Debt generates a great deal of discussion. Many people feel that all debt is bad, while others think a little bit of debt is perfectly normal and not worth worrying about. Many more believe that when used properly, smart debt can be a helpful tool to improving one's overall financial health. Those people would be right.
Before we can discuss what smart debt is, let's define its opposite: Stupid debt is any form of interest payment that doesn't go toward an appreciating asset. Borrowing money to put a hot tub in your backyard is one example of bad debt. It doesn't matter how nice the hot tub, it will never appreciate in value, meaning you are paying for something that in five years time will need to be replaced. That's not very smart. Another example is to borrow for that once-in-a-lifetime vacation. The minute you return home from your trip the thrill is gone but the interest payments keep heading out the door. That's a sure way to end up broke.
Smart debt, on the other hand, uses other people's money to grow your assets. By borrowing money from the bank to finance the purchase of your home, over time your equity increases through price appreciation and principal repayment. Investment properties take this principle one step further. Banks and private lenders provide capital to you to purchase rental properties. Once you've renovated the house and filled it with tenants, you're on your way to increasing your net worth.
The rental income from your tenants will help pay your mortgage. As the years pass, the interest portion of your monthly payment will shrink and the principal component will rise. Eventually you'll be in a position to refinance, withdrawing some of the equity built up in the house. Once done, the positive cash flow generated is free money. You've already removed your own invested funds from the property, living off other people's money.
To help understand smart debt, it's a good idea to look at how a company's balance sheet works, since the principles are basically the same. On the left side of the page are assets and on the right side are liabilities and shareholder equity. These two sides must always balance. Shareholder equity is the money remaining after subtracting total liabilities from total assets. Within total liabilities is the heading "long-term debt." These are funds the company borrows to increase company revenues well into the future. By leveraging, they're able to increase the overall value of the company. You can do the exact same with investment properties. Leveraging the equity in one property to finance a new property, which will in turn increase your cash flow, is what smart debt is all about.
Companies buy other businesses hoping to produce better annual revenues than the previous owner was able to do. The faster they generate revenue and pay down the debt, the faster the net worth or shareholder equity increases. This is smart debt at work and it works just as well for individuals as it does for corporations.