Some financial gurus will tell you to avoid debt at all costs. And while, as a rule, one should manage debt responsibly – ensuring a high, steady credit score without overleveraging – debt isn’t always a bad thing.
In fact, real estate investors commonly utilize debt to build wealth. If you’ve ever bought real estate, you know! That said, it’s easy for investors to go about leveraging debt the wrong way. And messing up debt means a heavy financial burden!
5 Rules for Effective Debt Management (Real Estate Investment Edition)
Rule 1: Put your debt where you can see it
Real estate is one of the best tools for building wealth. Value tends to grow over time, even throughout inflationary periods. While yes, investors often acquire debt as they buy properties, there are also some significant financing strategies to help investors get a handle on all their debt – not just their mortgages. A cash-out refinance, for example, allows property owners to borrow against the value of their home under a new mortgage agreement.
That money can then be used for anything: to pay down high-interest debts or avoid taking out other types of loans.
Rule 2: Know the status of your debt well
At any given time, you should know what you owe. Investors may be juggling multiple mortgages – and that’s not factoring in other sources of debt, like one’s personal mortgage and credit card. Keep a comprehensive record of all your debt balances, interest rates, and monthly payments. All links to accounts and lender contact information should be in one place. You should always know your net worth and the debt balances bringing it down!
If anything, just keep a spreadsheet on hand and updated.
Rule 3: Accept the power of leverage
Leverage is key in portfolio diversification as it empowers you to use less of your own money to acquire properties. While there are some benefits to buying in all-cash, it’s not practical for many investors – particularly those just beginning to build their wealth. An all-cash acquisition has no leverage and high upfront costs, making it harder to scale your portfolio. The only real danger of leveraging in real estate investment is if and only if the value of your property decreases. As an attentive and diligent investor, that’s not likely to happen.
Use common sense, make good decisions, and use leverage to your advantage. Leverage combined with cash flow and wise stewardship of your assets leads to wealth generation!
Rule 4: Build a relationship with a trusted lender
For the most part, investors will seek out traditional financial institutions to acquire lending. Keep in mind, though, that not every lender is experienced in dealing with investors. They don’t always know what you need and may be skeptical of lending. It’s true that lending standards are higher for investors, but it doesn’t mean lending should be a pain to acquire.
You want to establish a partnership with a lender that knows this side of the business. If they know the drill, they’re more likely to help you acquire lending without hassle. It also helps when juggling multiple mortgages, as most (if not all) of your debts can be in one place with one lender.
Rule 5: Avoid overleveraging
While leverage is great, investors must avoid overleveraging. To know if a property or portfolio is over-leveraged, calculate the LTV (loan-to-value ratio). A high ratio means that you’re making a minimal (or no) down payment. If a $150,000 home is financed with a typical 20% down payment ($30,000), your stock in that property is $30,000. It’s what you would get back if you turn around and sell with no change in the asking price.
Over time, you will pay down your mortgage and, hopefully, experience equity growth. Debts go down, value goes up. When you sell, you receive back your original downpayment, the value you’ve paid on your mortgage, and any value over what you paid for the property.
Investors must make careful choices to acquire the right properties for their portfolio and manage them properly – ensuring as few gaps in cash flow as possible while growing the property’s worth.
It’s not just about the properties individually, either. You can overleverage yourself when your debts outweigh the worth of your assets. Be careful of scaling your portfolio too quickly or taking on high-interest debts. Maintain a safety net that can handle your portfolio’s size and, as always, be diligent in your risk management.
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