there seems to be a lot of hype to pay off home mortgages early and supposedly save tens-of-thousands of dollars in interest.

So let’s crunch the numbers. Suppose you have a $150,000, 15 year mortgage at 4 ½%. The first number crunch is that if you factor in the tax deduction for mortgage interest your net interest rate is around 3 2/3 %. If you decide to pay off a mortgage early by paying an extra $250 each month you would pay off the mortgage in 11 ½ years at a savings of $11,000 in interest. But, if you invested that same $250 a month with a 5% return you would build an investment worth $46,500 with a return of $12,000.

Another example is people wanting a consolidation loan to pay off several debts. They may a few credit cards at 9% or 12% and they are willing to take out a 14% loan so they only have one monthly payment - No ... No ... No! You almost never replace a lower interest debt with a higher one. The exception is if you have a cash flow problem and need to lower your monthly payments to make ends meet.

For around 90% of people going into business, start-up capital comes out of their own pockets or from friends and family. This often means credit cards, a second home mortgage, or tapping into retirement accounts. Although these are not the best options, a lot of successful people have gone into hock betting that an investment in themselves will create success.The challenge of using debt as an investment is to control the debt. If you answer yes to any of the following questions you might be on the wrong side of debt:

If your income (business or personal) fell 20% or more would you have difficulties?
Have you written checks that exceed your account balance?
Are you in arrears on any bill because you don't have enough cash to cover it?
Are you using one credit card to pay another one?
Do you resort to using credit cards because you don't have money to write a check?

Handling debt is like handling any investment. You need to take a realistic look at your specific position, crunch the numbers, and make decisions based on your overall financial well being.

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Self Made

A blog on the self-employed and micro-business

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Katie Vlietstra - As Vice President for Government Relations and Public Affairs, I work to explain how actions on Capitol Hill can impact the self-employed. I love D.C. and have made my home in Capitol Hill, where I live with my husband and black Labrador, Coltrane. We love playing volleyball and softball on the National Mall. 

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