Isn’t it great that there are so many ways to get funding for real estate investing projects today? This is important because sellers somehow want to be paid for their houses when they sell them … Right? Just because there seems to be an infinite number of sources of money does not mean that these funds are easy to get … or if you can get them, they are easy to get.
In many cases, the borrower has to “jump through tires” in order to obtain the necessary funds. Credit approval, appraisal, LTV / ARV … and even then they usually don’t get it. All you need is “skin in play”.
Good debt vs. bad debts
Most real estate investors are familiar with the phrase “good debt vs. bad debt”. The problem is that most don’t fully understand the difference. My daughter knew the difference when she was 8 years old. I remember we had lunch and she went from asking “Plusses and Minus” to problems with the story. In the interest of “early education in life” I gave her story problems related to the business.
You would happen to learn everything about spending, up to profits … including the differences between good and bad debt. Her understanding was so thorough that she could recite the definition and, when asked, explained it more importantly.
Unfortunately, we are not taught this in school today. We learn how to be a financier/saver instead of being an investor/entrepreneur. In other words, we are never taught how “money works”, but we are certainly taught how to “work for money”. Knowing the difference between good and bad debt is not brain surgery, but the negative effects of ignorance can be huge. The difference is very simple. Bad debt costs money, good debt makes money. Yes, it’s that simple.
What the banks know, what we don’t know
The banks are aware of the difference. Just look at the difference between what you “pay” (and I use the word “pay” very loosely) for your deposits and what they “calculate” when you “sell”. Understand the business of banks to sell loans. They also know and understand the dictum “to have nothing but to control everything”. You live on it. What is fun is using non-binding debt. The real estate investor can do the same. You can almost become your own bank.
Bad debt costs you money because the bottom line is that you have less than what you started with. Good debt makes money because the bottom line is that you have more than what you originally started. In business, you compare profit vs. Expenditure. In our personal lives, we compare income with good “income replacement” … sometimes referred to as credit cards.
The obvious examples of good debt are things like SF rents, apartment buildings, commercial real estate, and other noteworthy cash flows. Examples of bad debts would be the aforementioned credit cards, boats, RVs, etc. Equity in our own home is not an investment. It doesn’t make us money, it costs us money to build it. If we now access it in the form of a loan, it becomes a debt.
What type of debt depends on what it is used for. Note that I’m not saying that we should refinance all of our homes, pay off the equity, and invest. If you choose to do this, you will not have my blessing. You put your home at risk. Not smart. Especially since there are so many other safe ways to get money for investments.
The power of composition … steroid duplication
Banks understand all of this. You use your assets/deposits in loans/debts. That is credit from them and debt to you. They have nothing and can, in fact, use credit to actually sell “virtual money” to you, often the “face value” of the assets they hold. This topic is for a different time. For this discussion, understand that the bank is using the power of duplication.
Would you like a very strong example? Start with a penny … just 1 cent. Then double for the next 30 days. So day 1 would be 2 cents, day 3 would be 4 cents, day 4 would be 8 cents and so on. Do it on paper. It will have a much bigger impact on you. What’s the answer? Try it. You will be enthusiastic. What you will see is an example of the finest compounding.
How do we do the same as real estate investors? Can we do the same? The answer to the second question is clearly yes! The answer to the first question is, you guessed it, using non-binding debt.