We've all been taught to avoid debt and pay it off as quickly as possible, but what if this conventional wisdom is holding you back? In this blog, we explore why leveraging debt, especially in real estate, might be the smarter move for building wealth and achieving financial freedom.
“Debt is like, honestly, the worst thing and you definitely need to pay it off”
This is pretty much what we've been told for most of our lives. I want to share with you why you may want to consider thinking the contrarian way which ultimately leads you to living like the rich, which is the 1% of the 1%.
When it comes to real estate investing, you regularly think about two key things that people tell you. *These are the two things I remember when I was growing up.*
I've spoken about renting and why you can actually build a lot of wealth through rent-vesting. If you're young, this is an even more important point as I think it’s one of the most important vehicles to get ahead.
Today, I actually want to talk about the second point, which is “pay off all of your debts”. Let’s talk through some of the pro’s for paying off debt.
Obviously, peace of mind is the first thing that comes to my mind. When you don’t have that debt, you're not answerable to a bank.
That is such a good place to be and that's why I talk about your principal place of residence being debt free because that's a place you're going to stay in for the long-term.
If you're going to get financial stress it starts at home, not just with the people that live there but also your house itself, your principal place of residence will also be the highest value property you own. So the largest amount of debt will be attached to that home.
Let’s also talk about interest payments…
You don't have to make interest repayments ever again.
I think as soon you read that, your face lit up, and you’re wondering, “how good that would be?”.
For now, you might be checking your account, and your seeing money coming out. It be might…
In some cases…
And you’re saying to yourself, "banks are the worst people ever!",
But, I want to break down something here…The banks are not actually against you. They're with you. I’ll explain what I mean about this
First, yes, sure they're charging a little more interest than they probably should. But they're a business and that's their business model. If they're so, bad, you have an alternative option, which is don’t use the bank at all. You say, “Okay, I don't like your interest rates, I'm not going to a bank to get a loan!”.
Well, without the help of a bank, I’ll need to front up all of the money. If I buy a house today at $500,000 for example, I need $500,000 in cash. That means, I need to have saved up my own $500,000. Whether it’s from selling assets I have, or doing it the good old way and saving to get there.
So wait, are the banks actually really that bad?
For example: If I use $500,00 and the help of the bank, I could put down a deposit of $50,000, plus other costs involved, so let’s say $85,000.
That means that with the help of the bank, they will fund $450,000, which also means I only need to use $50,000 of my own money to get into this deal.
And the best part is…
I get all the perks and benefits of the value of that property increasing!
Consider this scenario: If you and I went and bought a property, and I said, “Look I'm going to put in 90% you put in 10%”.
Then the expectation is that I would also earn 90% of the equity. Well, that's not what happens with property. What happens is the bank actually says: “All the equity growth is yours. We just want a percentage in the form of interest repayments”.
This should change your mindset and get you to understand that they're actually trying to help us. I know it's not a very popular opinion, but in reality, without the banks you could not build a multiple property portfolio as fast as having their help.
Another thing to consider when paying off all of your debt is that you just have more savings at the end of every month. If you think about it right now, a large portion of your income goes towards housing expenses.
Now that could be in the form of rent, or it could be in mortgage repayments. In this case, if you have no debt, you have no mortgage repayments.
In reality, a large portion of your income (and on average it's anywhere between 20-40% of your household income) is going towards mortgage repayments, and it could be more in today's situation.
But having no debt could mean that you could take up a job that's paying you less…
But you can work somewhere else where you actually enjoy.
We've looked at the pros of paying off debt and the wonderful world we live in when you don't have to worry about interest repayments. But what's the flip side? What are the pros of not paying off that debt?
This can grow your wealth considerably faster.
Consider this: You say to yourself today that you want to go and open up a business. But you need machinery, you need a fitout, you need stock. It’s going to very costsly to acquire these assets before you even start.
You could choose to do it by yourself and it would mean that it would take you lot longer or require a larger capital outlay.
Or, you go to the bank and you get a business loan and suddenly, you can be up and running sooner, and the business is operating.
It’s the same with real estate. Using debt, or leverage, you can secure the real estate that you want, and allow it to grow. This means that you’re in the market sooner, and can stay in for a longer period of time.
We've heard this saying over and over and over again:
Time in the market beats timing the market.
Well you have to first be in the market.
Believe it or not, you actually have more flexibility and choice by having debt.
What I mean by this is if all of your cash is going into this one deal, it means you limit the movements you can make. If you have to go to the bank now to take some money out, you can, but you have to go through hurdles and hurdles and you might not even qualify for a loan. That means you can't access any of that money that you've put in unless you sell the property.
If you are in a position where you're still working, you have the income and you just get an equity top up on the property, that means you can make payments into an offset, which is money you can access if needed.
The final thing that I want to talk about is diversification. If I have all of my cash in one property, I better hope that property is going up in value.
That could be your life savings in this one property, and if you decide you want to sell, but it's not the right time to sell, you dig a deeper hole. You start getting lowball offers, and now the stress increases suddenly. Instead, I would rather say put in a smaller amount of cash into the deal and have the rest sit in an offset account. This will offset some of the interest repayments that I would normally have to pay and it gives me maximum flexibility.
If I need the money today, I've got it there. When it comes to being in the market, I've already got the property, and if I've bought well I'm pretty much going to be slightly negative if not neutral when I purchase the property based on today’s market.
Although it could be a really good idea to get peace of mind by paying off your loans and paying your mortgage faster, let's just think about this with an example:
I've got $500,000. I could go out and purchase a property outright, and it could look like this:
Scenario 1
However, what I can also do is:
Scenario 2
I can also do this:
Scenario 3
And this is what you could make in each of the scenarios over the space of 20 years.
Here is the first scenario when just paying down debt.
Scenario 1
The numbers over time when using the $500,000 to purchase 2 x properties worth $1,000,000 all up.
Scenario 2
The numbers over time when using the $500,000 to purchase 4 x properties worth $2,000,000 all up (my favourite!).
Scenario 3
Now at this point you can decide to sell one or two properties and pay down all of your debt. That is the power of compounding when it comes to real estate. But this is only possible if you have the right strategy…
And most importantly, you have the mindset to use debt to your advantage to build out your property portfolio.
The banks can be your friend when you need them, and that's why they give you all the clues in front of you.
If you decide tomorrow to go and get a personal loan, or a car loan, the interest rate is significantly higher than a home loan where they're giving you the best rate. So hopefully after reading this you've thought about this differently.
Yes, the banks might try to screw you with a high interest, but in the biggest scheme of things if the bank allows you to be able to get into a property and hold assets for a longer period of time in my head it makes complete sense to go ahead and take up more debt to purchase property.
And if you need help with finding the right property, we’re here to help. Click here to book a call today.
Disclaimer: Search Property Pty Ltd (SP) does not provide financial or investment advice and does not hold a financial services license as defined in the Corporations Act 2001 (Cth). Any advice given by SP is general in nature and does not take into account your personal circumstances or objectives, financial situation or needs.
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