The Golden Rule of Loans: Asset Appreciation
Wednesday, June 24, 2020, 6:00 PM | Leave Comment
Borrowing money increases your debt-to-income ratio (DTI), a measure of your total debt payments relative to your total income.
As your DTI increases, creditors become more reluctant to lend you money — the rationale being that you’ll be less able to make payments on a new loan.
Consequently, large life events that involve debt — such as buying a home — become challenging.
Before you borrow more money, it’s wise to pay down existing debts first. Once your debt levels are low and you’ve increased your income, you’ll have room to take on additional debt. However, be careful about what you buy with a loan.
When you spend or invest your own money, you hope that the asset will be worth more in the future so that you can profit when you sell it.
At worst, the investment will be worth nothing in the future. You’ll lose all of your initial investment but nothing more.
Buying with other people’s money is riskier. You want the money to be there in the future since you have to pay the loan back along with interest. It’s critical that whatever you invest in will be worth more in the future than it’s worth now.
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Which Types of Assets Should I Borrow Money For?
Assets can change in value over time. If you borrow money to buy something, you want to make sure that the item increases in value — this is called appreciation. You can sell that asset in the future and profit.
Assets can appreciate for a variety of reasons, such as short supply, higher demand, or interest rate changes. On the other side of the equation is depreciation, which occurs when an asset’s value drops. Depreciation often occurs on things that wear down over time. These items break down with repeated use and eventually become unusable.
Avoid investing a loan into depreciating assets like vehicles. If you do so, you could become upside-down on the loan — meaning your loan balance would exceed the value of the item you’re borrowing for. If you had to sell the item, you’d be unable to pay back your debt in full.
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Assets That Appreciate
Assets that appreciate include things such as stocks and real estate. However, you have to consider the return you’ll earn on your investment as well as the level of risk.
According to Investopedia “it is inadvisable for an investor to invest a loan in a risky vehicle, like the stock market or derivatives.” These assets can drop fast in value. If they do, you’ll lose your borrowed funds, yet owe back the loan.
Homes, on the other hand, are considered much safer investments in terms of borrowing. Not only do they provide you a place to live, but their values generally increase over time. Plus, you can deduct mortgage interest on your federal income taxes.
Your real estate purchases can go beyond your own home, too. Another good use of a loan would be to buy investment real estate, such as single-family homes or apartment buildings. You can rent out these properties to tenants to earn rental income, or fix them up and flip them for profit after they appreciate.
Keep in mind that loans for investment properties will carry higher interest rates. Through a lender’s eyes, you’re more likely to drop your real estate business if it’s not working out than to give up paying for the house you live in.
Like any property, neither homes nor investment properties are guaranteed to appreciate. For example, homes lose value when the economy’s weak. There is always risk involved when investing your money.
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Assets That Depreciate
Assets that depreciate are usually consumer goods. These tend to have a limited lifespan and wear down with use.
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Cars: New cars lose as much as 20% of their value the moment they drive off the lot. Used cars continue to depreciate steadily for several years after. If you must finance a vehicle, follow the 20/4/10 rule. Put down 20% of the car’s purchase price, don’t take out a loan longer than four years, and limit all car expenses (payment, gas, maintenance, and insurance) to 10% of your gross income. Following this rule will make it easier to avoid becoming upside-down on the loan.
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Cell phones: New smartphones come out each year, making last year’s model less valuable in most cases. You also have to think about the amount you’re paying for data. If you finance a cell phone and have a data plan, you’re now paying out two separate income streams for a depreciating asset. Determine the amount of data you use each month and scale back your plan accordingly.
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Computers and electronics: Like phones, computers lose value as manufacturers release newer and more advanced models.
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Tools and equipment: Tools and equipment wear down with use, making them lose value over time.
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Affording Your Loan
Once you take out a loan, you’ll owe interest on top of the principal amount. Adding these two figures together shows you the total cost of the loan. Use a loan calculator to figure how much a loan would cost you in interest. From there, you can evaluate your investment and see if the returns would outweigh the interest payments.
Consider loan fees as well. Mortgage lenders may charge loan application fees up to $500. Most lenders charge you a loan origination fee of 1-8% of the principal for processing the loan. They determine the fee amount based on your credit and the loan’s terms. Some loans may also charge you a prepayment penalty for paying your loan off early.
Final Thoughts
Many people rail against debt, and for good reason. Being stuck with large debt and interest payments makes it tough to get by, let alone invest in the future. However, if you learn the difference between assets worth investing in and ones that should be avoided, you can build or maintain good credit.
This can be a helpful tool when leveraged cautiously. By limiting your debt usage to safe, appreciating assets, you’ll gain access to better opportunities in life and finances.
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