Utilizing Debt vs. Equity

“Debt is bad” or so we have been taught. Repeatedly it has been pounded into our heads to reduce debt; get rid of credit cards, buy with cash, not credit and so on. Is all debt really that bad? Can debt build wealth?

First, let’s clarify that personal debt, such as credit card debt, or a home equity line of credit that is used to pay for personal expenses is almost always considered detrimental to your financial health. However, debt which follows the acquisition of an income producing property can help you build wealth.

Leverage, the term used for debt financing, is an important part of most real estate deals. Using leverage to purchase an income producing property can increase your Cash-on-Cash Returns. The key to understanding leverage is knowing how much to use and when.

Looking back on the 2008-2009 downturn, it is clear to see that there are times when too much leverage on an asset can create catastrophic losses. Thus, it is key for us to understand leverage – to be familiar with the risks associated and know what level of leverage is prudent in each situation.

Loan-to-value is another term used to describe the amount of debt (leverage) on a property in relation to its value. Just prior to the recession of 2008-2009 there were many five-year loans being issued with very high (85-90%) loan-to-value rates. Two key mistakes that we can see here – very high leverage (85-90% LTV) and loans based on peak property values. As we all know, when those notes came due and the property values had dropped, then the need to inject equity to keep those properties was impossible for many investors. A better strategy is to reduce leverage as the market gets “hotter” and to write longer terms loans (10–20-year balloons payments instead of 5 years) as prices become increasingly unsustainable. Thus, when the inevitable correction comes, you are prepared to weather the storm, maintain your cash flow, and are at very little risk of ever losing the income generating asset you worked so hard to attain.

Use Equity to Counterbalance Leverage

The strategic use of existing equity can also dramatically increase your return on your real estate investment. Over time, as the mortgage is paid down and market values increase, the equity in your investment properties will also increase. This equity can then be pulled out and used as the down payment on another investment. Once again you use leverage to increase your returns. As mentioned above it is prudent to maintain 25-30% equity in your property. Currently most lenders require this amount of equity as a precaution against repeating the harsh lessons of 2008-2009.

Remember, not all debt is bad. Stay away from personal debt but use investment debt to build your net worth, property portfolio, and increase your cash-on-cash returns.