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How to Use Debt to Buy Real Estate

How to Use Debt to Buy Real Estate – (What you Need to Know)

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This article is part of our guide on fannie mae and non-recourse loans in multifamily, available here.

Debt can be a powerful tool for real estate investors. Using debt, you can leverage your money to make larger purchases to increase your return profile and reap the long-term benefits of owning and operating larger assets. 

However, it’s essential to understand the different types of debt available and how to use them responsibly before diving into real estate investing.

Key Takeaways

  • One of the benefits of using debt to buy real estate is that it allows you to own or purchase more property than you could afford to pay for in cash.
  • Buying income-producing real estate with debt is how you can lower the cash you need to buy a much larger asset than you could all cash.
  • The interest you pay on a mortgage is tax-deductible, and the expenses that were incurred to operate the property further shelter the dividends you pay yourself from the property.

How to Use Debt to Buy Real Estate

There are several steps involved in using debt to buy real estate, and they are as follows:

  • Determine your budget: Before you start looking for properties, it’s essential to determine how much you can afford to borrow. This helps you determine what purchase price range you can comfortably finance with the right debt terms.
  • Choose a lender: This could be a bank, nationwide lender, hard money lender, CMBS lender, bridge lender, agency lender, or other financial institutions. Shop around and compare rates and terms from multiple lenders to find the best deal.
  • Gather documentation: In order to qualify for the mortgage, you’ll need to provide documentation to your lender. This could include proof of income, tax returns, credit history, property rent roll, trailing financials, and other items.
  • Apply for a loan: Once you’ve gathered all the necessary documentation, you can apply for the loan. This typically involves filling out a loan application and providing all the required documentation to your lender.
  • Negotiate terms: If your loan application is approved, you’ll need to negotiate the terms of the loan, including the interest rate, repayment schedule, and any fees or closing costs. Be sure to carefully review the terms of the loan and ask any questions you may have before signing the agreement.
  • Closing: Once you’ve negotiated the terms of the loan and agreed to all the conditions, you’ll need to close on the loan and the property. This typically involves signing a mortgage or other loan agreement and paying any closing costs or fees.
  • Repayment: Once you’ve closed on the loan and purchased the investment property, you’ll need to start making a regular mortgage payment on the loan. Be sure to make these payments on time to avoid defaulting on the loan and potentially losing the property.

Types of Debt

types of debt

There are several types of debt that can be used to buy real estate, including:

  • Mortgages: Mortgages are the most common type of debt used to buy real estate. They are loans that are secured by the property being purchased or refinanced. Banks, credit unions, government agency lenders like Fannie Mae or Freddie Mac, and other financial institutions typically issue them. Mortgages come in various forms, including fixed-rate mortgages, adjustable-rate mortgages, interest-only mortgages, and jumbo mortgages. Depending on the area that the property is located, what use the property has, if its income producing, the condition, the property vintage, the experience, net worth, and liquidity of the borrower, and other factors, all influence which debt is best for your specific use case.
  • Home equity loans: Home equity loans are a type of loan that uses the equity in your home as collateral. They are typically used for home improvement projects or to finance other large purchases.
  • Private loans: Private loans are issued by private lenders, such as individuals or investment groups, rather than traditional financial institutions. Private loans can be a good option for those who don’t qualify for a mortgage or home equity loan due to credit or income issues. They also might be a better option depending on how fast you need to close and getting access to additional funding for renovations.

An Example of Using Debt to Buy Real Estate

Let’s say you want to buy a 62-unit apartment community for $5,000,000. If the property is stabilized with a 90% plus occupancy rate, you may qualify for a loan through an agency lender like Fannie Mae. 

Let’s say Fannie Mae gives you a loan at 70% LTV, which means that they would give you $3,500,000 in loan proceeds, and you would need $1,500,000 to get to closing. 

