Is Debt “Dumb” In Real Estate Investing?
Should you take on debt to further your real estate investing goals? As with virtually any question you ask about investing, the short answer is, “It depends.” Let’s take a look at the longer answer.
We should add “It depends on your investment goals, strategy, and style.” Experts disagree on whether or not it makes sense to borrow money to invest in real estate. Dave Ramsey, for example, says, “Debt is dumb, cash is king.”
A former real estate investor, Ramsey lost his metaphorical shirt and declared bankruptcy in his 20s. Today, he’s well-known for his Debt Snowball approach to eliminating debt. According to Ramsey, the only “good” debt is that which you take on when purchasing a primary residence.
We can all agree that certain types of debt are detrimental: credit cards come to mind immediately. However, debt that essentially pays for itself can be beneficial. For example, when you borrow to purchase a property that produces income, the debt can not only pay for itself but generate revenue.
Debt can be a powerful tool – or a dangerous weapon. It depends on how you use it. If you have a vacancy, you must continue to make payments regardless of the hit to your revenue. If a tenant destroys a unit, you have to pay even though it cuts into your profits. Your circumstances don’t matter to the lender: you could have $0 coming in, but you must make sure you have the agreed upon amount going out.
Without cash reserves and savings to cushion those impacts, debt can quickly become a crushing burden. You should have at least a few months (preferably six) of mortgage, interest, taxes, and insurance payments as a fallback. So, cash still is king even if you utilize debt.
And, of course, some debt vehicles are more risky than others. Those that require balloon payments or have adjustable rates, for example, can leave you financially stranded if you, or the economy, hit some rough patches.
On the other hand, borrowing allows you to leverage the cash you do have more effectively – if you are smart about it. You only want to take debt on against assets that will produce stable income, and you want to build in plenty of wiggle room between your mortgage payment and net rental income. Other conditions for good debt include:
- Ensuring financing costs are below the cap rate.
- Opting for fixed rates and payments.
- No personal guarantee (this can be tricky, but it’s optimal).
- Choosing a reliable, reputable lender. You don’t want to go with someone who will sell your loan to a giant holding company.
A sweeping generalization like “Debt is dumb” is not all that helpful for real estate investors. The smart move is to assess your strategy, goals, and make sure you have all the information (and cash reserves) you need before taking on debt for real estate investing.