“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 experience is extremely relevant to us as real estate investors.
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 carefully 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 contributed to his own real-estate-related bankrupty 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.
Do you have an opinion about using debt in real estate investing? Is debt dumb? Or is it smart? And if you use debt, what are your rules to invest safely? I’d love to hear it in the comments section below.
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Debted Investor says
How does a person verify someone who they may like but don’t know if they can trust by doing their due diligence–past references, a portfolio? What are other means? Websites do not seem to provide much information and there are sketchy “dealers” who will promise the moon (finding property, hard money lending, etc.,). Yes, this is from personal experience. Thank you Chad.
Chad Carson says
Hi Debted Investor,
That’s a good question.
Finding private lenders you can trust is the same process as building any other relationship – slowly, over time. Early in a relationship, you might not want to commit to a “marriage,” just a “date.” That could be in the form of a small loan, a short-term business venture together, etc.
Slowly over time you can increase the number of deals and length of deals.
I also like to know the potential investor or partner’s goals, attitudes, values, beliefs. Are those in alignment? Do I like the person? Can we get along.
If you’re having to use websites to know the investor, it’s not the type of lender I’m considering. I usually know them first, and THEN we start talking business.
If you’re just getting to know someone, I say get face-to-face, have some long talks, learn about each other’s histories, exchange portolios, references, etc. Then if you need extra verification on each other, by all means do more thorough and traditional searches too.
Craig Horton says
One of my life philosophy mantras is steady wins the race. With proper real estate investment over time steady wins the race. In fairly decent areas of a community values go up over time and you can raise rents over time. The key here is not to leverage too much and eventually pay off your real estate. I really appreciate where Chad is coming from in his comments. Several of my mentors have done this over a 20-40 year time frame. For me “Steady wins the race” is a good motto to live by.
Chad Carson says
I love that “steady wins the race” motto, Craig. And your many years of experience in the business validate that it does work! That mantra reminds you not to take excessive risk so that you can keep moving forward. And it also reminds you to take reasonable risks if it helps you keep moving forward. Thanks for sharing!
Rich on Money says
Coach, you know how I feel about this! We’ve talked recently. I’ve got an investment portfolio of 20 paid off single family homes. It’s the perfect example of the income floor you talk about. I’m two years from retirement, and while it would be easy (and tempting) for me to tap my equity, grow faster, and potentially make a lot more money, I’m very happy with the security that I have right now. More importantly, I have enough. I like the idea of, if I do decide to use debt, it should be tied only to the asset, not to my existing properties or to me personally. That will protect me and my family. You really should write a book!
Chad Carson says
Thanks Rich! I enjoyed our conversation, and I hope you know I’ve got a ton of respect for you and your process of building real estate wealth. I think it’s awesome that there are so many ways to accomplish a goal and that each different path can work depending on the comfort level of that person.
It was a big distinction for me that all debt isn’t created equally. I think that was my main motivation for writing this article. Debt isn’t the only risk we face as entrepreneurs. And like all the other risks, we just have to find ways to mitigate them. Going cold turkey is obviously one way. But the 8 rules I laid out share other ways.
I do need to write a book! Time to get on that:)
Natasha says
Thanks, Coach! Can you comment on why you feel the cash flow from free and clear real estate counts towards your income floor, but real estate with 30 year fixed terms doesn’t? I understand you’re not a fan of bank financing, but I have numerous SFHs with attractive 30 year fixed rates that it seems silly to pay those down faster than required.
Chad Carson says
Good question! 30-year fixed conventional financing is fine. I don’t have any problem with it. I think commercial financing with balloons, adjustments, etc is more risky. But why pay conventional loans off at all if they’re fine? It comes down to risk. As you reach a plateau of financial independence, growth has to balanced with mitigating potential risks that could knock you down. One of those is massive deflation where prices AND rents crater. If all your properties are leveraged, massive deflation could eat up all your cash flow AND put you at risk of losing what you do have because banks can foreclose. On the other extreme, if they’re all paid off – yes you would also lose equity and cash flow, but you wouldn’t be upside down and face losing what you own. But deflation isn’t our only concern. Massive inflation is also something to worry about after FI. And those low-interest, fixed mortgages are helpful in that situation. So, I think a happy compromise in the middle (and where I’ve landed) is having a mix. Some properties free and clear, and others more highly leveraged. I’d rather have one property with no debt and another with 80% loan to value than have 2 properties at 40% loan to value.
Patsy says
Excellent post, as usual. Although in general I dislike “both are right” as an answer, debt really, actually falls into the “it depends” category, doesn’t it? When, from whom on what terms shape whether debt is good.
