How to tell good debt from bad debt before you borrow to invest – Mary Holm

A: I haven’t read anything by Thomas Anderson. But I note that he has an MBA from the University of Chicago. I do too, so I’m guessing we may have been taught many of the same basic messages about debt.

In my columns and podcasts and books, I often distinguish between good debt and bad debt.

Bad debt is when you borrow to buy things that lose monetary value. The purchases might bring other big pluses, such as travel experiences, or beautiful clothes or furnishings, or fun toys for children and adults. But for the most part, they don’t bring in income or you can’t sell them later for more than you paid.

It’s fine to run up this sort of debt on a credit card or buy now, pay later, as long as you repay it before any interest or fees are charged. But if you are paying compounding interest – often at really high rates – it can be financially ruinous. You’ll have a lot less travel, clothes or toys in future.

Good debt is when you borrow to buy something that usually gains in value. One example is student loans. In general, people receive higher pay if they have a tertiary qualification. Another obvious example is property. But you can also successfully borrow to invest in shares, gold and so on.

The idea is to benefit from a gain not only on the money you put into the investment, but also on the money the bank or other lender put in. It’s called gearing.

The key is to make sure there is, indeed, a gain when you sell – big enough to more than compensate for the interest you’ve paid and any other outgoings in the meantime.

It’s not uncommon for property investors to find their rental income doesn’t cover the mortgage and other expenses. So they use some of their pay or savings to make up the shortfall.

All goes well until they lose their job or other income source. Or the tenants stop paying rent. Or the rental property needs expensive repairs and they also lose rental income during that period.

Or the mortgage interest rate rises fast. Or the Government again removes the tax deductibility of mortgage interest on rentals, or in some other way makes rental investing less favourable.

That’s when a landlord might find they can’t manage the mortgage, rates and insurance payments, and puts the property on the market. And unfortunately this is more likely in an economic downturn when property values may have decreased.

Sometimes, a landlord is forced to sell the property for less than they paid for it and the proceeds don’t even cover the mortgage. They’re left with no asset and a debt to the bank. Ghastly.

Before you borrow to invest, I suggest you:

Plan to hold the investment for at least 10 years, so you can be fairly confident its value will rise enough to make the whole thing – including all the interest you’ve paid – worthwhile.Work through the scenarios above and check that you’ll be able to cope. The golden rule: never be forced to sell.

Okay, now for the positive side. We’ve all heard about people who borrow against the equity in their home – the difference between its value and the mortgage – to buy a rental property. Then, when the equity in the rental rises, they borrow against that to buy another rental property. Before we know it, they own half a dozen properties or more and are seriously wealthy.

We also know of people who used debt to grow huge businesses or share portfolios. You say, “almost every large company and the vast majority of wealthy individuals” use debt, and that’s probably true – although we don’t know the stories behind many of the quietly rich.

But it’s also true that almost every company that goes belly up and every individual who files for bankruptcy has used debt. There’s more luck in this than many will acknowledge.

Good debt can certainly be a good thing. But go in with your eyes open.

Crypto ups and downs

Q: I was as horrified as you by the partner of your first correspondent last week having his house savings in crypto. As far as I can tell, it is not too different to a global Ponzi scheme at this point. There is no intrinsic value and minimal purpose, unless they can somehow truly make it work as a money replacement.

A: I have a basic rule: don’t invest in something unless you can see how it generates value. If you go into shares, for example, you own a tiny percentage of a company that produces goods or services.

If you invest in rental property, you – and the bank at the start – own a building that brings in rent. With crypto, it seems to be all about what might happen, but hasn’t to any extent yet.

But that’s not the only point here. Regardless of why cryptocurrencies have value, that value wobbles around hugely.

Our graph shows the price of the most widely held cryptocurrency, Bitcoin, has grown at an extraordinary rate. According to Yahoo Finance, $1000 invested in Bitcoin 10 years ago would be worth close to $400,000 today. Many people have watched that meteoric rise from the sidelines and then leapt in.

But there have also been several significant falls.

The first downturn noticeable on the graph is from late 2017 to late 2018. It doesn’t look large, but it was massive – an 83% drop.

Then, in just four months in 2021, the price fell 47%. In the next four months, it more than doubled, followed by a 71% plunge. And this year there have been two big falls, of 23% and 28%.

That volatility is why I was alarmed that the partner in last week’s letter had his property deposit in a cryptocurrency. We don’t know whether it was Bitcoin or perhaps Ethereum or something else. But all crypto prices are really volatile. What if the investment halves or worse shortly before the deposit is to be paid?

If you really want to invest in cryptocurrencies, I suggest you use money you don’t expect to spend for at least 10 years. And it would be wise to make it only 5% or so of your savings.

I hope the partner moves his money, now, to a term deposit, cash fund or similar.

