How Much Debt Should You Carry?

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My social circle consists of two wildly different worlds.

On one hand, I’m surrounded by real estate investors who, broadly speaking, love leverage.

Leverage allows them to create cash flow and equity out of thin air.

Leverage allows them to multiply small amounts of money into purchases of assets that are worth five to 10 times their down payment. Leverage allows growth, baby, growth.

Related: Real Estate Leverage: The Temptress

However, my other social circle involves personal finance bloggers. (I write a personal finance and lifestyle blog, and as a result, I spend a lot of time around people within that community). Generally speaking, this is in an incredibly debt-averse crowd.  They’re suspicious of being beholden to the banks, and they distain paying interest.

I’m over-generalizing, of course. There are plenty of real estate investors who recognize the inherit risk and limitations of leverage, just as there are lots of personal finance bloggers who recognize the benefits of taking on strategic amounts of debt.

I’m citing these examples to illustrate a general difference in mindsets — a cultural difference, if you will — between these two different groups. One group, broadly speaking, hears the word “debt” and is immediately suspicious. The other hears the word “debt” and imagines opportunity.

Both of these are solid approaches.

Yes, it’s true that leverage can allow you to grow your business faster and take advantage of unique opportunities.  I bought most of my properties between the years 2010 through 2012, when the market was suffering from severe lows. Thanks to debt, I could capitalize on those low prices.

There’s no way that I could have purchased six rental units in cash at the age of 27. But I could take out mortgages. And those mortgages allowed me to buy properties at the bottom of the market, during the depths of the recession. One of these houses has doubled in price already. The rest have also made solid equity gains. (And all of them, of course, produce handsome cash flow.)

With that said, I recognize that there’s also an inherent risk that comes with being beholden to the banks.  After all, there are thousands of real estate investors who have been forced into bankruptcy.

What’s a “Reasonable” Amount of Debt?

I don’t believe that there’s a universal formula for the optimal amount of debt.

Certainly, you’re limited by how much you can qualify to borrow.  (Although private lenders can help you find financing that traditional banks might not offer.)

But you shouldn’t necessary take out as much debt as you can qualify for.  Your own personal risk tolerance and your lifestyle goals need to factor into your decision-making matrix.

The general rule of thumbs that I use?

  • Don’t mortgage something that you’re not willing to lose. In other words, don’t put up a house as collateral unless you’re willing to lose that house (e.g. don’t risk the farmland that’s been in your family for several generations).
  • Always maintain solid cash reserves. Keep about 6 months of your properties’ expenses as “cash reserves.”
  • Don’t buy rental properties with mediocre cash flow. Buy mainly for cash flow purposes, and view any appreciation as a bonus.

These three rules help me mitigate the risk of taking on debt. (Of course, that risk still exists, no matter how much I minimize it.)

Related: Another Way to Use Real Estate Debt Wisely

Leverage Ratio

I also track my net worth. That means I add my assets, subtract my liabilities, and see how much money remains.

From that point, I can find my “debt-to-equity” ratio. The formula is simple: Debt/Equity (or Liabilities/Assets).

As a hypothetical example:

Assets: $1,500,000
Liabilities: $500,000

Net worth: $1,000,000
Debt-to-equity ratio of 0.33.

As a second example:

Assets: $1,500,000
Liabilities: $750,000

Net worth: $750,000
Debt-to-equity ratio of 0.5.

Decide what you want your optimal debt/equity ratio to be. (Note: The question isn’t, “How much will the banks let you have?” The question is: “How much are you comfortable accepting?”)

Then constantly monitor and track your Net Worth and your Debt/Equity Ratio in order to see where you stand. I like to review these numbers quarterly.

The Bottom Line

Is debt a good thing or a bad thing?  The answer’s not quite so simple. Debt is a tool, just like a hammer.  It can be used to build a house, or it can be used to smash your thumb.

Debt itself is neither good nor bad.  How wisely you use that debt is what makes the difference.
Photo Credit: Louish Pixel

How do you feel concerning debt?

Be sure to share your thoughts and comments in the comment section!

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About Author

Paula Pant quit her 9-to-5 job, invested in 7 rental units, and traveled to 32 countries. Her blog, Afford Anything, shares how to shatter limits, build wealth and maximize life. (At AffordAnything.com, she shares EXACT numbers from all her rental investments -- costs, cash flow, cap rate; it's all published for the world to read.) Afford Anything is a gathering spot for a tribe dedicated to ditching the cubicle. Read her blog, and join the revolution.

