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Real Estate Advice

Good Debt Vs Bad Debt: Preparing To Buy A Home

Hi guys, Robert Taylor here from Anthony Business Advisors and I wanna talk to you today about a topic. I mean there are controversial topics, and this is one huge one when it comes to personal finance and even company finance and that is whether there’s ever such thing as good debt. Here’s the reality, the reality is that there are folks out there that’ll say to have zero debt and you’re gonna be better off eat rice and beans or something like that and skimp and save and never incur any debt because debt makes you a slave. I get that, they’re wrong. Then there’s the other folks that say leverage is everything. You wanna leverage, you wanna, if you’re gonna go to school get student loans because it’s gonna pay itself off. They are wrong. The answer is always going to be it depends. And I always think of this old adage and I heard Warren Buffett talking about this once. It’s this, the old adage was a bird in the hand is worth two in the bush. And he kinda says that’s a good start but you really should look at the time horizon. What am I giving up versus what am I receiving?

So for example, if you have children and they’re gonna be going to school and you say hey I want them to go geta college education, not all degrees are worth the same. Would I incur half a million dollars of debt to become an English major? No. Would incur half a million dollars of debt to become a doctor, a medical doctor? Yeah probably because one is worth astronomically, is worth astronomically more than the other. And so it really comes down to is what am I giving up? If I am putting myself in debt, am I getting an asset in return? And the easiest way to look at this is an asset feeds you. An asset puts money in your pocket. And you gotta figure out how much money. So again if I’m doin’ the college thing, I’m looking at how much more money is it gonna put in my pocket than if I did nothing? How much is that debt gonna cost me? Is it 30%? Is it 5%? Is it 1%? All of those are part of the equation. So if you run across someone who says you should never have debt ever, the debt’s really horrible.

Okay, maybe in the personal realm for consumables. But if I am buying a house that is going to pay me money and the house literally pays off the debt and puts money in my pocket every monthI’m gonna say that that’s actually a pretty good scenario, and I am much more likely gonna go do that versus here is a debt, it’s 7% interest, it’s $100,000 and it’s gonna allow me to get a degree that is not going to impact my earning capacity at all. In fact, it may actually decrease it. That is not a good thing. The same token is let’s say I’m going into California and I wanna be a real estate investor and so I find a duplex in San Francisco for $2 million and somebody says this is a great deal. Values are going up and so I go out and I get debt to do this. Let’s say I get $2 million worth of debt at 4%. You feel like a big winner because you’re thinkin’ this is a great market. Guess what? Markets go up and down everywhere in the country.

Historically they average about a 4% increase nationally on real estate. If I am paying that, I am not getting anything for my money. In fact, there is zero that I am receiving. And more likely than not that property depending on what kind of rents I can get is not gonna be enough to pay for that debt which means I am bleeding every month to buy that property. That is not a good situation, I would not do that. What I would be looking at is will the property or will the asset pay for any debt and still put money in my pocket?So for example let’s say the same scenario, but instead of buying a two-million-dollar duplex in San Francisco, I’m buying a two-million-dollar building in Ohio. And let’s say that two-million-dollar building every year after the debt service, after it pays off the debt, still puts $100,000 in my pocket. So it pays for itself plus I get $100,000.

And I’m takin’ that action, I’m takin’ that action all day long. And basically it’s oh you shouldn’t be indebted. You should always calculate it and you should actually calculate it in a degree of error. You’re lookin’ at vacancy rates, you’re lookin’ at worst-case scenarios and you’re putting yourself in a scenario to where you can take that debt and you can actually make more money. Going back to our doctor scenario. What if it costs me $200,000 to get a medical degree? But that medical degree is going to increase my lifetime earnings by $5 million. And I’m not being crazy on some of these numbers. It’ll literally take you for a typical college degree is supposed to give you a lifetime earnings on average of about $1 million more. Well, that’s an average which means there’s some that pay less and there’s some that pay more. And I’m tellin’ you, the English majors are subsidizing all the medical degrees and the engineers and the lawyers out there.

There are certain degrees that are worth substantially more than others and you should be factoring that into your equation when you’re deciding what type of debt to give. Whether or not it makes sense. So we go back again to that bird in the hand worth is two in the bush, all right? What am I giving up? Am I giving up a bird and I’m getting back a half a bird which is a horrible scenario. Let’s just say am I giving up more than I’m receiving? Or is that bird, I’m getting two birds but that two birds are over a 30-year horizon, then I’m not getting much of a return on that. I should be looking at all of those equations to determine whether or not it’s something I should be incurring. Now that said you should start realizing that a liability, the debt is a liability. A debt bleeds you, a debt takes money out.

