Debt is dumb, cash is king.”
There is good debt and bad debt. Good debt makes you rich, and bad debt makes you poor.”
Robert Kiyosaki, from the Cashflow Game
“To borrow or not to borrow”, that is the question.
So which should you do when you invest in real estate? Is debt evil and dumb? Or is it a smart part of your wealth plan?
Kiyosaki says that debts like personal loans and credit cards are bad because they take money out of your pocket. 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.
Debt Is Like a Loaded Gun
I agree with Kiyosaki in part, but I share Ramsey’s extreme caution about the risks of borrowing money.
I don’t have any personal debt except a house loan, and I’d like that 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.
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!
Like a loaded gun, 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.
My observations, however, have been that most people 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.
Risk is the key word here.
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 make payments for months without receiving any income.
What happens when debts with large lump sum payments (balloons) must be paid off and you don’t have the money or the credit to make it happen?
Just ask Dave Ramsey. That’s how he went bankrupt in the 1980s.
Or just ask once mighty banks and big businesses during the 2008-2009 financial crisis. The result was a global financial meltdown because none of these borrowers could come up with the money to pay off their debts.
My “Good Debt” Rules
So what kind of debt do I see as a “good debt?” Here are a few of my rules:
1. Only borrow against assets that will produce steady income consistently. What assets fit this rule for me? Demand residential real estate. That’s it.
2. 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.
3. If I break rule #2, the loan must amortize to my threshold or below in a relatively short period of time.
4. Keep financing costs below the cap rate (My Video: Why Positive Leverage = Bliss)
5. Keep interest rates and payments fixed for long periods of time (10+ years).
6. Let the property be the sole collateral for the debt (no personal guarantee).
7. Hold large cash reserves for emergencies and unknowns.
8. Only borrow from people you like and trust.
The sources of debt that I’ve found to meet all of these standards are typically creative financing from sellers or private individuals and not bank loans.
Don’t Stay in Debt Too Long
Even with good debt, I think it’s important to wean yourself from the use of debt as soon as possible. Dave Ramsey does have it right that life is just more peaceful and flexible with no monthly payments going out the door.
My own goal is to own free and clear long-term real estate assets that produce enough income to meet my lifestyle needs.
So, once I own enough assets to produce this desired amount of income, why would I keep growing with debt and risking more? It’s time to get free and clear.
Growth can become an addiction. I have seen many otherwise smart business people crash and burn because they continued to grow using leverage without ever plowing back their profits to pay off debt.
What Will You Do?
I’ve made my own choices about using good debt in my business, but I also recognize that for others, something like a no-debt-Dave Ramsey strategy might work fine. I don’t believe in one-size-fits all solutions.
The main decision is what will you do? How will you fund your investments?
If you’d like to see real estate wealth building plans both with and without debt, check out these articles:
- Case Study: Financial Independence Using Real Estate Investing
- Case Study: $100,000 Per Year Rental Income
- The All-Cash Plan to Free & Clear Real Estate
- The Snowball Plan to Free & Clear Real Estate – The Snowball Plan
- The Buy 3, Sell 2, Keep 1 Plan to Free & Clear Real Estate
You’re the one who must be comfortable with your decisions and be able to sleep at night. So think for yourself, weigh your options, and most importantly move forward with your own investing.
Do you have an opinion about using debt in real estate investing? I’d love to hear it in the comments section below.