Good Debt vs. Bad Debt: How to Generate Profit and Minimize Risk

Making an informed decision requires having an understanding of the risk involved with taking on debt.

Financial stress might result from high or unbalanced debt levels, therefore it's crucial to consider the potential risks.

Debt, also known as “leverage” is a way to own more real estate properties with less capital upfront. Leveraging on debt can be a great way to build wealth and diversify your real estate portfolio. However enticing using debt may be, you must measure the attributed risks honestly and also review your own personal risk tolerance. It can also be beneficial that you always talk things with your financial advisor and legal team before proceeding with any debt you are planning to take on. Once you decided that taking on debt is the right move for you, you will want to prepare a plan in assessing that debt, along with the other debts as your real estate portfolio both grows and ages.

A quote that we have seen in the real estate investing community is “You marry the asset, you date the debt”. This means you can own the property forever but the way you fund that property can always change.

It is currently January 2023 and mortgage rates are considered high right now. Historically speaking, interest rates are at a very average level but the perception is that they are high due to the extremely low mortgage rate environment that we as a whole saw for the past several years. Moving forward, monitoring your debt will be more important than in recent years past when it was “easy” and made sense to refinance just about any time. With higher rates today you will want to be much more strategic with your debt.

Good Debt vs. Bad Debt is subjective but here is our general take on the subject when it comes to real estate investing. 

Good debt is debt incurred to acquire assets with the potential to increase in value or generate income. Mortgages on properties that are likely to appreciate in value are examples of good debt.

Bad debt is debt incurred to finance consumption or the purchase of depreciating assets. Credit card debt used to finance everyday expenses or business loans to purchase unnecessary vehicles or equipment that will lose value over time are examples of bad debt.

An example of what we like to consider good debt is when a person takes out a loan to invest in a property that is thoroughly underwritten and has a high probability of both, providing rental income, while also increasing in value.

An example of bad debt is when a person uses too much leverage to emotionally purchase an asset that needs more repairs and renovations than the property will be worth and also needs credit cards to finance those expenses.

When it comes to managing debt, making and following a budget will be helpful. Creating a savings account for your investment property and making advance plans for unforeseen costs might reduce the likelihood of running out of capital. It can be useful to keep track of loans and comprehend the conditions for repayment. For example, some commercial loans have a prepayment penalty, meaning the timing of your debt repayment or refinancing is important to think about in advance. Setting your calendar in advance so you can assess your overall debt annually or even semi-annually is encouraged. Making an informed choice when it comes to taking on debt can also be facilitated by examining various loan choices.

Many investors are more concerned today than years past, and should be about reducing their financial risk. While it may not be possible to take on no debt at all, being careful about how much debt is taken on is crucial. In order to prevent late fees or additional interest, it's important to comprehend the associated payment, prepayment penalties, interest rates, rate expirations and make sure that payments are completed on time. Additionally, it's wise to be educated about both the local and global debt situation, as it can have an impact on one's finances.

Remember this about Good Debt and Bad Debt

It's critical to keep in mind that sound money management practices, such as timely bill payment and refraining from taking on needless debt, can limit your risk in the long run. To help you keep track and understand your debt better, there are many calculators available online.  

Over the years we have worked with a variety of banks throughout Connecticut and to our surprise there is a wide variation of options available. We find that smaller community banks take a great deal of pride in supporting their local communities and want to work with local investors to better their communities. If choosing to use debt to build or grow your portfolio we always suggest meeting with multiple banks to see who may align best with your personal situation. Happy Investing!