When I was in college, I took on student loan debt. After graduation, I got into credit card debt. I then got married and began the American dream by signing up for mortgage debt. When the marriage failed, I was forced into paying the settlement debt. Through my short life, I am already quite well-versed in debt. And, quite frankly I’m sick of it.
As far as I’ve experienced, debt has kept me down and has only increased the fear and struggles in my life. Never once has it lifted my spirits or allowed me to smile with satisfaction. But, is this because I took on the wrong debt? What if I took on debt for investment purposes? Would this alter my opinion of the loan? In other words, is debt really a tool for wealth?
My divorce happened three years ago. Since then, I have met an amazing woman and we recently committed our love for each other with a wedding ceremony. We have a passion for exercise, being outdoors, and we are both frugal in nature. We recently combined our accounts and discovered that we have quite a lot of liquid assets. So much so that we feel strongly about investing it rather than just letting it sit to earn basically nothing in interest. The question now is, “How should we invest it?”
Investing with Cash or on Margin?
Between all of the different investment types, we feel the most comfortable investing in real estate. The bottom will likely not fall out of this market again and we’ll have a bit more control over a rental property than we will in the stock market.
Investing in real estate often takes a lot of cash – so much so that many assume that all the rentals out there are owned with the help of the bank. This is not the case. Quite a few investors purchase their rental properties will cash. This allows them to make bids on “only cash” deals and helps them alleviate the risk that comes with debt. Which is the best route though? Should we invest in real estate with all cash or should we buy on margin for larger potential earnings?
Buying With Cash
After being burned so many times with debt, my natural instinct is to never take on debt again. We currently have enough cash between the two of us to buy one single family home in our area and incur absolutely zero debt. With this route, we’ll be able to buy a $100,000 home, fix it up, and then rent it out for roughly $1,200 a month. All without diving into debt.
This sounds all well and good, but even if we’re able to earn $10,000 from the property each year, it will take us nearly 10 years before we’ll be able to buy the next rental. It’s a pretty slow process, but since the investment is fairly passive, it can be sped up with our additional earnings from our day jobs. By living frugally, we could actually invest in another rental property in less than two years. But still, is this process just too slow? Are we forgoing much of our profits by investing with cash only?
Buying on Margin
With the all-cash example, we were able to buy one rental property worth approximately $100,000. If, however, we decided to put 20% down on each property and get a loan on the remaining 80%, we would actually be able to buy five rental houses. This route would, of course, increase our mortgage payment from $0 to approximately $400 each month (on each property). In total then, our profits would be roughly 2/3 of our all-cash buy. So, instead of earning $10,000 a year on a property, we would earn about $6,666 on each property. However, don’t forget that we would own five properties. So in total, instead of earning $10,000 a year, we would earn 5 x $6,666, or $33,300 per year. By buying on margin and using other peoples money (OPM), we could more than triple our earnings each year.
The Factor of Risk
By crunching the numbers, almost everyone decides immediately that buying properties on margin is the way to go. After all, you could earn $33,000 a year instead of $10,000. It’s a no-brainer! Well hold on a second. You didn’t yet consider all the factors – namely the factor of risk on your $400,000 loan from the bank. By purchasing a house with the bank’s money, there becomes a risk of vacancies, you missing your payments to the bank, and ultimately, you getting your house taken away from you.
To illustrate this a little bit more clearly, pretend that you’re about to invest in a particular stock. You can either put your money into stock ABC that has historically earned between 4% and 6% for the last 30 years, or you can invest in company XYZ that has earned anywhere between -20% and 40%. The potential returns in stock XYZ are definitely greater (after all, you could earn 40% in a single year vs. only 6% from company ABC), but the uncertainty in earnings makes the investment much riskier! Investing in real estate with cash vs. the bank’s money is the exact same scenario.
How to calculate your risk factor
In the finance world, risk is accounted for by using a beta factor. From the example above, company XYZ is obviously a much more risky investment that company ABC. If the average market risk is a 1.0 beta, company ABC would probably be a .8 (or slightly safer than the market), while company XYZ would likely be a beta of 2.5 (meaning it’s 2.5 times more risky than the general market). If the yields of company XYZ aren’t projected to earn more than 2.5x the average market, then the investment is simply too risky and no longer makes sense.
The same is true when factoring the risk of a real estate purchase, but the risk is more difficult to quantify. Here are some factors to consider before taking out a mortgage for a rental property:
- What is the interest percent on the loan?
- What is the vacancy rate in your location of interest?
- How comfortable are you with investment debt?
- How much equity will you have in the home on the date of purchase?
- Do you have enough cash reserve to maintain a high-vacancy stretch for 6 months or more?
- If the bank calls your notes, could you repay the money within a 60 day period?
These are important questions to ask yourself. If any of them frighten you, then you probably should increase your beta factor when considering a mortgage. For me, question #3 is my problem area. I detest debt so much that I wouldn’t feel comfortable holding onto a mortgage for the long-term. It would anger me and keep me up at night. For that reason, my beta would probably skyrocket to 4.0, making debt a non-discussion. I would be much better off investing with cash and building equity more slowly.
In short, debt can be a tool to earn more money, but be sure to properly account for the risk in taking on a mortgage. Many have ignored it and gotten burned in the process, but others have carefully calculated the risks and have come out ahead.
What about you? Do you consider debt to be a tool for wealth?