Using Debt as a Tool

Debt is a huge topic in our culture. Americans are great at getting into it. "As long as I can afford the payments", they tell themselves. But let's dig a bit deeper into debt. Is debt good, or is it bad? It certainly would seem to depend on who you talk to, or who's advice you listen to. Take for instance Dave Ramsey. He's a huge proponent of debt free living. I can't say that I can argue with the logic. Especially for the "average" American, who trades time for dollars at a 9-5 job. Living free of consumer debt is a very worthy goal, and it opens up a lot of options and the ability to live with less stress and more freedom. But, can debt actually help you? In certain circumstances, and used the right way, the answer is "yes!".

Debt is a tool. Like any tool, it can be used correctly, and it can be used incorrectly. If you use a chainsaw to cut down a tree, and you know how to operate one, all is well. You're using it for the right purpose, and you're trained on how to do it properly. But if you've never used a chainsaw before, and you try to figure it out on your own, you're likely to get hurt. Even worse, if you try to use it in a way that it's not intended for, you'll probably lose a limb. Unfortunately this is the equivalent of where most people are in their financing intelligence and education. Our education system teaches the basics, and how to get a "regular" job, but it does a very poor job of teaching about the real world - especially when it comes to managing money. I'll admit that a lot of this responsibility should fall on the parents, not the teachers or school system. Just look at the amount of consumer debt the average American has though, and you'll see the the problem - you can't teach what you don't know (or at least what you don't practice). The "instant gratification", "buy it now and figure out how to pay for it later" mindset has taken over. Americans especially are addicted to it. But I'll digress here, as I don't want to get off topic. The point is, debt is overwhelmingly used in a way that is not beneficial to the consumer, but there is a way it can be used as a tool to further your financial goals.

Here's the basics of it. Debt that pays for itself, or brings in extra above the cost of the debt, can be good debt if managed correctly. Debt that costs you money, and that you need to figure out a way to bring money in from elsewhere to pay for it, is bad debt. Robert Kiyosaki puts it this way: if it takes money out of your pocket every month, it's a liability (bad debt); if it puts money in your pocket every month, it's an asset (good debt). This is why your accountant says your personal residence is an asset, but Kiyosaki would say it's a liability. Even if you own it free and clear, you're still paying out of your own pocket for insurance, taxes and maintenance.

One of the best examples of using debt as a tool is in real estate. Say you want to buy a rental property as an income producing asset. Your options are either to pay cash, or to finance the purchase. In most parts of the country, and for most individuals, saving up that kind of cash would take, well, a very long time. Or, you can use leverage (more on the power of leverage later), and finance part of the purchase. Not only does this allow you to buy the home sooner than if you tried to save to pay cash, it will allow you to buy more homes before then as well. Any cash you don't need to put into the property can be used to invest elsewhere. The key is to make sure the debt pays for itself, or better yet, the property cash flows and brings in money every month. If it's putting money in your pocket, and your using other people's money (the bank's and your renters) to buy an asset for you, you're using the tool of debt in the right way.

Here's another example. You want to buy a new car, which costs $50,000. I'm not an advocate of buying depreciating "assets" that are brand new, but let's just say for example's sake. You can either pay cash, or you have the option to finance. Say you're able to qualify for a 0.9% rate. The question you need to ask is this: do you have the ability and knowledge to go out and make a better return than what you're paying on the car? If you do, it'd be silly not to finance the car, as long as that's what you do with the cash is put it to work to create a better return. Now essentially you're using the banks money that they gave you for the car as leverage to invest, and you earn the spread. I also like Kiyosaki's example of when his wife Kim wanted a new car. He told her to figure out how much the payment on the car would be, go out and buy enough assets to cover two times what that payment would be, and then go buy the car. Using these two strategies together can be very powerful. Now you have assets creating income for you, paying for the car and bringing extra money in, and if you're using the banks financing, you keep your cash free to invest elsewhere.

Debt can be good. It can be used in very powerful ways. It can also cripple you and control your life. The biggest factor is how you use it. Educate yourself, know what you're getting into, and use debt to buy income producing assets. That's the right way to use the tool of debt.

Which First...Personal Residence or Rental?

