If you spend some time in the various personal finance spaces around the great Internet, you’ll eventually stumble upon statements like this:
Debt is bad! You should avoid debt by any means necessary!
While I don’t dispute the fact that living debt free might “feel good”, in terms of economical advantages, living without leverage is not mathematically sound – especially not in todays interest environment (0.5% 30-year fixed-rate loans are available in Denmark these days. 0% 15-year fixed-rate is available and even -0,5% 10-year fixed rate too).
But obviously there’s a huge difference between debt and leverage.
What do you mean Nick? Sounds pretty much the same to me?
Well, you might have heard the terms “Good Debt” and “Bad Debt”.
Debt is per definition bad – UNLESS you use it as leverage to purchase an asset.
If you borrow money to purchase a depreciating asset like a car, an iPhone or even a luxury vacation – well then, you’ve joined the owners club of bad debt.
On the other hand, if you borrow money to purchase an (expectedly) appreciating asset instead, welcome to the owners club of good debt – also known as L.e.v.e.r.a.g.e.
The most well-known of appreciating assets are of course real estate, but also rare (collectable) artifacts like paintings, watches, jewelry, sculptures, fine wine or even cars could be put in this category.
Education can sometimes also be considered as an asset, provided that said education grants you marketable skills that can increase your future income.
In general, it’s pretty acceptable in society that one acquires some good debt to purchase a home. The problem is, it also seems to have become acceptable to acquire a shit load of bad debt, because we’ve become a society built on status symbols. If your neighbors/friends has fancy new gadgets and expensive consumables, you automatically crave the same – at least that’s what we’re taught to believe.
I’m no different. I used to drive fancy cars and buy the latest gadgets, because I thought it would fulfil me. But guess what? It didn’t.
I never had any bad debt though – and you shouldn’t either!
So why is Good debt better?!
Well, it’s pretty obvious: when you use good debt/leverage to acquire an asset you otherwise would have spent 10-15 years saving for, you jump-start the compound-engine ahead of time!
This is why I chose to deploy some leverage in order to purchase my Property #1, and it’s also why I’m considering doing it again to purchase my next property! (I’ve already paid of the leverage-loan on Property #1). I also find that leverage can work as a great carrot for me to try and save more, to bring it down faster (only to deploy it again at some point, ofc 😛 ).
However, when you go to the bank to borrow money to purchase your own home, they first and foremost focus on your debt factor. Which mean they focus on your debt:income ratio.
The banks like to keep the ratio between your debt and your pre-tax household income at a maximum of 4:1. 5:1 then you’re “high risk”, and above that they’ll most likely deny you the loan.
When we purchased our current home, our ratio was 5.1:1, because we also had a vacation home. We later sold our vacation home (which led to me starting this blog) and our current debt factor is now 3:1 (give or take). This is a level that both I and the banks are pretty comfortable with. – However, it puzzles me that they wouldn’t first and firemost look at your expense to savings ratio and your savings rate. I believe savings rate would be the most interesting metric when granting loans to people. But I guess they also somehow factor in these metrics, so the debt ratio can be used as a guiding principle.
Whether leverage is worth it is entirely up to you. To me it’s simply a matter of math. If you can borrow at 4% and your asset appreciates (expectedly) 8% (or more) per year, then leverage is in my opinion a no-brainer (as long as you keep and eye on your debt ratio). Gearing investments always adds an element of added risk, so make sure you’re comfortable with adding more risk to your portfolio.
Since I’ve been at 5:1 before I don’t mind going there again, but I’d prefer to be around 4:1…
I (once again) have my Property #2 in sight!
What’s your debt factor, and are you comfortable at the current level?
If you have the “friværdi”, you could use that I guess. Will be very interesting to hear more about.
Right now I dont, because I’m aiming to get below 60% LTV. But if I was at like 40% LTV I probably wouldn’t blink twice to leverage that equity to buy another quality property. But unfortunately I’m not at 40% LTV. I could sell my house an buy a cheaper one (which my wife is eager to do). The problem is that it would take years to recuperate the notary fees and realtor fees – also moving is never cheap 🙁 But we are currently considering our options. We like where we live, but we could easily fit into a smaller more affordable Home for sure. My wife is into tiny houses, but that’s not really my thing haha. We’ll see!
It is easy to underestimate the risk, there is a reason the people you are lending from aren’t just buying the assets themselves, it’s never a “no-brainer” where you can just look at the expectation. IMO you have to be real clear why you think the asset is better (lower risk/higher reward) than it looks to the bank/lender. In the case of buying a private residence that’s easy to see since you are going to live there so you can eliminate the risk-vector of bad/no tenants (+ there are tax benefits compared to lending out the house). I can’t really come up with a similarly good reason for stocks or commercial real estate. I think that’s a big part of the reason why it’s considered fine to take out a loan for house, but people would blink twice if you told them you loaned a million to put in the stock market or into a commercial real-estate adventure.
On another note, if your goal is FIRE then leverage should be very short term, adding a bunch of debt makes you less independent until you get back out of it again.
Thanks for a fun article.
@P2035 are you saying you would rather be paying 2% on the loan of your car and then put cash into stocks you expect to pay out 3% annually. Because that gap seem way too narrow to account for the fact that 2% is written in a legal contract and 3% is just a hope, seems too small to even account for the taxes. I think you should pay off the car.
Hi Johan, thanks for another great comment as always 😉
I understand what you are saying, and it’s funny you should mention “a million” as an example, as that’s actually what I’m currently willing to borrow to get Property #2 into my portfolio. This would bring my debt ratio to around 4.5:1, which is still alot less than when we had our summer House. Unlike the summer House, Property #2 would only cost me the interest payments, and I would have no (presumably) maintenance and tax expenses on top of it, like we did with the summer House. So as I see it, if I was willing to borrow 1 million for a summer House on top of my Home (we did have a much cheaper House back then than we do now), I dont see why I shouldnt be willing to do the same for a property, which has a 15 year fixed rental agreement. As always, it really depends on the location and the quality of the tenants. In this case since it’s commercial real estate, I know the tenants quite Well, as their financials are public knowledge.
The only thing that’s different, is the interest rate (as high have to borrow at a higher rate).
Nice, never tough about calculating Debt/Income. Our debt sands at 72k (I even included debt to my mom, bank-parent is a serious financial institution 😀 ) then our 2019 income was 26k, so that makes our leverage somewhere 3x. Looks like were ok with leverage. I have one bad debt – car leasing. Bought 3y toyota… I just hate old car repair cost and breaking down car. Yes cost on transport increased now but at least I have a working car 😀 paying 2k€ for repair and it still breaks down after a month, that was just to much 🙂 I intend to hold my Toyota way after the leasing. Its a big question what is better old car with shit load of repair cost, or new car with leasing cost. I pay 2% for my leasing, no need to pay it down. I better invest money into 3-4% dividend paying stocks 🙂