General Tips
Shouldn't we pay down our debt?
By Dolf de Roos
May 11, 2006

November / December 2001

Since I wrote my last column, my new book “Real Estate Riches” has been released in numerous markets around the world. It has hit the best seller lists in New Zealand and Australia, and as I write is Number 7 on the Wall Street Journal as well as the Amazon.com Business and Investment best seller lists.

In writing this book, I set out not to create yet another “how to” book on real estate, but rather to share my underlying philosophies and convictions as to why real estate is such a lucrative investment.

The feedback received so far is phenomenal and extremely gratifying. While it is impossible for me to respond to each comment or question individually, I would like to use this column to address some of the more recurring questions that come up.

By far the most common question concerns mortgages used to acquire real estate. Surely, so the argument goes, if the name of the game is to build up equity, then the sooner you can pay off each mortgage, the better. A natural extension of this would be to use as much cash for the deposit or down payment as possible, to opt for a Principal and Interest mortgage, and to pay it down as fast as possible.

There is of course nothing wrong with such a course of action, and many property investors have become very wealthy by doing just that. However, it may be that this strategy is not the optimum way to increase your wealth rapidly.

Before I continue, let me concede that if you have no debt on a property (it is unencumbered by a mortgage), and the property market collapses, then although you may not be happy about the collapse, you will not go under because of a debt problem. Conversely, if you are mortgaged up to the hilt, and the property market goes down enough (capital values decline as well as rentals), then because of your debt loading, you may well be in severe financial difficulties.

In other words, taking on debt is inherently risky. However, I believe that the risk associated with real estate debt is far less than that associated with any other kind of debt.

Before you challenge me on this contention, let’s look at what banks, who have been in business for centuries, think on this topic. If we accept that a high risk requires a high reward, then it will not surprise us that unsecured credit card debt carries an interest rate (as charged by banks) of typically 20% per annum or more. Business loans on the other hand attract typically around 12 or 14% interest at present, while mortgages secured over real estate are typically at around 6 or 7%. To banks, real estate is seen as one of the least risky investments for them to lend money on.

In making these observations, it should be stressed that we are looking at averages. For instance, there may well be a credit card user who is more credit worthy (less of a risk) than someone else who managed to get a mortgage. But the market always looks at averages.

In the new book Real Estate Riches, I go to some length to explain why and how it is so easy to beat the averages in real estate. To truly beat the average in the stock market, you must possess sage-like qualities that many claim to have, but few have the bank balances to back it up. However, to beat the averages in real estate, you merely need to have the common sense to buy in locations that have higher than average growth, be it geographically, demographically, or based on any other discernable trend. For instance, a rest home by the sea in a fast growth city is likely to go up in value faster than a cottage in an abandoned mining town, even though both contribute to the average statistics.

So, if we can accept that debt on real estate is not as onerous as debt on a pleasure speed boat, or a stereo, or a new car, or a vacation, then we can address whether or not we should pay it off as soon as possible.

To simplify our thinking on this, imagine that you bought a house back in 1970 for $16,000, using $4,000 cash and a mortgage of $12,000. And imagine if, the day after you acquired this property, your uncle left you an inheritance of exactly $12,000. The question as to how soon you should pay off the debt could then be rephrased to: “Should you apply the $12,000 inheritance to pay off the one-day-old mortgage of $12,000?”

If you want to be secure in the knowledge that no matter what happens to the real estate market, you cannot lose your property on account of a mortgage, then by all means pay it off!. Such an action would be better than squandering the inheritance on consumer goods. And if, since 1970, that property will have risen in value to say $200,000, then you will have done very well.

However, there is another possibility. Instead of applying the inheritance to paying off the mortgage, you could also use the money to acquire more real estate. In fact, using the same 75% gearing ratio as with the first house, you could buy another three properties for $16,000 each, using a cash deposit of $4,000 on each one. You would then have, in total, four properties worth $64,000, with debts of $48,000. However, assuming all will have gone up by the same amount, you would by now have a portfolio worth $800,000 less the $48,000 debt, or $752,000 instead of only $200,000.

If what I say is true of how to apply one lump of cash of $12,000 (the inheritance), then it must also apply to two lumps of $6,000, or 24 lumps of $500, or, for that matter, 12,000 lumps of $1.

Every dollar spend repaying debt is one dollar that cannot be geared and used to generate more positive cash flow (surplus rental income over expenses) and capital growth. And so long as each new acquisition generates more cash flow after servicing the mortgage and other expenses, then the debt surely is “good debt”.

Next month I will go into how you can defer repaying the debt to your advantage.

Successful investing!

Dolf de Roos.