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How to Use Debt to Build Wealth in Real Estate

Using debt to buy real estate can be a great way to build wealth, but it’s essential to do so responsibly. Here are some tips for using debt to build wealth in real estate:

  • Stay away from speculative assets: It’s best to stay clear of real estate assets that are highly speculative and don’t produce cash flow. This is especially true when you add debt into the mix; being on the hook for a large loan can sink you if signed on a recourse debt. This means that the lender can seek recourse on your personal assets for the balance that’s owed after liquidating whatever they could from the underlined asset.
  • Focus on income-producing assets: Rental real estate and multifamily real estate are the best examples of this. Whatever lender issues you the debt, it will pay close attention to the borrower’s experience, but mainly on the underlying property’s ability to service the debt. Buying income-producing real estate with debt is how you can lower the cash you need to buy a much larger asset than you could all cash. With a property that comfortably covers the debt through its cash flow, you make the spread today. 
  • Use debt wisely: Don’t take on more debt than you know the property can comfortably service. Be sure to carefully consider the terms of any loan you take out, including the interest rate and repayment schedule.
  • Diversify your portfolio: Don’t put all your eggs in one basket. Spread your risk by investing in rental properties in different locations.
  • Stay disciplined: Stick to a budget and make sure you have enough monthly cash flow to cover your mortgage payments and other expenses.
  • Consider the risks: Real estate investing carries some risk, so it’s important to carefully assess the potential risks and rewards before making any investment decisions.

Related Read: How to Leverage Property to Buy Another 

Allows you to Own/Purchase More

One of the benefits of using debt to buy real estate is that it allows you to own or purchase more property than you could afford to pay for in cash. 

By taking out a mortgage and lowering your down payment, you can use leverage to be the beneficiary of all the long-term wealth-building advantages of owning larger assets, which boils down to more cash flow, equity, and net worth. 

Tax Advantages

There are also several tax advantages to using debt to buy real estate. For example, the interest you pay on a mortgage is tax-deductible, and the expenses that were incurred to operate the property further shelter the dividends you pay yourself from the property. 

Additionally, depreciation is the most significant way a real estate investor benefits from owning real estate. For example, multifamily real estate offers the strongest depreciation through what is referred to as bonus depreciation. 

This is done through performing a “cost-segregation study” that enables multifamily owners to claim a large percentage of that depreciation in the first year of ownership. The unused “paper losses” are then carried forward for years, further sheltering the annual distributions received from the property.

Debt Free Real Estate Investing

While using debt can be a powerful tool for building wealth in real estate, it’s not the only option. Some investors choose to pursue a debt-free real estate investing strategy, aiming to purchase properties without taking on any debt. 

This is a much more conservative and safe approach to acquiring real estate, in which you save on the interest on the borrowed funds, and no institution or person is breathing down your back every month. The downside is that you miss certain tax advantages and all the long-term appreciation that owning more assets with debt offers.

What does Dave Ramsey say to Invest in?

Dave Ramsey is a personal finance expert who advocates for a debt-free approach to investing, including in real estate. 

Ramsey recommends investing in a variety of assets, including stocks, mutual funds, and real estate and advises against using debt to make investment purchases.

What does Dave Ramsey say About Real Estate Investing?

Dave Ramsey advises against using debt to invest in real estate, stating that it can be a risky strategy that exposes investors to the potential for losses if the market turns against them. 

He advises investors to avoid taking on debt and instead focus on building up a strong financial foundation through saving and investing in assets that have the potential to appreciate in value over time.

However, Ramsey also acknowledges that real estate investments can be good for those who are able to purchase properties without taking on debt and who are able to manage the risks associated with investing in the asset class.

Frequently Asked Questions About How to use Debt to Build Wealth in Real Estate

Good debt would be considered any debt that is used to grow your income or net worth. A good example would be purchasing a cash-flowing instrument like a rental property, where the asset stably produces more cash than the cost to service the debt.

Three examples of bad debt are credit cards, high-interest loans, and payday loans. 

How to Use Debt to Buy Real Estate - Conclusion

Debt is a vital instrument to take advantage of when building a real estate investment portfolio. That being said, being mindful of carrying too much debt relative to the property’s value and not focusing on stable income-producing assets like rental property is where you can run into trouble.

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