THE STRUGGLE IS REAL
Battling Between Good Debt and Bad Debt
My wife is a huge Dave Ramsey fan. For many personal finance issues I agree with him. Like paying off consumer debt and investing 10-15 percent of your income. And purchasing term life insurance is a great way to protect your income for your family until you can self-insure.
A financial plan is like a cooking recipe.
My wife also makes great eggs Benedict. Several years ago she started with a canned hollandaise sauce. That worked, but then she found a hollandaise recipe online. That version tasted better. Then she started adjusting the amount of lemon juice and cooking order. It took about six months for her to perfect the taste.
Dave’s plan would be a vast improvement for most people in this country. It’s a financial recipe. Financial literacy is needed and most people don’t even understand and apply the basics.
But to excel financially in a shorter period of time, and not just get by, you need to spend time investing in financial education and learning strategies beyond the basics. Ask yourself why the recipe calls for certain ingredients and what variations might be worthwhile?
Just to be clear, I’m not talking about a college education or advanced degree in finance. I’m saying you need to invest in your financial education. Don’t just take someone else’s word for it.
Understand why you want to take a certain path. Get enough facts and learn about different investments so that you can make an informed decision for yourself.
Here is where we struggle. We know real estate is a great tool for building wealth.
But waiting to purchase real estate until you can buy it with cash is not the fastest way to build wealth.
After all, how long would it take you to save $150,000 for your first rental house? If the rent is $1500 per month and non-mortgage expenses run 40-percent of your gross income, how long would it take you to acquire a second house?
If you set aside $1,000 every month and were able to earn 10-percent interest, it would take 98 months, or just over eight years, to accumulate $150,000. By then the house would probably cost about $207,000. So add a few more years to the timeline.
In addition to the cash flow, you acquire equity through appreciation at the rate of inflation. If inflation runs about 4-percent a year, then you would acquire an additional $6,000 in equity through appreciation.
If you had $150,000 cash then another option is to buy four $150,000 houses, each with 25-percent down. Yes, there are other expenses such as closing costs, but we’ll keep the example simple. With inflation the four houses provide an increase in equity of 4 times $6,000, or $24,000 in one year.
Using debt wisely can help build wealth faster
During periods of high inflation debt can be a great tool to build wealth and provide a hedge against inflation
A bias against acquiring debt can also be an internal struggle in relationships that keeps you from acquiring assets.
It’s a struggle of good debt vs. bad debt.
Our first investment property was a huge mistake and came with negative cash flow. The cash flow was negative because we paid too much for the property and it came with high mortgage payments and HOA dues. My wife became more resistant to purchasing additional properties using debt. But together, over time, we have come to an agreement that we will not purchase property that does not stand on its own. It must have positive cash flow once the tenants are in place and the property is stabilized.
WHAT IS BAD DEBT?
We have seen that debt can be used in a positive way to acquire wealth.
We also don’t have to look far to see it abused.
Do you know anyone having trouble paying credit card bills? Or struggling to keep their house because they bought a new truck with high monthly payments?
Bad debt is when the debt is used to purchase depreciating “assets”. Things like cars, boats, and other consumer “must haves.”
Assets make money for you, but liabilities cost you money.
I’m not saying all liabilities are bad. After all, they are lifestyle choices. As my friend Karl said, “Don’t borrow money for depreciating assets.”
WHAT IS GOOD DEBT?
In general, good debt is debt that makes money for you.
In the example above, debt is used to increase the amount of equity acquired each year. It was used to acquire an appreciating asset that also had positive cash flow.
One caveat is that the debt should not cause you to lose sleep at night. That is a good measure to determine what level of debt is acceptable.
What about buying a house to live in? Most people will agree this is a good use of debt. After all, you are locking in a portion of your housing expense. You do not have much control over taxes, but the mortgage remains fixed as long as it remains in place.
My favorite asset to purchase with debt is cash-flowing real estate. Positive cash flow is a key ingredient to making it work.
An exception can be made for short periods of time to rehab and stabilize a property, but the long-term scenario needs to include positive cash flow for someone.
OLD-SCHOOL THOUGHT PROCESS
During normal times one classical real estate investing model was to acquire property, then pay it off over time. The property would grow in value as the tenants paid rent and in turn paid down the mortgage.
But not everyone wants to be a landlord.
Not everyone has great credit.
Some people do not want to put their credit at risk.
Banks are not always easy to work with. They place limits on how many mortgages you can have.
There is a way to acquire property and have it grow in value without being a landlord or putting your credit at risk. Read on.
RE-THINKING A STRATEGY FOR HIGH INFLATION
We are currently in a period of high inflation. It was induced by printing a huge amount of dollars during the pandemic.
This is unlike the housing market rise in 2005. That was the result of lax lending practices and high demand. It was very easy to get credit to buy a house.
The economy today is characterized by a devaluation of the dollar, showing itself as high inflation. Gas is also higher. Construction materials are higher. Groceries are higher.
Buying assets helps provide a hedge against inflation. How much is your house worth today compared to two years ago? What if you had $100,000 cash two years ago. Is there something you buy then that you cannot get now?
It’s not only the asset that appreciates, but rents continue to rise as well. As a bonus, the mortgage stays the same while the income goes up.
Buying assets with leverage can help produce additional wealth.
How much leverage is good? It depends on the cash flow and the investment horizon.
How well do you sleep at night?
What if your properties were all leveraged at 100-percent with no cash flow left to make repairs? That is a recipe for disaster.
While having everything free and clear from mortgages has less risk, it also provides a lower reward in terms of equity buildup.
I’d like to suggest that an overall leverage ratio of 50-75% is ideal for building wealth and maintaining cash flow. This ratio can be spread across multiple properties and investments.
WHAT ARE SOME TECHNIQUES FOR USING LEVERAGE?
Traditional real estate purchases required taking out a mortgage on a property and incurring personal liability for the loan. This is a time-tested and proven method, but is not the only one that works.
Buying a house subject-to the mortgage is another technique. You can buy the house and the seller retains the personal liability. Generally speaking, you must be willing to get out and meet with potential sellers to structure this type of deal. If a wholesaler or investor finds it they will keep it for themselves.
Some people just want to be passive investors. They want the benefits of owning real estate, but do not want to be active landlords or property managers.
Syndications are a way to purchase real estate with leverage without using your own credit. And, through a syndication you don’t have to be the landlord. As we have discussed in previous blogs, you still get the other benefits of owning real estate.
These partnerships are typically created for purchasing commercial properties priced over $1,000,000.
Commercial loans above this amount tend to be non-recourse, which means that the syndicators and investors do not have their personal credit on the line.
Passive investors are able to participate and enjoy the benefits of leverage without the hassle of property management or concern for their credit. This can also be good for those who have acquired a number of single family houses but unable to obtain mortgages for additional properties.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.