“Should I pay down my mortgage(s) or invest in new rental properties?”
Nor does that question end with mortgages and new investment properties. When should you pay down student loan debt, and when should you invest in equities? When should you pay down credit card debt vs. investing in, well, anything?
For that matter, what’s good debt versus bad debt? Or is there even such a thing as “good debt”?
Leverage – the ability to invest using other people’s money – is one of the great advantages of real estate investing. But as we know from Spiderman, with great power comes great responsibility.
Debt comes with risk, and risk must be managed. Here’s a framework for thinking about debt, investing, and how to balance the two by knowing when to aggressively invest and when to focus on paying down debts.
Good Debt, Bad Debt, Credit Card Debt
I’m a fan of Robert Kiyosaki’s definition of good debt versus bad debt:
“Good debt puts more money in my pocket every month. Bad debt takes money out of my pocket every month.”
It doesn’t get much simpler than that.
If you borrow money to buy an income property, and it produces $200/month rental cash flow for you, then that mortgage is good debt.
If you go $2,000 into credit card debt to buy a bunch of new furniture for your home? That’s bad debt.
Which brings us to an important point about credit card balances: it’s almost always bad debt. That doesn’t mean credit cards don’t have their place; they’re useful for rewards, if you pay the balance in full every month.
You can even use credit cards to buy real estate!
But credit cards tend to have usuriously high interest rates, if you don’t pay the balance in full each month. If you’re paying 12-22% in interest rates to borrow money from credit cards, and can expect an average return from stocks or rental properties of 7-12%, then it’s a no-brainer: pay off all credit card debt before investing a cent anywhere else.
I bought a rental property using credit cards once. It worked like a charm – but I made sure I paid off those credit cards as my first priority once I had the property under ownership. I put every penny I had toward paying off those credit cards, and within a few months they were paid and I owned the new property free and clear.
Always pay credit card debt off before looking anywhere else!
When I plan out what to do with my money, I think in terms of cycles.
To grow my investments, I start an expansion cycle. I aggressively invest money in equities, rental properties, and occasionally other investments like private notes.
My goals are twofold: 1. Expand my income, and 2. Expand my net worth.
Those goals work hand in hand with one another in most cases. A new rental property expands both my monthly income and my net worth. Mutual funds that pay dividends do likewise.
In an expansion cycle, I’m not afraid of taking on debt to expand my income and net worth. After all, good debt puts more money in my pocket every month, right?
So why not always be expanding? Why stop?
The time comes periodically for everyone when they need to pause and take stock. To evaluate their progress. To decide what to do next.
And often, to pay down debts.
There are a dozen reasons why we all need a financial breather sometimes. Perhaps the market starts free-falling, and we don’t know where to put our money.
Maybe retirement is approaching, and we want to trim our debts beforehand. Or you find out you’re expecting a baby, and suddenly start thinking about creative ways to pay for college.
Sometimes, life just throws a curveball, and we need time to reassess.
In these moments, I stop buying new investments, and either set aside money in cash, or pay down debts.
When I tackle debt, I typically follow the debt snowball method – pay off the smallest debt first, then apply the savings to the next smallest debt, and so on.
It’s a great way to pull back when I’m feeling overextended, or am feeling uncertain about where the market is headed.
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“Does This Mean I Should Try and Time the Market?”
If you’ve ever taken our free mini-course on small multifamily investing, you know my position on timing the market. Experts don’t know where the markets are going. If their job is to analyze a specific market, and they’re wrong just as often as not in their predictions, then you can’t predict the market either.
By the time a market crashes, and everyone’s freaking out about it, that’s actually the right time to invest. Back in 2010 and 2011, everyone was still down on real estate, and few people were investing.
But it was a fantastic time to invest.
The point? All the market-timers were wringing their hands and not investing in real estate. The people who continued using the fundamentals to analyze and invest have been laughing all the way to the bank ever since.
So, if consolidation cycles aren’t about timing the market, what are they about?
Your finances have their own rhythms, and you know best when you’re in a position to invest versus consolidate. You know your own goals.
When you’re feeling overextended, pause and pull back. If you start feeling uncomfortable with the amount of debt you’ve taken on, pull back. When you experience a major life change, like marriage, pause and pull back!
Instead of trying to time the market, time your own life.
The Beauty of Leverage and Real Estate
When you use debt and leverage other people’s money for your own investments, it opens a whole new defensive investment for you.
Instead of new investing in new assets, you can invest money in paying off your own debts, which will still give you a strong return on investment!
Say you borrow money at 6.5% to buy a rental property, and for the next six months you also invest heavily in mutual funds in your IRA. Then you max out your IRA, and wonder what to do with your extra money each month.
You can keep investing the money in the stock market, knowing that in the long term you’ll likely earn a 7-10% return. You can buy a new rental property. For that matter, you can invest in your niece’s cat grooming business.
But you have another option: you can earn a guaranteed effective return of 6.5% on your money, by paying off the mortgage on your rental property.
Leveraged rental properties make great investments because this “good debt” gives you options. You can leave it in place, knowing you still earn positive cash flow every month even with the mortgage.
Or you have the “defensive” option of paying it off, if you want to boost your cash flow even further and earn a guaranteed return on investment.
Rental property debt is a safe place to put your money, when all else seems too risky for your taste.
A Financial Framework
Try thinking in these expansion and consolidation cycles. It’s not the only way of thinking about investments of course, but it’s a framework that’s worked for me as a simple way to balance my short- and long-term goals.
There’s a comfort in laying out a concrete path for the immediate future, in knowing what your short-term goals are and exactly how they fit with your long-term goals.
My long-term goal is financial independence. To get there, I will continue building a portfolio of income-producing assets. And at times, I will need to pause for a breather, and put all my money somewhere that makes me feel safe and warm and fuzzy.
But even during those consolidation phases, I can sleep knowing that my money is still going toward my long-term goal of financial independence, even though I’m not actively investing in new assets.
How do you think about your investments? Have any frameworks you like to use? Share them below!