Janurary / Februrary 2002
In my previous column, I explained how paying down a mortgage rapidly may be a very safe way of investing, but that it does not allow for as much leverage and therefore potential growth as a strategy of using debt more aggressively.
To show that real estate investment was not as risky as other investments, we looked at interest rates charged by banks for various classes of investments. We saw that banks charge the highest rate on unsecured credit card debt, less on business loans, and least on real estate mortgages. Even banks think that real estate is safe!
Not only are banks keen to lend money secured against real estate (consider the plethora of advertisements offering financing on property, and the dearth of similar advertisements offering financing on antiques, jewels, businesses, phone-cards, stocks and bonds) but banks will also offer finance to buy real estate on much longer terms than the other loans that they do (reluctantly) offer. For instance, it is easy to arrange 25 year and even 30 year mortgages on real estate, at interest rates that in the US can be fixed for the entire duration of the loan. When finance is offered on cars, household appliances, or even businesses, you will never get a 25 year loan. In fact, in the case of vehicles, the loan will obviously have to be repaid in a shorter time span than the expected life of the collateral.
Finally, we used a simple example to show the difference between using cash to pay off debt, and using that same cash to buy more real estate. In the example, we imagined owning a single property bought with $4,000 cash and a $12,000 mortgage. We then asked if you were lucky enough to receive a $12,000 windfall (in the example an inheritance), should you use the $12,000 windfall to pay off the $12,000 debt on your one property, or should you leverage the extra $12,000 to buy another three properties (each for $4,000 cash with a further mortgage of $12,000). If all properties went up by the same amount, then we saw that in the former case, you could have had property worth $200,000 with no debt, and in the latter case, property worth $800,000 with $48,000 debt.
Ultimately, the question as to how much debt you should have (I am talking “good debt” here, that is debt secured by appreciating assets such as real estate, rather than “bad debt” such as consumer debt to buy a stereo or car) depends on how much risk you are willing to take to get far greater returns than you would otherwise get with no or less debt.
The more debt you have, the more you will make when the assets against which the debt is secured go up in value. If that was all there was to it, then everyone would just acquire as much debt as possible. However, the converse is also true: the more debt you have, the more you will lose when the assets against which the debt is secured go down in value.
There is risk associated with having debt, and that risk can be succinctly summarized as, “What are the chances of the asset you are acquiring with debt going down in value?”
I have addressed the chances of real estate going down (and a strategy to minimize the effects on yourself) in my book Real Estate Riches. Let me add here that if having a $20,000 mortgage on a $340,000 property prevents you from getting a good night’s sleep (because you are worried as to how you will pay off the $20,000), then I would suggest that you should not have such a mortgage. However, there are many people who have a $340,000 asset with only $20,000 of debt left on it, but who still do not consider borrowing against this asset to borrow more money to use as a deposit or down payment on their next investment. It’s not that they would lose sleep if they did this; rather, they just don’t think of doing it.
Banks like us to have “Principal and Interest” mortgages, also known as P&I mortgages, as they like to know that all their mortgages are being paid back. (Once you have paid off a mortgage, they will tend to phone you and ask if you want to do it again.)
As an alternative, you can try to get an “Interest Only” mortgage, where you only pay interest on the entire debt, and then pay back the debt in one hit at the end of the term.
Having an Interest Only mortgage makes sense from a technical point of view. Given that principal repayments are made with tax-paid money (you cannot claim principal repayments against your income), whereas interest payments on investments can be deducted against rental income, why use tax-paid money to reduce the mortgage, when doing so reduces the amount of the mortgage outstanding and therefore reduces the interest bill, which therefore reduces your tax-deductibility. You would be far better off using the same tax-paid cash as a deposit on the next property.
Many people report back to me that Interest Only loans are not as easy to get as a standard P&I mortgage. That is true. Some banks will not consider them at all, and others will only offer Interest Only for a short number of years, after which they expect you to switch over to a standard P&I loan. In this case, you can accept the Interest Only loan for say the initial 2 year period, but at the end of this period refinance and ask for another 2 year Interest Only loan, or if need be go to another bank.
There is another way of getting money without having to pay back interest. The loans are known variously as a “Revolving Line of Credit”, a “Revolving Loan”, or a “Credit Line Mortgage”. In this case, you may borrow up to a fixed percentage of the appraised value of a property, and you have the ability to borrow up to that maximum, or pay back principal, every day. In other words, you could withdraw $80,000 for anything (say a deposit on a new investment) today, and then tomorrow deposit $10,000 (say income), deposit another $15,000 next week, and take out $37,000 the week after. These loans give you total flexibility, and you only pay interest on a daily basis on any amount outstanding.
Then, all you need to do every couple of years or so is get a new valuation or appraisal, and, assuming the value has gone up, you will be able to borrow more against this asset.
In this sense, banks have done your homework for you: there is no other investment at all where they will let you borrow a large percentage of the value of that investment with no requirement to incrementally pay it off. You can use the cash you would otherwise apply to principal repayments to buy more investments, even those where you borrow on the same basis again.
You decide whether this is food for thought, or a call for action!
Dolf de Roos.