“To invest with debt or no debt.” That is the question.
Some financial experts like Dave Ramsey suggest never borrowing money except to purchase a primary residence. Dave experienced first-hand the downside risks of debt when he went bankrupt in his 20s. He was actually a real estate investor, so his bad-dad experience is extremely relevant to us.
Others, like Robert Kiyosaki, say that debt is ok if you borrow “good debt.” Kiyosaki says that debts like personal loans and credit cards are bad because they take money out of your pocket. But good debts, on the other hand, pay for themselves. Debts used to buy income producing real estate assets, for example, bring in more money than the debts takes out.
So which should you do when you invest in real estate? Is debt dumb? Or is it a smart part of your wealth plan?
I think they’re both partially right. My take is that debt is both dangerous and useful. So, you have to treat it like a loaded gun. Let me explain.
Debt Is Like a Loaded Gun
I agree with Robert Kiyosaki that “good debt,” especially in real estate investing, can benefit us. But I share Dave Ramsey’s extreme caution about the risks of borrowing money. Yes, debt CAN be dumb in many cases. And most of the time, cash IS king.
For example, I don’t carry any personal debt except a house loan. And I’d like that mortgage to go away soon. But I have chosen to use debt and other forms of leverage in my real estate investing.
To me borrowing money is like using a loaded gun. A gun can be used for productive purposes, like shooting a deer for dinner. And in case you’re wondering, yes, I did grew up out in the country!
But the problem is that most people are too careless and do not know how to safely use a gun. So most of the time the loaded gun is actually more dangerous than the potential upside of the meal!
Debt used very carefully with very conservative terms can be useful when buying a residence or when buying investment real estate. It’s useful because it increases your return and shortens the time to reach your goals. It also allows you to buy when you have access to good deals, even if you don’t have enough cash.
My observations, however, have been that many investors are not careful or conservative when acquiring debt. The end result is that they take on too much risk and build their entire financial structure on a shaky foundation.
When Debt Is Dumb in Real Estate Investing
Debt is inherently risky because payments must be made whether or not your asset continues to produce income. What happens if, for example, your tenant moves out and tears up the property? That doesn’t matter to the lender. You may have to make payments for months without receiving any income.
If you don’t have large cash reserves to compensate for that risk, then debt is dumb. I shoot for about 6 months of total principal, interest, taxes, and insurance payments sitting in cash. If you have a lot of loans, this means you need to hold a lot of cash.
Debt is also especially risky when you have large lump sum payments (i.e balloons) that must be paid off. If your balloon payment is due and you don’t have the money or the credit, the lender is in control. In this case, debt is VERY dumb.
Just ask Dave Ramsey. Balloon notes are how he went bankrupt in the 1980s.
And just ask once mighty banks, big businesses, and real estate investors during the 2008-2010 financial crisis. Because of a global financial meltdown, these borrowers could not come up with the money to pay off their balloon debts. Even though they had good credit and strong businesses, their lenders said “pay us our money!”
And before you say “that can’t happen to me,” just know that most of the investors and companies who got in trouble said the exact same thing. They assumed it couldn’t happen to them. But when credit markets dry up and asset prices crash, everyone who wants to refinance gets told “NO” in the same way.
So, using debt carelessly CAN be very dumb. And perhaps more than any other business, we real estate investors blindly take on excessive risk in the name of the “debt is good” mentality.
To use debt more wisely, here are some rules I’ve created for myself to determine good debt.
My “Good Debt” Rules
So what kind of debt do I see as a “good debt?” Here are my rules:
- Quality assets: Only borrow against assets that will produce steady income consistently. What assets fit this rule for me? Demand real estate (primarily residential).
- Positive leverage: Keep financing costs below the cap rate. This means I have “positive leverage,” and Positive Leverage = Bliss.
- High Debt Coverage Ratio: Maintain high debt coverage ratios. This means you have plenty of cushion between your net rental income and your mortgage payment. I indirectly measure this with a minimum net income after financing.
- Low LTV: Keep loan balance below a conservative threshold. 70% or less is a good target for quality income real estate, but it should be much lower if the quality of the income or real estate is worse (like class C or D properties). This allows you to more easily sell or refinance if needed. If I break this rule, the loan must amortize to my threshold or below in a relatively short period of time (3 to 5 years).
- Fixed Interest & Payments: Keep interest rates and payments fixed for long periods of time (10+ years).
- No Personal Guarantee: Let the property be the sole collateral for the debt (i.e. no personal guarantee). This is not possible with most residential mortgages. But it can happen with larger commercial mortgages and some private loans. I am often willing to give a lender a lower loan to value (for their security) in exchange for no personal guarantee.
- Cash Reserves: Hold large cash reserves for emergencies and unknowns. As I said earlier, I like to keep 6 months of total principal, interest, tax, and insurance payments.
- Know Your Lender: Only borrow from people you like and trust (this doesn’t include most banks, unfortunately, because they usually sell off their loans to big holding companies).
It’s not usually possible to meet 100% of these rules. But having the rules lets you know when you’re compromising so you can compensate and reduce risk in other areas.
For me, creative financing like seller financing or private loans tend to meet most of my rules better than other sources. Some traditional residential mortgages also do a good job, but investors are limited to between 4 to 10 of these types of loans.
Commercial mortgages have a huge variety of loan types, some very risky and some that could be reasonable. You just have to ask a lot of questions and read the 500 page documents they present to you 5 minutes before closing (I hope you noticed my sarcasm). In case you were wondering, Dave Ramsey primarily had these types of loans when he got into trouble and went bankrupt.
And short-term hard money loans have the shortest fuse of all. You have to be VERY careful with these loans because the economy and your financial situation can change quickly. You need to have back-up plans for your back-up plans in order to sleep comfortably at night borrowing at high interest rates over very short terms.
Don’t Stay in Debt Too Long
Even with good debt, I think it’s important to wean yourself or reduce your need for debt as soon as possible. Dave Ramsey does have it right that debt is dumb if you keep it forever. Life is just more peaceful and flexible with fewer or no monthly payments going out the door.
My primary financial goal has always been to own free and clear real estate properties that produce enough income to meet my financial independence number. I see this as a safe, secure income floor in retirement.
And beyond that income floor, it’s also reasonable to build a parallel real estate portfolio to invest for the upside. This is where some long-term, good debt may still make sense. It’s a way to hedge against future unknowns like inflation and other economic uncertainties.
But once you’ve reached a plateau of financial independence, it’s foolish to continue growing too aggressively. Resilience and security are equally important. You don’t want to slide back and have to start all over again.
Growth and debt can become an addiction. I have seen many otherwise smart real estate investors crash and burn because they couldn’t let go.
The key is to remember that debt (and money in general) is just a tool. Your life and doing what matters are the goal. Once a tool has served its purpose, it’s ok to put it back in the toolbox!
How Will You Use Debt in Real Estate Investing
I’ve made my own choices about using good debt in my business. But I also recognize there are multiple ways to accomplish the same thing.
For some of you, a no-debt, Dave Ramsey-style strategy might work fine from the start. You can check out my All-Cash Plan to Free & Clear Real Estate for a step-by-step wealth building guide.
Others of you may choose to use debt as a tool, but then you want to pay it off as you approach financial independence. You can check out my Rental Debt Snowball Plan for a step-by-step wealth building guide using that strategy.
Still others may use leverage very heavily and trade your way from small properties to enormous multi-unit apartment empires. You can check out my Trade-Up Plan for a step-by-step guide to this wealth building approach.
You’re the one who must be comfortable with your decisions so that you can sleep at night. So think for yourself, weigh your options, and most importantly move forward with your own investing.