That the only time you should be using liabilities is to acquire something that’s paying you money. Which means you don’t use debt to buy your clothes. You don’t use debt unless it’s a uniform or a suit and you need it to be an actor or an actress or maybe a lawyer so you’re going to court or whatever. But with very few exceptions, you don’t use personal consumables and use debt to buy it. It’s a recipe for disaster. And so when you hear people start talking about having zero debt, a lot of times I say personal credit cards, absolutely. You can have them, but they’re for emergencies. Don’t get used to using them. And you absolutely don’t want to buy a liability like a car with a loan that is also a liability. So the car costs me money plus the loan costs me money. The next thing I realize is that I am a slave to that vehicle. I am having to work for that vehicle. The much better scenario is to have something that is providing you income to pay for that vehicle. So if I buy an asset.

So I’ll use the example of buying a rental property. Let’s say that I’m looking around and I’m trying to find something that’s generating positive income and I’m actually gonna use a loan to get it but it’s giving me a positive income stream of $500 a month. I would budget that $500 a month towards my vehicle. In other words, if I am going to go ahead and get debt for the vehicle, I don’t want to have to work to pay for that debt, I want to have an asset pay for that debt. And the most successful people that I have seen, and I’ve been doing this for over 20 years, we do over 6,000 tax returns every year for nothing but business owners and investors, I know who makes money, I know who doesn’t. The most successful people buy assets that pay for their liabilities. So if you’re gonna have debt and you have an asset paying for it, that’s okay. If you’re gonna buy a Lamborghini but you have an asset that’s paying for it, that’s okay. What’s not okay is you going out and getting into debt up to your eyeballs so that you’re working to pay off that debt constantly. Now that brings us squarely to the question of your personal residence. Your personal residence, is it an asset, or is it a liability?

The easiest way to look at this is does your home cost you money every month or does it put money in your pocket? If you’re like 99. 99% of the folks out there, your home is costing you money. The only exception is when you have a duplex and you’re renting outa half or you’re house hacking and you have a bunch of roommates that you’re renting to. Otherwise, if you’re like normal folks that are just buying a house and that’s where their family lives, it’s a liability and it’s pulling money out of your pocket. And then you go out and you get a loan on that. So you’re buying a liability with a liability and you wonder why you start having problems. It’s because you are in this, I call it the losing loop where you’re working to pay off a liability and it’s a vicious cycle. You’re working to pay off the interest that is working that you use to buy another liability that is your home.

And so you have two exciting things. We have two liabilities that are pulling money out of our pocket. We have the house that’s pulling money out of our pocket and we have the loan that’s pulling money out of our pocket. So it’s critical that we extinguish that loan or that we get assets that pay for that loan. And so I’ll give you an example. When I moved down to Las Vegas in 2007 I came from Seattle and I moved down to Las Vegas to run our offices down here. We have three offices here in Las Vegas. When I did that, I looked at the Las Vegas market. This was before the depression or the recession, however you wanna categorize it. This was before the economy just went off the cliff. It was before Las Vegas homes lost 75%of their value on average. So I was looking at properties and I still remember this to this day. To buy a house in the neighborhood where I wanted my kids to go to school, I was gonna have to put a down payment of about $200,000 down on these and these were million-dollar houses. Everything was way ramped up. And I said there’s no way in heck I’m gonna pay that. I can rent that same house for $3,000 a month. And so you know what I did?

I said hey that’s my cost of living is $3,000 a month. That’s what I’m willing to do for a house to be in this neighborhood. Great neighborhood, beautiful houses, great neighbors, all these things, great schools, this is what I wanted so I took the $200,000 that would’ve been a down payment and I bought multiple rental properties. I actually bought three rental properties in the Las Vegas area. And those properties provide rents. And those rents, you use that rent to pay for your rent. And guess how much money I’m coming out of pocket every month? I had about, it was right around, let’s just say it was $3,000 a month coming in and it was $3,000 a month was my lease payment.

I was at a zero. In other words, I had an asset that was paying for my liability. Had I purchased that home, I would’ve been paying not only what I’ve been paying the property tax, not only would I have been paying for the mortgage interest on that loan which would’ve been sizeable, significant. I would’ve been paying for all the upkeep and everything else but I would’ve also been at risk for when it took its dive. And that property lost over half its value. None of that occurred and I wasn’t even exiting money out of my pocket every month. I was just sittin’ there lookin’ at it going wow this economy’s really shifting. That’s horrible, but it wasn’t beating the snot out of me. Had I done what everybody else done and leveraged myself into a property that I could never afford, then it would’ve been a really bad situation. I’m not gonna say that I’ve never done that or that I’ve never made mistakes. I absolutely have.

