For most of my life, I’ve hated debt.
I’ll avoid borrowing money from friends / relatives, so I want to borrow money from a stranger (eg a bank) even less.
But in the last 2 years, I’ve realised that if used correctly, debt can be a good thing. Its taken me 20 years to figure it out, and a radical change in the way I think.
Please noteÂ that what I talk about in this post is just a general guide.Â You need to adjust it to suit your individual circumstances (or better yet, get qualified financial advice… as I’m not a qualified financial advisor)Â
Most rich people in the world got there by what is known as “good debt”
As an example, bad debt is borrowing money for a car (or boat, TV, fridge, etc). Lets say you borrow $20,000 for a car. As you pay it off over a few years… due to interest, you end up paying, say, $30,000. During that same time, the value of the car drops to $10,000. Its a lose-lose situation (you pay more than it was worth, and it drops in value).
However, borrowing money for something like shares or an investment property is good in many ways.
Lets look at property (but shares are similar, but need less money up front).
Since most people will have had a mortgage for aÂ few years, chances are that your house is now worth quite a bit more than what you paid for it. eg: you paid $200,000, you took out a loan for, say, $190,000, and you now owe $100,000. In the meantime, the house is now worth $350,000… Thats a win-win situation… you owe less, and what you bought is worth more than what you borrowed, and all the interest you paid, combined.
At that point, most people think: big deal, I can’t get my hand on the $250,000 of equity in my own home without selling it… and then where will I live?
At some point, I read a book by Jamie McIntyre. It was then that I realised (after a lot of thinking!) that I can access the equity in my own home without selling it.
I kept thinking “where’s the catch”… where’s the flaw… it can’t be this easy.
Using the above example, a bank will be prepared to refinance your loan as a “line of credit”. A line of credit is basically like a credit card with a huge credit limit (using your house as collateral).
Lets say you get a “no doc” line of credit (Ie the bank will lendÂ you up to 70% of the house value, and you don’t need to provide proof of income). So, onÂ $350,000, a bank will lend you $245,000. You already owe $100,000, so you can draw $145,000.
The other nice thing about a LOC, is that you can arrange to have the interest payments be drawn out of the LOC itself… you don’t really need to repay your house… sort of.
The catch is that by taking the interest payments out of the LOC, the $145,000 available will gradually decrease as its used to pay the interest on your remaining loan. Once the money runs out, you must pay theÂ interest in full.
This can give you some “breathing room”, but its much better to put this money to good use like this:
From the $145,000,Â use $105,000 as a 30% deposit on a $350,000 investment property. Make sure you get an interest-only loan (I thought it was a crazy idea, but there is a reason for it).
So, you now “own” $700,000 worth of property (2 X $350K), but you owe the bank $450,000 (scary isn’t it!). the breakdown is: $100K on your own property, $105K from the LOC (as a deposit), and the remaining $245K as an interest-only loan (possibly from another bank).
Now, you need to make sure you can meet the repayments for the next few years (about $40,000 per year), but its not as bad as you might think:
- You still have $40,000 in your LOC. You can use this to meet repayments if you occasionally don’t have the money.
- You have a tenant in a house that will pay about $18,000 per year
- You need to pay the remaining $22,000 annual interest, but via negative gearing, the Aussie government will help you, so that you only need to pay, say, $11,000 per year (exactly how muchÂ depends on your income).
Now, as time goes on, things will get easier:
- The rent will increase as house prices increase (so the tenant pays for a bigger part of what you owe.
- Property values increase (I’ll demonstrate the effects in a moment)
- Your wage / salary will increase in line with inflation
Its generally accepted that in any 10 year timeframe, property values will, at least, double.
So, If you can hang out for 10 years, then here is your situation:
- You now “own” $1,400,000 worth of property (2 X $700K), but you (still) owe the bank $450,000 (not so scaryÂ now!)
- The tenant pays about $700 per week ($35,000 per year)… so you now need to pay $5,000 per year in interest…
- negative gearing will probably decrease the $5,000 a year even further.
What do you do now?
Repeat the process again: revalue the properties,Â refinanceÂ both properties to obtain 70% of $1,400,000. Then buy another investment property (or 2!).
Some say if you can own 10 average priced properties, then the renal income will be enough for you to retire.
With a bit of effort, you can pick properties whose value increaseÂ aboveÂ average… then the process just happens quicker.
Personally, I’ve only just started going down this path, so it will be a few more years before I start seeing the benefits from borrowing to buy property and shares.
But I’ve got a good feeling about this… I only wish I was savvy enough to do this when I was twenty years old.