11 Comments

  1. Kevin Brown on

    Paula

    Tremendous article. Best article Ive read on BP in weeks. I have loans on 3 rentals, and have 3 free and clear. I often debate taking out loans on the free and clear houses (I paid cash for them, they aren’t paid off loans) and generally feel its best to leave them free and clear. I was also completely averse to using loans for properties I flip until recently. Simply because Ive been able to get better financing for flips, versus hard money I am now a huge fan of leverage on flips. I totally agree that managing debt is a matter of balance and personal comfort level. We all invest in real estate for different reasons, and although the general goal tends to be similar, everyone has to go about things in their own way

  2. Charles McNelly on

    “The question isn’t, How much will the banks let you have? The question is: How much are you comfortable accepting?” —VERY wise approach here! Great article, Paula!

  3. Great article Paula. I struggle with the debt issue almost daily. I have been reading the Dave Ramsey books and he hates debt. However I see it as a necessary evil if you want to grow your business unless you have plenty of your own cash. I do not like paying interest on anything, but sometimes you gotta do what you gotta do. By leveraging my debt I have been able to acquire multiple properties in my 18 months of business, where as I would have only have been able to do 1 or 2 without debt. In my hometown I have been buying properties at 30-40% of their value and rehabbing them up to 70% of their value, then flipping them or renting them. We have made small profits on the flips and we get at least $300 positive cash flow per month on the rentals. So far it has been working great. What are some pit falls I need to look out for with this model?

    • Kevin Brown on

      Charlie

      I know your asking Paula, and not me but here’s my 2 cents anyway. IMPO Dave Ramsey hates debt for the same reason lots of investors lost their shirts in this business. Over leverage. If you have 50 properties at 90-100% leverage with no cash reserves for when the road gets rocky, your going to be in trouble. At the end of the day if your business grows organically and you buy properties right, I feel the risk is significantly lessened. If you are all into these properties at 70%, you can fire sell the to another investor and although you may lose a little money, you aren’t filing bankruptcy

  4. Great points. I am always leery when property only cash flows 15%, on a minimal down opportunity. All my properties cash flow 15%, with 25%+ down in the initial purchase. When you can get 15%, on a large down payment, you have some cash flow you can temporarily sacrifice if you have to.

    The Banks have gotten wise to near nothing down, and although not impossible, long-term zero down scenarios are not as common as they used to be. In the ‘old’ days, nothing down, and large cash back at closing was even readily available.

    In reality, a mortgage is just another expense. No different than utilities and maintenance. A mortgage is just part of the operating cost.

    I have properties that are paid off, and others I have mortgages on. As long as the mortgage doesn’t take too much cash flow, you are OK. And as long as the mortgage is only attached to the one property, you can cut that one loose. If you have 25%+ in the game, odds are, you can sell the property, and pay off the mortgage. That will salvage your credit and get rid of the personal guarantee.

  5. I love how you brought up the 6 months of expenses in reserves. I feel that not many people consider that in their ROI equation. These people who say they are putting $0 down and think their returns are infinite, are not taking into account the 6 months of cash reserves sitting there collecting 0% interest. The more leverage, the more reserves are needed for 6 months of debt payoff therefore lowering the ROI closer to levels where a fully paid-off property are at. It may not tip the ROI scale in favor of no leverage (especially with rates being so low) but when you consider the other benefits of owning fewer paid-for properties vs. more leveraged properties, I like the paid-for route better. Great post Paula! Love your blog as well!

  6. Interest. People forget that you are not actually paying the interest on investment mortgages.
    Your Clients/Tenants are the ones paying the interest on your behalf (or they should be) just like they are the ones building your equity in the investment property, not you. You just have to keep your credit in good standing and be smart enough to capitalize on the opportunities at hand. Great article!

  7. I think it is important to clarify that there is good debt and bad debt. Paying interest on a credit card for consumables = bad. Paying interest on a mortgage for a cash flowing house = good.

    It would be interesting to compare the net worth of your real estate investor friends vs. your personal finance friends to see which is the group you should be hanging around with and taking advice from and which is the group you’d be better off just keeping as friends.

  8. I like that you pointed out that debt is a tool.
    Like all tools you can use them to do amazing things, and if not used properly can kill you.
    The wise prudent use of debt can grow your portfolio quicker and bigger than saving up to do all cash purchases. If you over lever your properties or you take on too many too fast without proper systems and reserves in place you can sink.

    You don’t here many stories of people that built multimillion dollar portfolios using all cash purchases but you also don’t here many stories of investors losing their free and clear portfolio during the crash.
    To each his own…

  9. Paula, I liked your article! I agree that the way you look at leverage is a personal choice. But as you outline in your article, there are 3 important factors you must consider BEFORE deciding to leverage. I also really dig your “leverage ratio”. Solid way to get a strategic view of just how risky you are. I’m currently at 50%…not good, not bad. I’m pretty sure the book “The Millionaire Next Door” spoke about most millionaires typically being leveraged at 60-40. I think I’ll aim for that :)

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