Most ordinary people would be horrified by the concept of using debt for making profitable investments in real estate. It is because debt has acquired a bad reputation that most people just stop thinking that there can be anything good about debt. However, it is actually the crucial factor that typically differentiates a normal person wanting to purchase a property from a seasoned real estate investor. In fact, if you were to analyze the investment patterns, you would come to realize that most real estate investors actually leverage the power of debt to make investments in real estate.
Good Debt and Bad Debt
Debt that is used profitably to put money into your pocket and make your net worth grow is actually quite different from debt that drains your wallet for a temporary enjoyment like a vacation or the purchase of a household appliance. The concept of bad debt is very well known to most people, only they don’t recognize it as bad debt. Essentially, bad debt is the money you borrow to satisfy your desires, not your real needs. For example, if you took on a personal loan to go off on a vacation to an exotic place or swiped your credit card to buy a designer handbag, it would be bad debt.
On the other hand, if you were to take on debt to acquire an asset or make an investment that would generate income for you it would be good debt. Bad debt occurs when you spend on things that progressively lose their value, which essentially amounts to money flowing down the drain. Good debt has the power to generate income for you and increase your net worth. In real estate investing, your aim is to acquire an asset using borrowed funds to generate a positive cash flow or a profit upon exit.
Investing Using Good Debt for Profitable Investments in Real Estate
Now that it is amply clear that only good debt is to be used for investing, it is important to understand how debt can be used for this purpose. Individuals who are money-savvy use good debt to increase their worth and wealth and also may invest in real estate to generate a steady cash flow using borrowed money. Mostly these people are investors and not end users of the property. This concept of investing with debt is derived from “Rich Dad” who is a firm believer in using other people’s money or OPM to pump up his returns on capital invested. Example.
The disadvantage of debt is that usually, only a specific percentage of the property’s purchase price can be borrowed. Normally, investors are able to borrow up to 70% to 80% of the cost price of the real estate and have to chip in with the rest from their own resources or even by using money from other people. In the context of real estate investing, the greater the sum of money you can borrow from others, the higher the rate of return.
Steps Involved in Purchasing Real Estate with Debt
Investing in real estate with debt is conceptually not very complicated. However, you need to take every step in the right way so that you don’t end up shooting yourself in the foot. Here’s how you would normally go about leveraging debt for your real estate investment:
Identify your real estate investment opportunity: The most critical step in real estate investment is finding out real estate that you can not only afford but which, will be a profitable investment for you, either by way of a steady cash flow that is sufficient to cover your debt servicing cost or as a profitable sale after a defined holding period. While there are real estate brokers and online resources in plenty that can help you to find a profitable opportunity, it is by knowing your job that you will be able to home into a property that will be a gold mine. The profit potential of the property is a function of its location and use as well as factoring in of its potential in the medium, and even long-term. You have got to keep your ears close to the ground because changes in zoning laws or development activities like bridges, highways, canals, etc. may significantly affect its future value. It is best to take your time over the selection unless you happen to spot a fire sale.
Purchase the property: After the property has been identified, you need to get the loan and make the purchase. Typically, you should look at making a down payment of 10% to finalize the sale and proceed as quickly as possible with the application process for the rest of the money. It helps to have the loan pre-approved with only the details of the property provided by you to the lender at the time of the purchase to ensure you don’t lose out on any lucrative opportunity.
Leverage your investment: In financial parlance, the act of using a small portion of your own money to obtain a loan of a greater amount is called leveraging. If your investment has been wise, it will start appreciating in value and you can use this equity to make further investments. The process spares you the trouble of saving up again for the down payments required for the ensuing property purchases. The only thing you will need to ensure is that you are earning enough from your investments to be able to make the repayments on time.
Once you have made the first transaction profitably, you can obviously make a series of property purchases using the collateral of your earlier purchases to keep on building your wealth. If you doing it in the right way, you will soon have a mix of rental properties, coworking centers and properties that you hold for some time before selling them off which will help you to make profitable investments in real estate. Your growth is only limited by your ability to find investment opportunities and maintaining a strong cash flow that enables you to service your debt repayments.
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