How debt helps you build a property portfolio

Whilst it’s possible yet difficult to save your way to a property deposit, it’s almost impossible to save your way to a comfortable retirement.

If you attempt to save a lump sum for an outright property purchase, you might only buy one or if you’re lucky two homes over the course of your entire life.

You simply can’t save money fast enough on an average income to keep up with the growth in property prices in most capital cities.

Enter leverage.

The whole aim of leverage is to borrow other people’s money to control a larger asset and enjoy the investment returns you make from controlling that much bigger asset.

Example 1: No debt or leverage

Say you’ve got $100,000 in cash, and it will return 10% per annum.

In one year, your investment is worth $110,000 and you’ve earned a $10,000 profit.

You also have no debt, so all that profit is yours.

Example 2:  Using debt and leverage

Leverage allows you to borrow money to earn a return. Picture: realestate.com.au

What if you took that same $100,000 and borrowed $400,000 to buy a property worth $500,000?

Let’s assume the same 10% return, but this time you’re paying 5% interest on the borrowed money.

After a year, the property is now worth $550,000.  So, you’ve made $50,000 whilst paying $20,000 in interest.  But, you’re still $30,000 in front.

Using leverage, you’ve increased your total return three-fold from $10,000 to $30,000.  You’re building wealth three times faster than if you hadn’t borrowed money at all.

That’s the power of leverage.

But remember, for leverage to work, the expected capital return must always be higher than the interest rate on the borrowings.

As your investment is growing quickly, you’ll be able to use the equity that you’ve earned in the initial investment much sooner to buy a subsequent property.

For example, if you need another $100,000 to buy a second investment property, it would take 10 years of earnings under example one, but just three and a half years under example two.

As long as you can afford to service the debt, you’ll build wealth substantially faster than if you didn’t use leverage.

Your money is working harder for you because it’s controlling a much bigger asset.

Yes, you’re paying interest with leverage but the bigger asset will generally return more rental income as well.

Three types of debt

Debt isn’t always a bad thing. Picture: realestate.com.au

So, what about the fear of debt?

Most people have been taught that all debt is bad.

But we think that debt is misunderstood and knowing the three types of debt will help break down the fear.

1. Horrible debt

Going into debt to fund the purchase of something that decreases in value isn’t a great idea. Picture: realestate.com.au

You use horrible debt to buy anything that goes down in value.

Examples of this kind of debt include personal loans, credit cards, and store cards.

You should steer clear of accumulating this type of debt.

It’s absolutely fine to have a nice car and fashionable clothes, but save up and pay with cash, rather than financing these purchases by going into debt.

2. Tolerable debt

The debt from a mortgage is an example of a tolerable debt. Picture: realestate.com.au

Think of the tolerable debt used to buy a family home.

It keeps a roof over your head, but it’s not making you any money.

The reason it’s tolerable is, whilst your property might be going up in value, you’re typically the only one paying for it.

3. Productive debt

Going into debt to fund a long-term investment that earns money is productive. Picture: realestate.com.au

Sensibly embrace productive debt to buy income-producing assets that are likely to grow in value.

Ideally, we’d all have zero debt, pay no interest at all and have mountains of cash to buy investments outright.  But that’s just not realistic for most Australians.

The beauty of the productive debt on an investment property is you’re not servicing the debt alone.

The main difference between tolerable and productive debt relates to who pays the interest.

In a productive debt situation, it’s the rental income or tax concessions that will contribute the most to paying off the interest.

So you’re contributing a much smaller amount to service that mortgage than with a tolerable debt situation.

With a tolerable debt, you pay it all.

So, making friends with productive debt may well be the key to financing a comfortable retirement.

For more from the Property Couch, visit thepropertycouch.com.au or subscribe to the Property Couch podcast, available on iTunes or Android.