Anybody who’s been in real estate has made mistakes. It’s how you learn from them. And one of the things that I learned there was when you’re using debt, you want to make sure that you have assets that are paying for those liabilities. Now let’s say that you’re already in debt. I have a bunch of credit card debt, I have a bunch of house debt. What should I do? So there’s the easiest thing to do, and I’m just gonna do this mathematically. And there’s lots of folks out there, there’s the Dave Ramseys, the Dani Johnsons of the worlds that teach how to attack debt and I’m just gonna make it mathematical for you. In my world, I always look at the highest interest rates. And I say how much is it costing?

Whichever one’s costing me the most, those dollars that cost me the most I’m gonna pay back the soonest. So if I have two loans. One’s a 0% 12-month loan. That’s on a credit card or something like that at an introductory rate or something. Versus I have a 30% credit card. And I have $1,000 on each. I’m gonna pay the $1,000 that’s at 30% before I pay the $1,000 that’s at zero. A lot of these folks will start just attacking them willy nilly and they’re not really looking at it. The other thing I look at is debt for student debt for example I can never bankrupt. I can never get away from it. So I may be wanting to pay off some of my student debt before some of my other debts that I could extinguish if there was a, if I had a major illness or something and I had massive medical bills or something like that which is the leading cause of bankruptcy, by the way, is medical expenses and health expenses that you’re not able to pay. If that occurred, I’d still be able to get away from my consumer debt. So I might be attacking the type of debt that I can’t get rid of first. The other thing I look at in, let’s just say, it’s the mortgage debt and the mortgage debt that I can deduct and it exceeds my standard deduction with everything else and I am getting a tax deduction every year for it. Maybe I’m not going to pay for that one first, maybe I’m paying my credit cards that I get no deduction for. I cannot write off the interest I’m paying. Maybe I wanna get rid of that debt first. All of those are factors. And so if anybody ever tells you oh this is the only way to do it, there’s one way to do it, they’re absolutely full of poopoo.

They’re absolutely full of it. There’s no way they know without actually breaking it down. And different types of debt are treated differently. Even more importantly certain types of debt are really tough to get. If I have portfolio loans on real estate, they’re really tough to get. Maybe I don’t pay that one off right away if I’m comparing paying off a house or paying off a portfolio loan, it might be easier to get this loan, so maybe I wipe it out first. Because I know if I get into an emergency situation and I need capital to avoid a horrible situation that I can go get loans on this. Or let’s say if I pay off my credit card debt, I don’t just cut up the credit card. I might freeze it in a block of ice so I can’t get to it. But I am not gonna destroy that credit card. I wanna keep access to those funds so if I do have an emergency, that I do have access to capital. And that’s how you end up breaking it down is I attack the debt that’s most costly. A lot of times people have access to money they don’t even realize. So for example I had a client in Seattle and he and his wife each had IRAs.

They were rollovers from a 401kand from a previous employer. So they both worked, they ended up leaving the employer and starting their own business and they had, I remember their wife had $130,000 in her IRA and he had 90,000 in his. And they had credit card debt of $70,000 in their startup. And I looked at ’em and I said why are you paying all this interest to these credit card companies? And they’re oh you couldn’t get a loan for anything else. I said hold on for a second, I said you have money in a retirement plan. Now you can’t borrow from an IRAbut you have your own business, just set up your own 401k, roll the money into there, you can borrow up to $50,000 each from your plan. Well in his case it’s up to 50% of the money so he could borrow 45,000, his wife could borrow 50,000 ’cause she had 130,000, he had 90 so he could borrow half of the 90. But either case, they could borrow enough to pay off all of their consumer credit card debt.

That average was 11% a year that they were paying on that consumer credit card debt. When they paid it off, they rolled it into a 401k, borrowed the money, now they pay themselves the interest and it’s a really small interest amount. At that time it was about 3%. So they paid themselves the interest, they eliminated 11% interest payment on $70,000 which if you can do the math, I’m not gonna figure the compounding but just say it’s somewhere around $8,000 a year. That they save immediately. They still have the same amount of debt, it’s just it’s different, they’re paying themselves. If you have whole life insurance or if you have indexed universal life insurance or you have an IRA or a 401k, these types of things, you can borrow off of those assets.