First, thanks to Steve for the inspiration for this topic.

 I'm glad you're thinking ahead to make sure you know what you're getting into. The last thing you want to do is go out and buy a home, whether it's a personal residence or rental first, and then find out you just put yourself in a position where you can't do the other. I took a slightly different spin on the question, but I think I'll get the basis of it answered.

First, let's cover the basic differences between owner occupied loans and non-owner occupied loans. With conventional financing, you have a few different options on the personal residence side. You might be able to qualify for a low down payment program and put down as little as about 3% of the purchase price, or even zero down if you live in an area where the properties may qualify for USDA financing. Keep in mind that with either of these options, likely you will be paying mortgage insurance in addition to your typical principle, interest, taxes and insurance (PITI). If you can put a significant amount down, you might be better off going with a 20% down program without the mortgage insurance.

On the non-owner occupied side, you'll see a big difference in down payment requirements, as well as a difference in rates. Typically you'll need 15-20% down to purchase a home that will be a rental property. You'll also see slightly higher rates. This is a reflection of the lenders perceived risk in this type of loan. The more "skin in the game" you have, the less likely you'll default on the loan. The nice thing about these loans, is often you can use a portion of the rents to help qualify for the loan. For a new purchase, you might be able to get 75% of the rent counted as part of your income to help qualify. Once you have 2 years tax returns operating the home as a rental property, you can then use the actual income of the property to qualify for additional loans.

One strategy to consider is actually buying your personal residence first, and converting it into a rental property later. The benefit is that you get the low down and lower interest rate terms of an owner occupied property, even once you convert it to a rental. Check your loan terms to see if it states that you must live in the home for a specified period of time first. Make sure you do your calculations first as well, as when you go to purchase another property in a couple years you will likely have to be able to qualify for both the existing mortgage payment as well as the new one you're attempting to get. This may not be the case if you have gained some equity in the property, but be prepared for it just in case, especially since there's no telling what loan programs will be available 2 years down the road. Something you might even consider doing that could help with this is buying a 2-4 unit residential building. For 2-4 units, you can still get residential financing, and you then have additional units paying for your mortgage that you can use as income to help qualify for both the initial loan, as well as another loan later. If the rent of the other unit(s) covers, or at least almost covers the mortgage (or better yet the building cash flows), you're golden in a couple years and you won't have to worry about trying to qualify for both the current building and an additional one.

The other benefit with buying a future rental as a owner occupied home first is that, if you use a low down payment program for the initial purchase, you're using more leverage on the property. If you buy it as a rental first, you are putting more of your own money in, and you can't get that money back out unless the property and rents go up in value enough to be able to refinance later. As a rental property, with conventional programs, even when you refinance you will be required to keep a larger portion of equity in the property. With a low down owner occupied loan, you have less of your own money in the property, and more of other people's money in the property. As long as it still cash flows with the higher leverage, that allows you to use your own money for other investments.

Now, there's one wild card I want to throw in the mix here, and that is seller financing. A lot has changed with this since Dodd-Frank went into effect, but seller financing can be and still is done on a regular basis. There are a ton of benefits to negotiating seller financing. You're negotiating directly with the seller, so there is a lot more flexibility to the terms that can be created versus the "our way or the highway", "take it or leave it" banks. The other great thing is that, if you create seller financing on a rental property, that loan is not on your credit report so it most likely will not count against you and hurt your ability to qualify for a conventional loan. Why not go out and find a rental property that you can buy with seller terms, and also go buy your personal residence? "Why in the world would", you may ask, "would a seller finance the sale of their property?". Well that, my friend, is an entire topic by itself and for a separate post at a later day (I guess I just figured out the topic for my next post).

One final disclaimer; conventional financing terms, programs and criteria change on what seems like a daily basis. Make sure you're connected and build a relationship with an experience, knowledgeable mortgage broker who stays up on the latest changes and can help create a game plan for you based on your specific situation. Lastly, make sure you make a plan, as it sounds like you are, but then act on it. Don't overanalyze all the different potential scenarios. Be smart, come up with an action plan that makes sense, and then go out and make it happen.

Simon Sinek: How Great Leaders Inspire Action Commercial Real Estate