When we earn income we have 3 main options for how to put it to use. We can spend it, we can save it, or we can give it away. Many new investors have some degree of debt and are anxious to get involved in real estate or stock investing. The question they then ask is “should I use my savings to pay off my debt, or to invest?” Unfortunately there is no one size fits all answer for this, and the only real answer is “it depends”. This article explores when each decision is most appropriate.
Debt – Friend or Foe?
As we grew up, many of us were indoctrinated with misguided beliefs about money such as:
- Money is the root of all evil
- A penny saved is a penny earned
- Debt should be avoided at all costs
To invest in real estate, we need to use debt. In fact, the ability to purchase real estate using debt is called leverage, and leverage is one of the reasons real estate is such a great asset class. To buy properties using debt, we can’t subscribe to the belief that money is evil. When used foolishly debt is a foe, but used wisely it can be our greatest ally. Leverage is a powerful tool that multiplies the effort of each dollar we invest.
Cheap Debt vs. Expensive Debt
Once we understand that we’ll need to use debt to buy real estate, we can start to look at it as a potential friend rather than a villainous foe. When evaluating whether or not we should pay off our debt, the first thing to do is consider how expensive that debt is. We can measure the cost of debt by looking at the interest rate.
The cheaper the debt we are able to use, the better our cash flow, and the greater our returns. When using debt to leverage our investments, we want cheap debt over expensive debt.
As a quick example, let’s say you have $25,000 in cash and aren’t sure what to do with it. If you have an outstanding balance on a line of credit where you’re paying 4% and have an investment where you can earn 10% or more on that same money, what do you do? Should you pay off your line of credit, or put that money into an investment?
My suggestion would be to keep the cheap 4% money and make a smart investment where you’ll cover the 4% interest and make a nice spread. In effect, this is the same thing the bank does when they pay you 1% on your savings balance and then lend it out to homeowners at 4% as a mortgage.
Other Considerations
When considering whether you should pay down your debt, here are a few other considerations.
1. Reserves
It is important to keep some reserves to give yourself financial flexibility. As they say “cash is king”. Being stuck in a bind without access to funds can force you to sell assets at the worst possible time. Having some cash reserves or excess credit gives you the flexibility to weather the storms or investing and sleep well at night.
2. Your Debt Level
If you have too much debt you may have trouble qualifying for financing. High utilization on various credit facilities can have a negative effect on your credit score. Alternatively, your ratios may be pushed out of whack by high monthly debt servicing costs. At this point, working with a mortgage broker to plan your next few purchases is a wise step.
3. Risk Tolerance
As investors, we don’t want to be over leveraged. What has happened to during the credit crisis is a perfect example of why this is the case. Each individual has their own level of risk tolerance so the definition of “over leveraged” varies from case to case. If you’re feeling some stress over your level of debt, paying down your debt to a more comfortable level may be your best choice.
Whatever your situation, the decision to pay down debt or invest your savings comes down to the price of your outstanding debt and whether you can comfortably and confidently earn a spread on that money while having the financial flexibility to weather the inevitable dips of the investment you choose.
photo credit: striatic
