How to Judge Good vs Bad Debt in Real Estate Purchasing Decisions.
When investing in real estate, it is crucial to understand the concept of good and bad debt. Good debt is a loan that will ultimately increase your net worth, while bad debt will decrease it. Therefore, it is essential to know how to differentiate between the two when buying real estate. In this essay, we outline six principals to judge good debt vs bad debt in real estate buying.
First, when considering a property, ensure that it has an appreciation potential. An important not on appreciation is to consider the source of appreciation. Appreciation is the general trend of an asset changing in value, which can be positive or negative. The most fundamental reason an asset increases in value is because its income increases. Good debt should not merely be about paying the loan, but it should appreciate in value over time. This means that you should buy a property that is located in a growing location and has a growing rental yield. By investing in such a property, you are increasing your chances of making a profit in the future, and the loan will have been worth it.
Second, the interest rate and payment terms must be understood before entering into any agreement. One should look for competitive interest rates and manageable payment terms. This means you should compare the rates offered by different lenders to determine which is the most favorable. The debt service payment is often one of highest line-item expenses on an asset’s Profit & Loss statement and minimizing this cost by competitively bidding the loan will help to maximize the asset’s profit.
Third, consider how much debt you can take on. In other words, your debt-to-income ratio should be examined. The debt-to-income ratio is the amount of debt you currently have compared to your income. Personal finance experts suggest that this ratio should not exceed 36%, and to be safe, it should be kept below 28%. This means that your ability to borrow will depend on your earning capacity and income level. Therefore, it is essential to determine the amount that you can handle and not acquire debt that will result in financial distress. This ratio ultimately helps to determine the limit on your asset buying.
Fourth, one should always buy a property with practical and functional features in good condition. Features such as location, structure, and quality workmanship are not easy to modify, so it is essential to find a property that ticks all the necessary boxes before buying. When buying a property, always emphasize its strengths over its weaknesses. This will ensure that the rent remains competitive in the current market, and the property value appreciates.
Fifth, consider the state of the market when assessing potential good debt vs. bad debt. Research the property market regularly and stay informed about any market fluctuations, as even the smallest change can affect property values. If the market is in your favor and the value of the property is likely to increase, it can be a good idea to finance a loan for this. Simplified, in times of inexpensive financing (low-interest rates), it is favorable to purchase assets with higher debt ratios and in times of expensive financing (high-interest rates), utilizing more cash or equity to finance the purchase.
Last, it’s important to understand that borrowing excessively can lead to bankruptcy and financial ruin. Good debt is essential, but it must be balanced with other financial goals. Proper financial planning and budgeting should be used as tools to manage and predict finances. One should also note that there are other financial instruments available that do not require a loan. These instruments may include stocks, securities, or other assets that have reliable returns and require less borrowing. In short, compare your investment options to strike a balance between risk and expected returns because real estate is only one investment path, where others may be more rewarding for your portfolio.
In conclusion, to determine good debt versus bad debt when buying real estate, the fundamental principal is understanding the risks of pursuing outcomes. Proper debt management is understanding the variables; such as interest rate, rental yield, mortgage time, and the state of the market, amongst others. Ultimately, good debt in real estate should promote growth in your net worth while maintaining the debt service, without risk of default. Any small or large buying decision must prioritize this rule.
To see how Team Sobiko’s Realtors® may assist you, please visit our underwriting, commercial or residential service pages.
This publication was created with the help of artificial intelligence software, which was then reviewed and edited for accuracy by a Team Sobiko staff member.
