There’s a big difference between good and bad debt. Bad debt is money borrowed to buy “stuff” that rapidly depreciates in value. Good debt is money borrowed to buy assets that appreciate in value and produce income greater than the carrying cost of the debt. The perfect example of good debt is to tap some of your home equity and use it to buy a good piece of property at a good price. Let’s say you bought your home for $100,000 with $20,000 down five years ago.
Today, it’s worth $140,000 and your mortgage has been paid down from $80,000 to $75,000 . . . so your equity in the property has risen from $20,000 to $65,000. (The $140,000 value minus the $75,000 balance on the mortgage leaves $65,000 in equity.) You take out a $25,000 home-equity loan to buy a piece of rental property. You hunt out property bargains and strike a deal on a property for $200,000 that has $25,000 in gross rental income.
You’re borrowing 90% of the purchase price, or $180,000, from a mortgage lender. The other $5,000 you’re using for closing costs. (There are ways to keep your closing costs this low — 2-1/2% or less of the purchase price — which I’ll cover in a future ETR message.) You make an allowance of 10% of the gross rental income ($2,500) for vacancy and 1% of the purchase price for maintenance ($2,000). That’s $4,500 that you subtract from the $25,000 you would expect in ideal conditions.
So now you’re counting on $20,500 in annual rental income, or about $1,708 a month. You borrow the $180,000 at 6.5%, so your monthly principal and interest payments are $1,140. Taxes work out to, say, 1.5% of the purchase price — which is $3,000 a year, or $250 a month. Insurance is $1,200 a year, or $100 a month. In addition to this, you pay interest-only on the home-equity loan at 4.5%, or about $105 a month. So your total monthly PITI (principal, interest, taxes, and insurance payments) is the sum of all these — or $1,595 a month.
Yet, your monthly rental income — after making an allowance for vacancy and maintenance — is $1,708. This means that, after your major expenses and allowances, you’re cash-flow positive by $113 a month — even though you bought the property with 100% financing . . . and even financed the closing costs! When doing a deal like this, you should be sure to have sufficient savings (four months of PITI as a minimum) in case unexpected expenses come up. But if you manage the property well, you should be able to keep vacancy far below 10% and increase your net monthly income. Now, let’s see what happened.
When you did the deal, you took out $25,000 in equity from your home and turned it into $20,000 in equity in your investment property. (It’s only $20,000, because $5,000 was consumed by closing costs.) So your net worth initially declined by $5,000. But there are costs to any transactions. Was this one worth it? Well, let’s say the property goes up by the long-term national average of about 6%. After a year, it’s worth $212,000.
And on a 30-year amortizing loan, the mortgage has decreased by about $2,000. So, on a property that was 100% financed and has paid for itself, you’ve picked up $14,000 in equity in a year. After five years, at 6% annual appreciation, the property is now worth about $68,000 more than you paid, and the loan balance has declined by about $11,000. So you’ve now picked up $79,000 in equity on a property. If you bought undervalue and the market is rising a bit faster than the long-term average, you might get 8% annual appreciation. This would boost your equity by about $105,000 over five years.
At the same time, rents tend to go up 5% to 6% a year. Yet, the bulk of your costs (your mortgage loan) can remain fixed or capped at a lower rate of increase. This will tend to increase the net income you receive from the property ever year. To make this work, you have to buy right. Be a sharp buyer first and a creative and sharp borrower second. My example supposes a gross rental yield of 12.5%. (The gross rental income of $25,000 is 12.5% of the $200,000 purchase price.) That’s very hard to find right now in my market; 4% to 5% is more the norm.
Yet, when you know how to scout out values, you can do it. Four of the properties I’ve bought in the past year had yields ranging from 10% to 13%. And those yields are rising, as local rents are increasing. What’s more, in certain “distress” sales, you may be able to pick up properties with 15% to 25% gross yields. These can provide very healthy net cash flow from the very beginning, even when 100% financed.