May 2, 2013 by Dymphna 1 Comment

The Trade Off: Less Debt Or More Income?

First of all, I want to thank you for all the emails and letters you’ve sent me the past week or so. Today, just so you know that I read your emails and letters, I’m going to revisit a common problem that many of you have asked about. It’s actually a very good question with more than one right answer.

And by the way, I’m happy to get your emails, letters and comments, so keep them coming! Your communications let me know your concerns and questions and where you are in your thought process in your real estate investing journey. And that’s a very good thing, because it doesn’t just help you and me, it helps everybody…

Don’t let debt own you!

So it seems that quite of few of you are struggling—or probably a better word would be “weighing the choices”–of whether to use the income from your real estate portfolio to pay off debt or buy more property. I understand this dilemma, but it’s not the worst problem to have, is it? Remind yourself that having this choice means that you’re in a much better financial situation than you would be if you didn’t have this decision to make.

The fact is, most people live their lives facing the dreary reality of having to only pay debt because their debt owns them! Most don’t take the opportunities before them to free themselves from their jobs and live life the way they really want to. So good on you for making the effort and taking the steps you have made toward changing your life!

Debt should mean opportunity

Now, that doesn’t mean that having debt isn’t a big responsibility, because it is. But the circumstances have changed just a bit, haven’t they? It’s important to recognize that fact. It’s also important to understand the kind of debt that you’re carrying and paying for every month. When you make that analysis, you see the debt for what it is, and the opportunity it represents in your life.

For instance, as an active real estate investor, some debt is a necessity if it helps you to get into a property you otherwise wouldn’t be able to. This is true if you’re just starting out with your first PPR or your first reno, or even you’re buying your third block of flats. Buying a positively cash flowing property or a chunk money deal is using debt wisely. And, from a tax perspective, interest on investment property debt is tax deductible. This is very important because it helps you keep more of your passive income in your pocket!

On the other side of things, if your debt is from too much personal spending on your credit card or you went out and got yourself a fancy car with no money down, well, then you’ve got a big problem. That’s the kind of debt you want to eliminate from your life. That’s the kind of debt that turns you into a slave for life, isn’t it? By no means do you want to carry that kind of debt!

What’s your income threshold?

So when you talk about paying debt off as opposed to doing something else with the money, it’s important to realize what kind of debt you’re carrying and why. There is a threshold that I like to reach before I begin to think about paying off any large chunks of mortgage debt on my properties. That threshold has to do with your current income level. Remember why you got into real estate investing in the first place. A big part of setting yourself free from your old job and your old life is about replacing your income three or four times over so you’re not worried about income anymore.

That income replacement level is a very important benchmark to establish and to reach before you begin to pay down your property debt. After all, putting your income worries behind you is why you’re investing in real estate, isn’t it? Once you’ve replaced your income three or four times, then you can begin to think of reducing the mortgage debt on your properties.

More than one right answer

But how should you go about it? Since the debt on your investment properties gives you a tax break, you don’t want to eliminate too much of that too soon. At the same time, you are subject to changes in the interest rates on your debt. Today, we’re in a falling interest rate environment. That means that the cost of borrowing money is cheap and more affordable.

However, when the interest rates begin to rise–and they will at some point–the debt service on your portfolio mortgages will also rise. From that perspective, it does make some sense to pay down your mortgage debt while the interest rates are lower. But what’s the best way to do that?

The answer is that it will depend on several factors. Let’s assume that you’ve reached your income goals and that your income worries are behind you. Let’s also assume that you have put the proper structures in place to protect you portfolio. Other factors to consider are things like how much has your portfolio increased in value? What other tax-deductions do you have to offset your income? How many properties do you have that are simply breaking even but have substantial equity?

Other factors include how much your passive income has surpassed your goals and how comfortable you are carrying debt, even if it’s good debt. Some people just don’t sleep well with debt in their portfolio. That’s a personal thing and is certainly a valid concern. If that’s the case, you can painlessly access your passive income to systematically reduce your portfolio debt.

For example, if your income replacement goal was four times and you’re now earning five or more times your old income, then you can use some of the “excess” income to pay down a mortgage on one or more properties. You don’t feel any effects of those payments because you’re already set for income. Not only that, but if you pay on the mortgage fortnightly instead of monthly—you’re not paying any more, you’re just paying it every two weeks—then you will cut the payoff time by something like 40 per cent!

You can also access equity chunks to pay off debt. Say, for example, you have a property or two with minimal positive cash flow but you have quite a bit of equity in the property. You can sell that property and use the money to payoff the debt on some of your higher cash flowing properties. This will not only increase your monthly income, but will streamline your portfolio while reducing your debt load.

Of course, there are more considerations that will be a part of your personal situation. It’s important to maintain your income needs, protect your assets and keep your own tax position in mind. The right answer involves all of these things and more, and we will talk about those soon.