The concept of leveraging is very well known among investors; We prefer to use Other People’s Money (OPM) rather than our own money. The idea is simple: we can use our money to make more money and we use OPM to make more money too; the gains on our own money must be higher than the interest we pay on OPM.
If you don’t know this concept or it doesn’t sound intuitive to you, let me give you a simple example. You have $50k and you want to buy an asset that costs $50k. You can get 10%+ on your money, if you invest wisely, and you can pay the bank a much lower rate to use OPM.
A typical question I get is “I have these many thousand dollars, should I pre-pay my mortgage or should I invest?”.
Rules of thumb
I personally use a few rules of thumb:
- I pay off my mortgages when the money you can make on my own money is less than the interest I have to pay on my mortgage(s).
- I pay off my credit when the money I make on my own money is less than the interest I pay on my credit.
- I leverage (aka use OPM) when the interest I have to pay is smaller than the NOI I can make on the borrowed cash.
- I use OPM when the money I can make on my own money is more than the interest I’ve gotta pay on the borrowed money.
So, let us look at my own situation. If you have a look at my investments, I’ve got an interest bearing account which barely keeps up with inflation, about 3500 in P2P lending platforms, which make 11%, and a 2k in bonds, which again, barely keeps up with inflation (this averages to 2% on my entire portfolio). Per year, I pay way more in interest than what I make on my money. Yet, I am liquid enough to pay off one of my rentals. I’ve got 30k siting in the bank* and I’ve got two mortgages at about 4,5%. In theory, since my money is only making 2% on average, I prepay my mortgages. However, note that both my Rental Properties generate more than 4,5% – so in my book, it is OK to leverage!
People often translate this rule of thumb into something more practical: “if my new rental property generates enough cash to pay off the mortgage and put a few bucks in my pocket, its all good”. In short, I agree.
I’ve seen people able to make a lot of interest on their money and spending it on a Rental because they wanted to “remain debt free”. What many people fail do realize is that debt can be very good if you know what you are doing. Without leverage, you can’t get as far, especially if you are on the work hard + save hard route.
*The reasons why I keep $30k sitting in the bank, making less than 1% (currently breaking even with inflation) are: 1) it enables me to negotiate RE more comfortably, 2) it enables me to sleep at night; should my properties a new roof or other big maintenance event, I am covered up.