Should We Be Afraid of Debt?
Being full time in real estate, I have conversations regularly about real estate investing with my friends. We agree on many of the principles surrounding investing, however a common argument that arises is: Should I use CASH or DEBT to buy investment properties???
This is an interesting question. And I do not think there is a wrong answer. It is rather a question of, “What is my risk tolerance?” and “Is this risk worth the reward?”
If you have little tolerance for risk, the answer is simple. Buy for CASH.
Otherwise, there are multiple benefits to using someone else’s money instead of your own.
Let’s walk through an example.
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Say you make $50,000 as a single person.
–You have $100,000 in savings.
–You find an investment property that you can buy for $100,000.
–It rents at $1,000/month.
–The depreciation you would be able to deduct from your taxable income would be $3,636.36. (This number comes from dividing 100,000 by 27.5 years of depreciable life as written in the IRS tax code.)
Scenario A: You use $100,000 CASH to purchase the property
1) You receive $1,000/month in rent, totaling $12,000/year.
-This equals a cash-on-cash return of 12% (12,000/100,000).
2) You also get to reduce your taxable income.
-A $50,000 salary puts you in the 25% tax bracket.
-Subtracting the annual depreciation (50,000 – 3,636.36), your new taxable income is $46,363.64.
-That’s a total savings of $909.09 (3,636.36 x 25%).
So your total return is 12.91%. (12,000 + 909.09 = 12,909.09/100,000)
(This does not include the potential appreciation of the property)
Scenario B: You use DEBT to purchase the property
Assume you qualify for a 20% down, 30-year fixed, conventional loan with an interest rate of 4.5% (very common in the current market).
In this case, your down payment is $20,000 and your monthly mortgage payment is $405.
1) Again, you receive $1000/month in rent.
-Now we use the $1000 rent to cover the mortgage payment every month.
-So you receive $595/month (1000 – 405)
-This totals to $7,140/year, and a cash-on-cash return of 35.7% (7,140/20,000)
2) Will be the same as above. (909.90 in tax savings from depreciation)
Bonus: There are a few added benefits for taking on the risk of a loan.
The first year, based on the amortization schedule you would be paying $1,291 in principal and $3,574 in interest (Check out this link if you are unfamiliar with amortization schedules: http://www.investopedia.com/terms/a/amortization_schedule.asp?lgl=myfinance-layout-no-ads).
3) You will be gaining $1,291 in equity from paying down the principal.
4) You can deduct the interest from the mortgage from your taxable income the same way you can with depreciation.
-So, you subtract the interest from your previous, already tax-reduced income (46,363.64 – 3,574), which gives you a new, taxable income of $42,789.64.
-This adds an extra $893.50 in tax savings (3,574 x 25%).
So your total return is 51.2%. (7140 + 909.90 + 1,291 + 893.50 = 10,234.4/20,000).
(This does not include the potential appreciation of the property)
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The biggest difference between the two scenarios is the amount of money you put into the investment: $100,000 vs $20,000!
Now, take Scenario B a step further. You STILL have $80,000 left, compared to Scenario A.
Potentially you could take that $80,000 and do what you did in Scenario B, 4 more times.
If you did that,
1) You would be generating $35,700/year in cash vs $12,000/year.
2) Your taxable income would be $13,948.2 vs $46,363.63, saving you $7545.27 vs $909.90 in taxes.
3) You would be gaining more and more equity each year, boosting your returns every year!
You do all of this using the same amount of cash you had to begin with in Scenario A, but you take on the added risk of potentially not having renters and possibly defaulting on the loan.
Should we be scared of Debt? I say no, but, as always, it depends on who you ask.
-Nick Bond
RE Investment Strategies