When making financial plans there are two basic schools of thought to get your information from. One group says that debt is bad, and that you should limit or eliminate all debt as soon as possible. The other group argues that getting rid of consumer debt is wise, but that borrowing money to buy investment properties or start businesses can be a smart investment.
Who do you listen to? The answer is that it depends. For example let’s look at the debt approach.
If your strategy is to purchase single family homes at favorable mortgage terms, receive monthly cashflow, grow equity and increase the value of the property over time then this strategy may work. However the alternative, no-debt strategy would leave you saving up and purchasing the whole investment with cash. Sound difficult? You bet!
So which strategy is better? Well that depends on which provides a better, risk-reward ratio. The following are a few risks we should be aware of when investing in real estate: Law suit risk, credit risk(that we won’t be able to pay the mortgage, thus losing the property), cashflow risk (that costs will rise to the point where we don’t receive adequate cashflow). These are just a few risks.
Of these three risks, which ones are effected by taking out a loan? Credit risk and cashflow risk are both effected. Credit risk isn’t even a concern with the no-debt approach(because there’s no mortgage) and cashflow risk increases with the debt approach because there’s increased monthly expenses in the form of loan payments.
A different risk we haven’t discussed yet is the risk of loss of capital. For example let’s say you make the investment in a limited liability entity and are thus only able to lose the money you have into the deal. With the all-cash approach your risk is much higher than the debt approach.
Overall the risks of using debt are slightly higher. However in terms of returns the returns can potentially be much higher than if you only use cash. In addition, purchasing a property with cash takes longer to save up for , lengthening the time it takes to make the original investment in the first place.
So which is better? It all comes down to if you are willing to take slightly more risks to potentially make much more ROI. As long as you are sure to never borrow more than 80% of the value of a property, the debt approach will usually work slightly better. Lastly, the most important takeaway is that simply investing is the most important step. So stop waiting and start taking steps towards financial freedom today!