Here’s another fun one, you can actually use your stock account. Let’s say I have a bunch of stock in Microsoft, IBM or some Blue Chip portfolios or I work for an employer’s things, a lot of folks don’t realize that can be used as collateral for the debt. And if you have collateral for the debt it’s much cheaper than if you don’t. So if I go to a credit card company and I say hey I need to get a, I wanna use money from the credit card company, they’re gonna charge me quite often it’s gonna be around 10%. I think the average is 13% nationally. So let’s just call it 10%. They’re gonna charge you at least double digits because it’s not sittin’ here being secured. But if I used my stock portfolio and I go to my stockbroker and I say hey, do you guys have a security backline of credit? Do you guys have something where you can loan me money based on this portfolio that you know I have here? They will do that and it’s generally speaking, it’s super cheap. It used to be 75 basis points over. It was quite literally two and 3% during all the nastiness that was going on during our recession. And you could actually get that money and pay off these high-interest credit cards. Whoa, now all of a sudden I’m getting at myself away from these users rates and these predatory lenders that are, and I’m not gonna say anything bad against the Visas and the Mastercards of the world, but quite often you’re paying really high-interest rates when I have the ability to get a very low-interest rate. Now a lot of you guys look at your house loan and you say well that’s really a low-interest rate, why would I wanna pay that off earlier? I agree with you, I would actually trade a list from my car loans to everything else and I would say hey if I have any debt, I wanna see what I’m paying and I want to attack certain types of debt first. And especially the high interest. If I’m paying more than 10% on the money, I’m going to attack it rabidly to get rid of it. And even if I have to borrow out of another asset. So for example people used to get the home equity lines of credit,send their kids to school, and things like that. Now, I wouldn’t necessarily do that ’cause that’s not deductible anymore. But it’s still cheaper. So all things being equal, let’s say I get a HELOC on my house and it’s at 4%. That’s much better than using 13% money on my Visa. Or going out and getting a student loan at 7%or something like that. I might still be able to get cheaper money. So that’s kinda the truth about debt is it’s not all created equal. There are no one size fits all for everybody. You actually have to do the math.

And if any time you’re questioning, if the first thing you ask yourself is am I getting debt on a liability, in a liability real simple, it costs you money every month or is it an asset that brings in money? If I have debt on an asset, does the amount that the asset brings in cover all of the debt and still give me some cushion? If the answer is yes then that’s probably good debt. If it’s not debt, then it’s probably not. Now the only other thing you look at is the old bird in the hand versus two in the bush and if you are taking out debt on something that’s gonna be significantly more valuable in the future, for example, a medical degree, engineering degree, something, legal degree, something along those lines where you can definitely say if I incur this debt it’s going to pay me off three or four times the amount that it’s costing me. That everything else is probably not good debt. But if it falls into that category then it’s probably going to be worth it. And when you have somebody say never ever ever ever get into debt, they’re just not quite thinking of it that there is such thing as positive debt. It’s just that you have to do the math and you have to go in with your eyes open.

Last little tip for those of you guys who have mortgages. A lot of times they’re talking about a 15-year mortgage or hey what if I double up payments? Here’s the truth on mortgage sis you always have to be wary prepayment penalties if you pay off too much interest. But these financial instruments are created to front-load most of the interest. And so the first few years of a mortgage generally speaking you’re getting a nice deduction for it but you’re paying mostly interest. But if you just did an extra payment. If you went bi-weekly instead of every month or if you just made an extra payment every quarter, just four extra payments a year you’d literally cut the payment stream, you’d cut a 30-year loan and you’d cut it to I think it’s 19 years, I forget the math exactly on it, but I think it shaves off 11 years if you just did extra quarterly payments. If you can’t do quarterly payments, just do one extra year something like that. Or just kick an extra 50 bucks, whatever it is, you just start doing it, you can actually pencil out the math and see what it saves you if you can.

The best route is to say hey that debt’s okay as long as I’m taking my money and I’m investing in something that’s returning a greater return than that debt is costing me. So again if I have a 4% interest rate on a mortgage but I have pieces of property that are generating 10% a year, yeah I’ll keep that debt. That’s okay. Because I am getting way more off of my leverage than it’s costing me and that’s the old bird in the hand two in the bush. And it comes down to just simple math and it’s doing the calculation. So I hope this helps. This is the truth on debt. There is good debt and there is bad debt. And the problem in our country is that we are marketed that bad debt day and night all day long because somebody else is lookin’ at it saying they’re using debt to actually give you that debt. They’re borrowing it from somebody else like at a bank. They’re using your checking and they’re paying you very little on that savings account that you have and they’re loaning it out at a much higher route.

They have debt, they’re making money off of it, that’s called good debt. Bad debt is when it’s costing you more than you are ever gonna hope to receive it in exchange. And again if I’m just gonna leave you with one little final adage if you like. Well, what if I could borrow money all day long at 10% and I’m paying somebody 10%but I can loan it out at 5%, would you ever do that? Heck no, that’s just crazy, that’s insanity but we do it every day because we don’t actually track our numbers. We, but if we flip that around, would you pay 5%so that you can make 10% on it? Absolutely. Then you become the bank and that’s good debt. And I hope that makes sense to you. And with all things, whenever I start talking taxes or anything financial I always say that there are three rules. It’s calculate, calculate and calculate. It’s pretty simple, get your pencil out. And you can usually figure that thing out in about five minutes. I hope this has been helpful.