A lot of people are scared of debt, and for good reason. Seems like everyone these days is graduating with over $50k in college debt. Moreover, a lot of these younger folks also feel the need to purchase a new car, new clothes, and a swanky new apartment as soon as they start their career.
Naturally, it probably takes someone a pretty long time (a few years?) to overcome the initial debt hurdle. Once the debt is cleared, a person can FINALLY start their path towards building wealth. For anyone who has had to overcome paying off large amounts of debt, the feeling upon finishing debt repayment is beyond liberating. It really does feel like the weight of the world has been lifted off your shoulders. And I’m sure the first thing these people say after winning the battle is:
“Never again! I am never going into debt EVER again!!!”
To dismiss all debt as “bad” or “evil” would be the wrong thing to do. Regardless of what mainstream media says, there is a difference between good debt and bad debt. Bad debt is easy to identify — this is the type of debt that we are all used to — the kind that will take you to poorhouse. Bad debt accumulates when you purchase things that are not assets, but liabilities (e.g. consumer debt such as: cars, season passes, fancy clothes, yachts, etc.).
Good debt is different. In fact, it really isn’t debt at all. Good debt has been such a powerful force in helping so many achieve massive amounts of wealth that is goes by an entirely different name — LEVERAGE.
What makes leverage so powerful? I believe the best way for me to illustrate its awesome power is to use a real life example.
In early January of this year, the bank approved my short-sale bid to purchase Rental Property #2 for $290,000. Through the use of leverage, I did NOT have to come up with the entire $290,000, which would have been impossible for me to do at the time. Instead, I only had to put down 20% for the downpayment, and borrow the rest from the bank.
Still, even though I only needed to come up with 20%, I didn’t even have that! But I did have a dividend portfolio that was valued at just over $60,000. I had a decision to make. Do I liquidate my stocks to purchase this property?
Because I was only putting down $58,000 of my own cash, I had to rely on using leverage to borrow the remaining $232,000 from a lender. But without leverage, I wouldn’t have been in position to close the deal.
Hindsight is always 20/20, but even in early January, I knew that I got a good deal on the property. I was crossing my fingers everyday, hoping the short-sale lender would approve the sale. That’s right, I was praying the bank would say “yes” to lending me money.
To come up with the $58,000, I was forced to liquidate the majority of my dividend stocks. As we all know, the stock market has been on fire this year, and the S&P 500 and Dow Jones have hit historic highs. So, let’s say my stock portfolio was worth exactly $58,000 at the time of sale. Had I held onto the shares and not purchased the rental property, my stocks would of course be worth more money today. Let’s be extremely optimistic and say the shares would have appreciated by 30%.
That means the $58,000 would now be worth $75,400 today. That’s a tidy sum and a VERY handsome profit in only 6 months time. I’m sure many investors would be thrilled with that kind of appreciation.
In January, the property appraised for $290,000. Since that time, the property has appreciated to $420,000 (this is what nearby comps are selling for in July). That’s a return of 44.8%, which is just slightly more impressive than the 30% received from stocks.
At this point, you might be wondering, so what’s the big deal? You just got lucky and made a little bit more money.
Well, the big deal is that I didn’t put $290,000 into the deal. Through the use of leverage, I was able to do better than that. You see, I only put in $58,000 into the rental property. If I was to sell today, I would receive $420,000 (excluding agent commissions, taxes, fees, etc.). Once I paid back the bank their $232,000 loan (actually less, since the monthly mortgage has reduced the principal), I would pocket $188,000. In total, my $58,000 investment would have grown to $188,000. This is a staggering 224% return on investment!
Your Options After Profit
The above example clearly shows what a powerful tool leverage can be, if invested wisely. But it gets even better. By using leverage in real estate, there are actual tax laws in place that would allow you to pocket the entire $188,000 and not have a pay a penny in taxes! This simply isn’t possible with stocks. If you sell stocks, you’ll always be hit with some kind of capital gains tax (whether short-term or long-term).
Real estate is different. If you owned and lived in the property, you can capitalize on up to $250,000 ($500,000 if filing jointly with a spouse) without paying taxes. The only provision is you would have had to live in the house in two of the last five years, at the time of sale.
For an investor, you can shelter the profits from taxes by doing a 1031 exchange. You would simply sell the property, and roll over the funds to invest into a more expensive property. Potentially, you could have enough ammo to buy a commercial apartment building. These techniques are exactly what savvy real estate investors use to snowball their wealth and portfolio. And guess what? They use leverage to purchase that commercial building as well!!
Lines of Credit
But suppose you didn’t want to sell. Say you’re like me, and you really like the property you purchased. It’s located in a fabulous area, it cash flows on a monthly basis, and you are able to attract quality tenants without any effort. Let’s say you also feel like it could appreciate even more over the next decade. What could you do then, to access some of that equity tax free?
There are many ways, and I am looking into them as we speak. You could go back to the lender and ask for a cash out refinance. The bank would re-appraise the property (say it appraises now for $420,000), and you could redo your loan to pull equity out.
You could also apply for a home equity line of credit (HELOC). This works like a credit card, and the bank would open up a line of credit for you to use at your discretion. You would make re-payments that charged interest that fluctuated with the prime rate. But as a perk, the interest on the HELOC would be interest deductible.
Using a line of credit is a smart way to allow an investor to pull out equity out of an appreciating asset. The best part is the money you take out (say $40,000) is not subjected to any taxes.
It Almost Feels Like Cheating
Once the money is out, you are free to invest it anywhere. In the previous example, you could use the $40,000 to rebuild a dividend portfolio, or use it to purchase another rental property.
After that, you can easily imagine how this process could repeat itself, over and over again. Granted, there are ALWAYS risks involved when using leverage, and one has to perform the necessary due diligence to protect themselves. Nevertheless, it should be quite evident how leverage can be utilized to help a person amass wealth rather quickly.
I’ve saved up funds to purchase dividend stocks. I did it for a whole year. I’ve also saved up for the downpayment of a property on three separate occasions. It takes a long, long, long time to build up to even just $60,000. Especially since the majority of this money has to come from my employer, which is subjected to 40%+ in taxes! Without leverage, I would need many years (eons) to save up $188,000 in post-tax dollars. So, when the real estate market is down, and the deals are SCREAMING, telling you to BUY, you owe it yourself and your financial well being to use leverage so that you can take advantage of those “once in a lifetime” opportunities. Don’t be scared away from taking on a little debt. Just be careful, and remember the following:
“Leverage is a double edged sword that cuts sharply in either direction. Use it wisely, and you’ll be wealthy beyond your wildest dreams.”