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.
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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.)
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:
Net worth: $1,000,000
Debt-to-equity ratio of 0.33.
As a second example:
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!