President Richard Nixon took the United States off the Gold Standard in 1971 and turned money into debt.
From the Gold Standard to Debt
Until 1971 the United States dollar was backed by gold. This meant that for every $1 that existed in circulation there was an equal amount of gold held by the United States government. US currency notes were previously issued as receipts for a deposit of the precious metal. Indicating that a deposit had been made in the treasury for that amount of gold. This was quite literally printed on the bank notes.
When President Nixon took the US off the Gold Standard he severed the tie between US currency and gold. By doing this he turned the US dollar into a fiat currency. This meant that it now officially was only backed by the good standing of the United States government.
Money is only a promise
Money became debt, a promise that over time the government will honour all trade that is conducted with its currency. This meant that the government was able to print as much or as little money as it wanted. This is because it is backed only by a promise.
As a result of money being debt money is only created now when a debt is incurred. What does this mean?
Let’s use buying a house as an example.
Let’s say you buy a house for $300,000 hold on to it for 10 years and then sell it for $550,000. This would sound like a good return on investment. But it is important to understand that the value of the house has not changed. It is still the same house for all intents and purposes. It is the value of the currency that has changed and it requires more of the currency to purchase the house.
If the sale were to be made in a different form of currency, then the price would be different. If for example the agreed currency was Pound Sterling then the price might £425,000. If it was in gold then it might be 370 ounces. The point is that the value of the property is based on whatever the chosen currency.
How does this help us?
When you get a loan from the bank to buy a house the bank is not giving you money. It is literally creating an agreement whereby you agree to pay them back at a certain rate for a certain period of time. If you don’t then they take the house and make an agreement with someone else. When you meet these criteria they give you the deed to the property and you own it. However before you sign on that dotted line, then that money does not even exist.
The government allows them to do this legally through legislation. Smart fiscal managers and politicians decide what is a good risk and create rules to manage this risk. If the risk is too high then they say no.
When you sign the contract and incur the debt then you are only really obliged to pay back the interest. This is why banks often offer interest only loans. It is also why many governments give tax incentives for investors allowing partial or complete deductions for interest expenses.
If you are willing to maintain the debt forever, and have the income to do so, then you never really have to pay back the capital. By paying back the capital you complete the contract and no longer owe any debt. You also own the property outright.
There are investors who do this, however, this is a strategy that must be fully understood before being committed to. The point for illustrating this is that experienced investors and wealthy individuals use debt to their advantage. There are good forms of debt and bad forms of debt, and there is value in owing money.
Good Debt vs Bad Debt
If you have ever looked at ways to purchase items then you are likely to have come across some form of debt financing. The most common types of this are bank loans. Banks will loan money for the purchase of consumer items and investments. They have different rules for various types of loan products and they have different types of loan products for different uses.
Different loan products are neither good nor bad. However, when we talk about good debt vs bad debt then we are actually talking about how we use them.
Credit cards are a valuable product when they are used effectively. The most effective way to use a credit card is to use it for maintaining cash flow. What does this mean?
Using a credit card for cash flow means only spending money on it for things that are necessary. These things may include regular bills that you have in the maintenance of your business or household. Paying the water rates or the phone bill purchasing the groceries. The important thing is to pay off the credit card before the end of the interest free period every time. That way you always have a flow of cash available when you need it.
This would then be classified as a good form of debt. If on the other hand you had a credit limit well in excess of what you can pay off at the end of each period this becomes a problem. If you only buy consumer items with no value beyond personal satisfaction then this is referred to as bad debt.
Your home is not an asset!
Depending on who you ask then a home loan may be a good debt or a bad debt. However we tend to take the view of Rich Dad Poor Dad writer Robert Kiyosaki in saying that a home loan for a personal residence is a bad debt. This does not mean that you shouldn’t do it, quite the contrary. You just need to be smart about the way you go about it.
Robert does not actually say that it is a bad debt. Only that your personal home is a liability not an asset. This is because you always somewhere to live and even if you own it outright it will always cost you money. Things that cost you money and do not provide and income that exceeds those costs will always be a liability.
Making the decision to buy instead of renting a personal residence is a personal decision. If looked at through purely business eyes then you would determine whether it was more cost effective to do one instead of the other. The choice is yours.
How to use good debt
This requires a little home however it can be summarised quite simply. Good debt is debt that is used to produce a positive income. It is important to define the income as positive because if the debt does not produce an income that is sufficient to pay all of the associated expenses then it is simply a liability. It is taking money out of your pocket and putting it in some else’s pocket.
So let’s take a look at the concept of buying a house again. If you borrow $300,000 to buy a house. The finance arrangement with the bank is for 20 years at 10% interest this means you will pay $2,895.06 per month. This may vary slightly depending on the financial arrangement and potential fees and services. This is a principal and interest loan. This means that each month a little bit is paid off the principal $300,00 capital as well as the interest.
If you were to finance this as an interest only loan as part of an investment strategy then this would be more like$2,500 per month. Lets say the rent is $400 per week and after all expenses and deductions this property produces a positive cash flow of $25 per week. The loan on this property would be considered a good debt. This is because it is producing a positive cash flow for the owner.
There are so many people today who think that all debt is bad, however this is not the case. There are different types of debt that are used for different reasons. It is actually the reasons that the debt is used and the nature of the agreement surrounding the debt that makes it good or bad.
Student debt is notoriously a bad debt, because in extreme circumstances they can’t be washed away by bankruptcy. Many students when they enter the workforce do not earn nearly enough in their careers to repay what they owe. There are other students who get high paying jobs and are able to pay back their student debts very quickly.
However, debts that create a clear positive return on investment are fantastic ways to leverage debt to great advantage. These are the good debts that experienced investors talk about.