We’ll let Investopedia have the last say: “It’s difficult to predict what one Bitcoin will be worth at any given moment because it is such a volatile asset. By 2030, one Bitcoin could be worth millions or nothing, depending on what happens.”

The alien perspective

Q: With reference to last week’s suggestion of burying gold in the backyard: it makes me think – what if aliens visited us and they saw this Earthly species spend huge amounts of time and energy digging up gold, only then to put it back into the ground!

What would they think of us? (Also, it is not just backyards. A large portion of Fort Knox is underground!)

A: Good point! Mind you, there’s quite a lot else that would probably puzzle aliens – like why we don’t appreciate more the wonderful planet we live on.

For those who don’t know, Fort Knox is where a large portion of the US gold reserves are stored.

First-home warning

Q: Unless the rules have changed, the young writer of your first letter last week won’t be able to use her KiwiSaver to later build a home on the section she is buying with her partner, as she will already have an interest in land once the section is purchased.

Equally, she can’t use KiwiSaver to buy the land on its own. So essentially, she misses out on the first-home buyer KiwiSaver withdrawal.

I have seen this happen to a few people who didn’t realise buying land then building later fell through a crack in the rules.

A: You’re partly right and partly wrong.

It’s correct that last week’s correspondent won’t be able to withdraw her KiwiSaver money to help pay for building a house on land she bought earlier.

“KiwiSaver funds cannot be withdrawn later for construction costs if the land is already owned,” the Inland Revenue Department (IRD) says.

However, she can make a KiwiSaver first-home withdrawal for the initial land purchase. “Schedule 1, Clause 8 of the KiwiSaver Act 2006 allows withdrawals for purchasing land intended for the member’s principal residence, provided they have been in KiwiSaver for at least three years,” the IRD says.

What’s more, there’s no time limit for building the home.

“No statutory time limit applies. The withdrawal is based on the member’s intent to build and live on the land. Some providers may request evidence of intent (eg a concept plan or declaration), but this is a provider-level requirement, not a legal timeframe.”

The IRD added a couple of other comments:

“The process is managed between the member and their KiwiSaver provider. Inland Revenue does not get involved. If the member and provider cannot agree, the provider’s financial disputes resolution service may be able to assist.”“Withdrawals can also be used for deposits before the purchase agreement becomes unconditional, provided funds are paid to a stakeholder (usually the vendor’s solicitor).”

Conclusion: the young woman should use her KiwiSaver money for the land purchase.

Meaningful Christmas gifts

Many charities offer Christmas gift programmes. You buy items for people in need that are given on behalf of your family or friends. For example, you might donate money for school equipment in developing countries. You receive an acknowledgement to give to your relative or friend to show what they have “donated”.

It makes a great Christmas gift – more meaningful than buying stuff for one another that is often not wanted.

Each year, this column runs a list of charities that take part in these programmes. I’ve asked each one to describe their programme in 20 words or less:

ChildFund New Zealand: 0800 808 822 or www.childfund.org.nz: “Gifts that Grow – Give meaningful, life-changing and transformational gifts for children including meals ($20), chicken ($26) and goats ($79).”Christian World Service (CWS): 0800 74 73 72 or https://gift.org.nz. “Before Christmas slips by, give water – give life.”Leprosy Mission New Zealand: 0800 862 873 or www.reallygoodgifts.org.nz. “Share God’s love this Christmas by curing one person with leprosy, restoring hope, dignity and new beginnings in their life.”Mend NZ: 021 060 9631 or www.mend.org.nz. “Help us mobilise youth with gift of prosthesis or hearing aid, to gain dignity and opportunity in Pacific, Asia, Africa.”Save the Children New Zealand: 0800 167 168 or https://gifts.savethechildren.org.nz/. “Give the gift of a bright future! From clean water to a school library, your Good Gift helps kids thrive.”World Vision New Zealand: 0800 800 776 or www.worldvision.org.nz/smiles “From emergency food to school supplies to beehives, choose a meaningful gift that changes lives with a World Vision gift.”

Footnote: World Vision has produced a report “looking at how many of the things we give at Christmas time are likely associated with modern slavery. At least 10% of our total imports are likely produced using child labour or forced labour. The top five riskiest products are: electronics, clothing, textiles, palm oil (in cosmetics and food) and footwear”.

The report is at tinyurl.com/RiskyGoods. World Vision says: “It provides powerful motivation to give more meaningful and ethical gifts this Christmas.”

* Mary Holm, ONZM, is a freelance journalist, a seminar presenter and a bestselling author on personal finance. She is a director of Financial Services Complaints Ltd (FSCL) and a former director of the Financial Markets Authority. Her opinions do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.

Catch up on the debates that dominated the week by signing up to our Opinion newsletter – a weekly round-up of our best commentary.