The goal is free and clear, ultimately, and knowing when to stop is the wisdom that many don’t develop.
Thank you for a nuanced discussion with some thought-provoking nuggets!
Chad Carson says
Thanks Patsy! Yeah, debt is one of those tricky subjects. It really does depend on the person and the debt itself.
And I’m personally on the same page with the free and clear goal. I’m not sure if 100% of my portfolio needs to be that way, but certainly a significant chunk. And a lower debt, more flexible, and more relaxing portfolio is certainly my ideal!
DiversifiedDoc says
Excellent post on a great topic. I’ve struggled with this decision on my portfolio of single family homes. If you ask 10 people, you’ll get 10 different opinions regarding the use of leverage. Once concept I’ve not seen discussed is the tenant multiple required when using leverage vs. paid off properties. If your goal is $6,000/month of passive cashflow, that can be accomplished by 10 free and clear properties at $600/month or 30 leveraged properties at $200/month. The leveraged properties probably have a better ROI given the low interest rate market we are in, but what about ROTI (Return on Time Invested). For those choosing to self manage, would you rather receive calls from 10 tenants or 30? I’d love to hear Coach Carson’s thoughts on this.
Chad Carson says
Hey Diversified Doc! Thanks for reading and commenting. I think you make a great point about the tenant multiple. Return on investment is not the only criteria – especially when you’ve reached a level of wealth that gives you financial independence. Simplicity and low-hassle are prime criteria as well. I’m not practicing extreme simplicity myself since my partner and I have about 90 units, but between the two of us we’d like to reduce that number over time for exactly the reason you mentioned. I also tackled this very subject in the case studies of How Many Rentals Do You Need to Retire.
Buddy Broome says
Great post, Chad! I think that debt/leverage is probably the most misunderstood element of investing (in particular real estate investing).
I have heard that debt (leverage) is like rocket boosters on a space shuttle and I agree. The rocket booster is essential to get one out of the earth’s gravitational pull, but once one is outside the earth’s gravity, the rockets are to be jettisoned as they are no longer needed.
I think that debt/leverage (in particular, seller finance and options, which while it is not debt is another amazing form of leverage) is what gives people starting out, maybe with little to no money, the ability to use leverage (the booster rockets) to build the net worth needed and once the net worth goal is achieved, that net worth can be translated into cash flow, thereby making the debt expendable as it is no longer needed and sometimes hinders the cash flow.
I think, and I believe you agree, that what makes real estate such an amazing wealth builder compared to other investments is the ability to use safe leverage to build large net worth.
Like you said, not all debt/leverage is created equal and your gun analogy is on the mark. Before getting leverage people need to know how it can hurt them and how to minimize it.
As always, great stuff, Chad. It is really wonderful content!
Chad Carson says
Thanks Buddy! You and I are 100% on the same page that more creative forms of leverage can be safest in the long run. Seller financing, leases, and options are some of the least understood and therefore least used tools we have as investors. I guess we both need to keep spreading the word!
And I love your rocket booster analogy! Can I borrow that?
Buddy Broome says
Yes, Chad, you are right, we do need to keep spreading the word!
Absolutely, feel free to use that analogy, glad that I can help!!!
Hailey Roemer says
The All-Cash Plan to Free & Clear Real Estate link is broken
Chad Carson says
Fixed. Thanks for heads up.
mike says
From a net worth point of view and not a cash flow point of view. Investing in a market where interest rates are increasing only suppresses housing prices. Which will inevitably decrease how much you can charge for rent and how much you can raise rents in the long term.
Chad Carson says
Thanks for commenting, Mike. It’s hard to know how different economic changes will affect the future rent prices, values, etc. But I can certainly see prices slowing down as loans become less affordable with high rates, as you said. What is your strategy given what you see in the future?
kris patel says
In 2010 e could get 110% loan on a NNN drug store, problem was too much negative cash flow. I sold one and got another with 25 yrs fix rate and COC of 5%, property will be free and clear after that. Lease was 25Yrs guarantee and 50 annual option, no payment to make after 25 Yrs. If no renewal at least land and building be worth more than my down payment. Was happy with this decision. Thanks
Donica says
Thank you for sharing!
This post was very insightful and answered some of my lingering questions!
I’m with the concept of buying free and clear real estate and only leverage properties when it makes sense.
I love your example of owning 10 properties at $600 monthly cash flow each vs 30 properties at $200 monthly cash flow….. great analogy for what I’m doing in my real estate investment business!!!
Thank you again
Abin says
Great article thanks for sharing this y