Borrowing is bad (sometimes)
As I have mentioned, I am a fan of Dave Ramsey’s teachings in many ways. In fact I probably wouldn’t be doing this without his teachings; but I do use debt. That’s right, I use debt. It’s taken a while to not see this word as a bad word after years of Dave’s teaching. I use debt as a tool and a “lever” to maximize returns. “Hi, my name is Will….and I use debt.” Feels like some sort of 12-step program.
I have begun to see debt not as a bad word but as a tool. I think of it like the word “gun” (I’ll try to keep this non-political). If you were raised in an urban environment where guns are used for violence, or if you come from a war zone then this word probably carries a lot of fear and possibly even pain for you. If you grew up in a rural area where a gun is used for killing animals that you can eat and nourish your family with, then the word has another meaning all together. The “gun” to you is a tool and the word isn’t any more scary than the word “chainsaw” or “hammer”. You understand it can do damage if used irresponsibly but it can also be a tool to help people. The risk is decreased by learning how to use it properly. Just like any of these tools, you may choose not to use it because the perceived risk is too great for you. And that is fine. I only suggest that you continue to learn about the good and bad of mortgage debt and at least reduce some of your preconceived fears by looking at it as a tool. There is some risk. No doubt about it. Everyone must decide what their own risk tolerance is.
Remember, most of the alternatives carry risk as well. If you choose not to use the chainsaw, but instead select the axe, there is still risk. If you choose the hand saw there is still risk. Part of the risk is from the tool used and part is from the opportunity cost of not using the chainsaw and being done faster and able to move on to another job. The axe is heavy and sharp and is amazing when used by an experienced person. But it is rarely as fast as a chainsaw for felling large trees. The hand saw is lighter and possibly less dangerous but could be much slower than the chainsaw which means you will be working longer and not be able to do other beneficial tasks. Debt is like this. If you have a gut reaction against debt in any form, I suggest you try to learn more about it and compare it to a chainsaw. If you educate yourself about long-term, fixed-rate debt and still feel it is too risky, then don’t do it. Just like using a chainsaw without confidence, you will probably be more dangerous with debt than if you truly understand it and see it as a tool. Remember, you can use no debt (the hand saw) too but it won’t work as fast. If you choose this route you must get very good at it by finding the very best deals and learning to save money aggressively. Without leverage, real estate is still a great asset but it is the leverage that makes it the best asset class that I know of.
This is how I see debt. It can be used to buy depreciating garbage and can sink you. Or it can be used to buy appreciating assets and can magnify your returns and get you where you want to go. You can buy houses with cash and get where you want to go with what some see as more safety; albeit slower. This is like walking. Or you can use smart leverage and it will be like getting a car. More leverage still is like a race car. You may get there much faster, or you may crash and burn up and have to start walking again.
Regulation (love it or hate it)
The current lending environment is heavily governed to protect us (the consumer) from ourselves. Regardless of your views on government regulation, this was the reaction to our most recent recession. Before 2008, I recall loans being given out based on “stated income”. In other words, I could just tell my banker what I made. Loans were also given out at 100 percent LTV (loan to value). Now days we must file piles of paperwork to substantiate our income claims and the LTVs are closer to 70-75% for investment properties. These regulations limit how much leverage you can take on and essentially help us avoid getting into the “race car” situation I mentioned above with over leverage. With a 75% LTV, you then will have 25% equity. 25% equity means that you could have a drop in value of 25% before your are upside down in a given property. This is like insurance. Before the recession, when people could take out 100% LTV loans, they would be upside down with a 1% drop in value. They then had to try to hold on through the depths of the downturn and many couldn’t. This meant financial ruin for these people. While 75% LTV generally means you bring 25% downpayment to the table, you can also create that equity through creative methods that we discuss here. In the traditional model (with current rules) with 25% downpayment paid by you, in a downturn you may not become upside down but you will be losing the money you put down. If you create that equity it is not a cash loss for you but a loss of equity that you created. And all of this is only realized if you sell the property. But for me it is less troubling to see a decrease in value created out of thin air than value I paid for with cash.
What If I Use Cash? Cash Guy vs. Smart Debt Guy
(This section has a lot of numbers so it may take a few reads. The next post will build on this so message me or comment if you are unclear)
If you are considering using cash, I am all for it if you have the saving discipline and completely hate the idea of debt. You can build a great portfolio over time and have lower risk of defaulting on a loan (because there is none) or losing the property. However you will risk not seeing as much growth as the guy who is using some smart debt to buy five houses while you acquire one. That is also a risk. Assume 75% LTV for the following examples: If Cash Guy invests in one house worth 100k and in five years he sees 20% increase in property value, he sees a gain of 20,000 dollars to his net worth. If Smart Debt Guy buys five equally valued houses (100K) that he tries to BRRRR but comes up a little short and leaves 10,000 cash invested in each one he will see an increase in net worth of 100,000 dollars! Pretty impressive, huh? The ROI (Return on investment) is even more convincing. Cash Guy invested 100k to make 20K. That is a 20 percent ROI over the given period (not annually). Smart Debt Guy invested 50K to make 100K. That is 200 percent ROI over the same period. This is what makes real estate a better investment than many others in my opinion.
Now what if there is a downturn and they both lose 20 percent of their value from the original 100K value? Cash Guy loses 20,000 of his original investment if he sells (hopefully he can ride out the cycle before selling and realizing that loss). Smart Debt Guy loses five thousand dollars of his invested dollars in each house for a total of 25,000 dollars of lost cash value if he sells. This means that he does potentially lose more money than the cash investor. If he had bought traditionally at full price and put down a 25% down payment, he would have lost 125k in equity that he paid cash for. What limited his loss here is that he essentially created 15k in equity by doing a semi-BRRRR. This means that the first loss of value in a downturn will be from his “created equity” and the following loss would begin to dip into the equity he paid for. Only after a 25% decrease in value would he be truly upside down with his mortgage.
This is all just food for thought – an exercise in evaluating the risk of debt vs. the risk of using only cash. The numbers were oversimplified by not considering closing costs etc. for the sake of easier numbers to visualize. Tax benefits and cash flow were not considered either. Both of which we’ll explore in more detail in the the next post. We’ll also be talking about the hedge against inflation that mortgage debt allows us. I hope that this post helps you begin to find your level of comfort with mortgage debt.
Some of your decision will be based on your financial position outside of real estate. If you are leveraged on multiple cars and furniture and can’t seem to get caught up then real estate debt is probably not for you at this time. I would suggest reading Dave Ramsey and becoming obsessed with personal finance. If you, on the other hand, have multiple other investments or a large amount of cash saved, then trying using debt for real estate may be the thing you have been looking for. Ultimately, I would not advise using debt if your financial house is already shaky. Build a strong foundation and then build on that.
This post has been a lot to take in. Next week’s post is about cash flow and leverage and may be my favorite educational post yet. I discovered a few facts about leverage through the process of writing it and it re-inspired me. Through your investing and especially in life, “Keep the main thing the main thing!”