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043: Embrace Good Debt – Friday Fundamentals

Embrace Good Debt

We’ve all been taught to avoid debt. Today, we’re going to learn why you should embrace debt. Yes, embrace debt. Take on more of it.

The debt we’re talking about today is good debt. We’ve talked about the difference in good debt and bad debt in previous episodes.

Good debt, is the kind of debt that someone else pays for you. Debt that is secured by an asset. One form of good debt is a mortgage on an income producing rental property.

Real estate investing is a great way to achieve wealth and financial freedom. Leverage is one of the things that sets real estate apart from other asset classes.

Leverage is using other people’s money to buy real estate that you control. In most cases the other people’s money comes from the bank in the form of a loan for a rental property.

Most banks require you to put 20% down of your own money, and they’ll loan you the other 80%.

By intelligently taking advantage of leverage, one can grow their real estate portfolio and passive income stream larger and faster than by not using leverage.

Scenario 1

We’re going to buy a $100,000 house for cash. The property rents for $1,000 per month. Since we don’t have a loan on the property, our cash flow is $750 after we’ve paid insurance, taxes, and maintenance.

Scenario 2

Now let’s take that same $100,000 and buy rental property using leverage.

We’re going to buy the same type of properties as in Scenario 1. Each of these $100,000 properties will require $20,000 down payment, and we’ll borrow the rest of the money from the bank.  With $100,000, we can afford the down payment to buy 5 properties. These properties are the same as the property in Scenario 1, so we’re renting them for $1,000 each.

Now we do have a mortgage payment on these properties, so that does reduce our cash flow. Rather than the $750 cash flow in the first scenario, our cash flow will be $400 per month for each property.

But remember, we were able to buy 5 of these, so our cash flow is 5 times $400 for a total of $2,000 per month.

You see by using smart leverage we were able to increase our income from $750 to $2,000 per month.

Let’s go back to Scenario 1, and fast forward 10 years. We still have our 1 property, but it has appreciated to $150,000. Awesome! We have made $50,000 from appreciation, from our original $100,000 purchase. That’s a 50% return!

Now let’s apply this to Scenario 2. Fast forward 10 years, and each property has appreciated to the same $150,000.

That’s $50k or appreciation for each of our 5 properties, for a total of $250k on the same $100,000 initial investment. That’s a 250% return!

As you can see, leverage gives one the ability to control more property, thus increasing cash flow, and returns from appreciation.

People who don’t understand the power of leverage, are making a mistake by paying off their rental properties, as we can see from comparing these scenarios.

So don’t shy away from debt. Use good debt to your advantage, and you will be well on your way to achieving financial freedom.

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