Real Estate… Answered

Common wisdom says debt is bad and you should pay it off as quickly as possible. But the numbers don’t work. When you start to understand real estate investments and rates of return, you realize you can make more money by investing your money than paying off debts. Only, is that the right move?

The answer is… it depends on your individual circumstances. Ask yourself the following three questions before deciding what to do:

Is It Good Debt or Bad Debt?

In Robert Kiyosaki’s best-selling book, Rich Dad, Poor Dad, he defines good debt as a loan that puts money in your pocket and bad debt as a loan that costs you money. The mortgages on rental properties are considered good debt because they are a real estate investment that produce monthly cash flow. Credit cards are considered bad debt because you lose money every month on your interest payments.

I agree with his definition, but I’d like to add one more qualifier. Good debt increases your credit score; bad debt decreases it. For example, credit cards can significantly improve your credit score and buying power if you pay off the balances on a regular basis. Paying your car loan on time every month can also significantly improve your score. On the other hand, maxing out a credit card and making the minimum payment will significantly reduce your score. So, it’s considered bad debt.

How Is Your Debt to Income Ratio?

While it’s not an exact science, the general acceptable debt to income ratio is 33/38. You can use up to 33% of your gross monthly income for housing expenses and up to 38% on your combined housing expenses and other consumer debts. If you consider the numbers carefully, you can use up to 5% of your monthly income for credit cards, your car, or student loans. Anything beyond that cuts into your ability to buy real estate investments.

So, if you’re making $5,000 per month, you want to pay no more than $250 per month in consumer debt. That’s not much. Your minimum payment on your student loan, plus a car payment probably exceed 5%. If you want to borrow as much as you possibly can to buy real estate investments, you’ll want to pay them off. Otherwise, you’ll be limiting your borrowing power.

Do You Know What You’re Doing?

Now for the tough one: do you genuinely believe you can make enough money from your real estate investments to justify keeping your debt? It’s common for successful investors to have thousands or even tens of thousands of dollars in credit card debt. They’re not worried about it because they can consistently make a high enough return to justify carrying the debt. For example, if you’re paying 6% on your credit cards but making 40% from your investments, it just makes more sense to reinvest your profits.

But not everyone is a successful investor. If you are just getting started, it’s a risky move to carry a lot of debt. The odds are against you making money fast. More than likely, you’ll spend a lot of time browsing the market before making your first real estate investment. You might also lose money on your first few deals. If that happens, you don’t want to get caught with a lot of debt or an overloaded debt to income ratio. You’ll need as few liabilities as possible.