Stupid Debt, Smart Debt

The rich are different. And they think about debt differently. Most people struggling with overwhelming debt dream about being debt-free. Yet many wealthy individuals willing get in and out of debt all of the time. In fact, debt is part of their overall financial strategy.

 How does that work?

It’s smart debt. Smart debt is using debt to leverage money. For example, if I can borrow money at 6% but can make 10% investing it, it’s smart to borrow in order to invest. Granted, such situations are incredibly rare in actual real life, but it’s a theoretical answer.

Smart debt is always about improving your bottom line, that is, your individual net worth. For example, let’s say I shop around and find a very underpriced home on the market for $100,000. I buy it, putting $10,000 down and taking out a $90,000 mortgage. If the house could truly be resold for more money, that’s smart debt. Let’s say I invest another $10,000 to spruce the place up. Now I’m in the hole $110,000. But if I can turn around and sell the place for $150,000, I just made $40,000. That’s using debt the way the rich do.

But if I really really really want to go to DisneyWorld and don’t have the money and load up my credit card for $10,000, that’s not improving your net worth. You may have memories, but you’re out $10,000 and there’s no hope to recover that (you can pay it off, but you can’t turn around and “resell” your vacation). Not only that, you owe interest which is rent on your money.

Smart debt is characterized by three things:

1. There is an exit strategy. You don’t get into smart debt unless you know how you’re going to get out, when you’re going to get out, and what your emergency exit plan is in case disaster strikes.

2. You are leveraging or amplifying the power of your money, that is, you are using the debt to “buy an opportunity” that won’t otherwise be available to you or would not be wise. For instance, if I buy a house with a mortgage, thinking I can re-sell, it might not be smart for me to liquidate my 401(k) plan to make the purchase … but a mortgage would work.

3. The smart debt improves your net worth.