In the world of finance, there is typically a notion of “good” and “bad” debt. Normally, good debt is any kind of financing that helps you acquire and build wealth. For instance, student loans and mortgages are classic types of good debt. On the other hand, bad debt is financing that doesn’t help you improve your financial situation. Common examples of bad debt include credit cards and personal loans. That’s not to say these types of debts aren’t helpful or can’t be used to build wealth. But more often than not, they are utilized for day to day expenses or unexpected costs. With that in mind, self liquidating debt is a type of good debt. This is because self liquidating financing involves purchasing an asset that currently or eventually will produce enough income to cover the cost of financing. Ready to learn more?
Table of contents
- What does self liquidate mean?
- Can I self liquidate?
- What is the usefulness of self liquidating debt?
- Acquiring self liquidating debt
What does self liquidate mean?
Let’s start with the definition of liquidity. In finance, liquidity is a gauge of how easy it is to convert an asset into cash. For example, bank accounts, GICs and inventory are very liquid assets. But on the contrary, real estate and businesses are not liquid because it can take months or even years to finalize a sale — and that’s assuming you have an interested buyer.
Self liquidate refers to debt that pays for itself using the asset originally purchased using the debt. In other words, it’s debt used to purchase or develop an income producing asset. The idea is to use the income from the asset to cover the cost of financing so the entire project is self sufficient. Let’s explore some of the pros and cons, then the various components.
|Great strategy to establish and build wealth||Requires some sort of investment, such as time or a down payment|
|Straightforward and easy to understand||While it’s a lower risk type of debt, it’s not completely risk free|
|Ability to earn business income and capital gains simultaneously||You can still lose money on your investment with self liquidating debt|
|Possible to possess numerous self liquidating assets at once||Usually not attached to a liquid, easy to sell asset|
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What is self liquidating debt?
Self liquidating debt is any type of financing used to purchase an asset that produces enough income to repay the debt itself. Traditionally, the debt is a term loan, but it could also be a line of credit, private equity or any other kind of debt – but more on that in the next section.
What is a self liquidating loan?
This loan is a type of self liquidating debt in the form of a traditional term or instalment loan. Keep in mind that self liquidating loans require consistent, scheduled payments. In order for a loan to truly be self liquidating, it has to cover the cost of the principal and interest – not just one component. It’s wise to have an income producing asset that generates stable, continuous cash flow to comfortably meet your loan payments.
What is a self liquidating investment?
A self liquidating investment is the underlying asset behind self liquidating debt. It’s the asset that produces income to repay the debt. Most commonly, the investment is real estate or a business, but it could be anything that produces income.
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What is an example of self liquidating projects?
The two most common examples of self liquidating debt are rental properties and businesses. With a rental property, the landlord purchases a piece of real estate using a mortgage. Then, the landlord finds tenants to reside in the property in exchange for rental income. Once the income from rent is enough to cover the cost of the mortgage principal and interest, it becomes self liquidating debt. A rental property is a classic example because the consistent cash flow from tenant’s payments comfortably covers the ongoing, periodic debt payments, thereby being self sufficient.
As for a business, this can go one of two ways. First, someone can choose to start up a company using financing. After growing the business, the owner can use the income to cover the cost of financing thereby becoming self liquidating debt. It’s important to note that with a startup there’s a period where the debtor would have to make payments without income. Although, the ultimate goal is to earn enough income to cover the cost of the debt. Or, someone can choose to acquire an already operational business. The revenue generated from the business can cover the debt thereby creating self liquidating debt.
These are just two examples of self liquidating debt, but the opportunities are infinite! Literally any asset that produces enough income to cover the cost of financing is sufficient – don’t be afraid to get creative!
What isn’t self liquidating debt?
To ensure you understand the concept of self liquidating debt, let’s explore what it isn’t:
- Debt used for vacation purchases, such as flights, cruises, hotels and so on
- Unsecured debts, such as credit cards or personal loans
- Student loans and other financing for education
- Any other debt that is not used to purchase an income producing asset
Keep in mind that certain expenditures or types of debt might need to be incurred to form self-liquidating debt. For instance, you might need to take a flight to close the purchase of a business. Or, you might need to go to school to learn a particular skill to be able to create self liquidating debt. However, these types of costs would be indirect.
Self-liquidating debt merely means that an asset is producing enough income to pay the debt used to purchase the asset. But you will incur other expenses to achieve this status. In other words, to truly build wealth with self liquidating debt, you need to earn enough income off the asset to pay the debt and the related expenditures – and then some more to pay yourself!
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Can I self liquidate?
Yes, anyone can partake in self liquidating debt. However, don’t underestimate the dedication involved. Self liquidating debt doesn’t magically happen, it takes a lot of work to build and maintain. In addition, self liquidating debt can involve a monetary investment. For instance, if you want to purchase a rental property, you’ll need a down payment to secure a mortgage. Finally, self liquidating debt is not normally a small financial commitment, it’s often a big, serious one. Once you’re in it, it can be challenging to get out too. Be sure to consider the gravity of your choice before moving forward.
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What is the usefulness of self liquidating debt?
Self liquidating debt is useful because it’s essentially debt that pays for itself. It removes the concern of where money will come from to meet a loan payment or other financial obligation. Furthermore, you are able to turn a profit quite easily with self liquidating debt. Not only are you earning stable income, you will benefit financially from the appreciation of the underlying asset. The appreciation won’t be realized until you sell, but it still contributes to your wealth in the mean time.
What are the risks?
Nothing in finance and business is certain. This means self liquidating debt isn’t promised, even if you do purchase a great income-producing asset. In the worst case scenario, you won’t be able to cover the cost of the financing and might be left in a tricky situation. However, you may also have to invest into the asset further after you purchased it. For instance, if you purchase a building and it needs a big repair that you didn’t know about before hand.
Regardless, self liquidating debt is risky, especially depending on what type of asset you want to purchase. Be sure to consider potential risks before entering into agreements and figure out ways to address them. And of course, always be sure to read the fine print!
Acquiring self liquidating debt
Self liquidating debt is appealing to investors for a lot of reasons as we saw above. You can build wealth and diversify revenue streams. Worst case scenario? You default on the debt and the underlying asset is sold to cover the cost of your debt. Moreover, the process of acquiring and maintaining self liquidating debt can be a very rewarding experience because it’s not an easy feat!
With that being said, self liquidating debt isn’t guaranteed to make you money. The definition of self liquidating debt is debt that pays for itself with the underlying collateral. However, that doesn’t mean it pays for the other costs associated with the asset. For example, if you have a rental property, you will likely incur other costs, such as repairs, taxes, and utilities. There is no guarantee that self liquidating debt will cover both the financing and operational costs. And what if you suddenly lose a tenant? Self liquidating debt doesn’t necessarily last forever – it has to be acquired and maintained. To conclude, there are a lot of financial benefits to using self liquidating debt, but nothing is guaranteed!
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