So, enough about bad debt for a moment and let’s talk about good debt, how you can use other people’s money to pay for your assets. Let’s assume that the mortgage market gets back to normal one day for a start!
Imagine you have £60,000. You want to buy a one bedroom flat to let out and can’t decide whether to get a mortgage or buy it outright. Why would you even consider getting a mortgage if you could buy outright?
If you have one flat worth £60,000, and if it appreciates at 8% per year (conservative estimate) how much would it be worth in 1 year? 10 years? What about any positive cashflow?
Let’s assume that your plan is to build up a ‘stable’ of buy–to–let properties and your goal is to generate income now, rather than create a nest egg for the future.
If you have six flats worth £60,000, and they appreciate at 8% per year, would you be six times better off? How much would they all be worth in 1 year? 10 years? What about any positive cashflow?
Would it be six times as much?
Do the sums.
If you have £60k spare cash and you use that money to buy a £60k flat which generates an 8% per annum appreciation in value (conservative appreciation figure) with a £100 per month positive cashflow. At the end of one year you will have a flat that has appreciated by £4800. You will have generated £1200 positive cashflow in one year. You will be a total of £6000 better off in the first year.
If however, you use your £60k to put down a 15% (£9000) deposit on several flats costing £60k, you could afford six flats, or £360,000 worth of property. If that appreciated by 8% per annum, at the end of one year your appreciation figure would be £28,800. Again, if you generated a positive cashflow of £100 per month, if you multiply that by 6 flats, you have made in the first year £7200 positive cashflow. Add to your appreciation of £28,800. Total gain in Year 1 of £36,000.
£6000 better off or £36,000 better off? Six times better off in fact. You choose.
What about Year 2?
If you keep your one flat and it appreciates by 8% and generates £1200 positive cashflow, you will have made another £6,384 in Year 2.
If you refinanced your six flats to release the equity, you could get 85% (£330,480) of the new value of £388,800. You pay off the original £306,000 total in mortgages, leaving you still owning the original six flats, with 15% equity still in, and you have £24,480 in your pocket to go shopping for more flats.
You buy another 3 flats at the same price you paid for the first six (you are good at finding bargains now!) but have to stump up a bit of cash to make up the third deposit) and you now own nine flats, six that have appreciated in value by £31,104 in total plus a positive cashflow of £7200 (rent plus yearly increase, less the slightly increased mortgage), and three that have appreciated by £14400 in total with a positive cashflow of £3600.
Total gain in Year 2 using leverage = £56,304.
£6384 better off or £56,304 better off? Again, you choose.
And you are a lot better off in terms of tax, because all the interest paid on all your mortgages is tax deductible against rental income, as it is a business expense. Whereas if you buy something outright, you get taxed on all the income, as the Inland Revenue doesn’t take capital repayments into account as a business expense.
Please note: Obviously this example hasn’t taken into account legal and valuation fees and costs of finance etc. but is just for illustration of the power of leverage. You should always get advice about your own personal circumstances and do the sums carefully, taking into account all costs.
What’s your strategy?
You need to decide if using good debt would help you achieve your financial goals faster. Perhaps you are perfectly happy with no debt at all, perhaps you have all the income you need. That’s fine.
But perhaps you would like to leverage a smaller amount of money to reach your bigger income goals faster.
Are you being held back by your fear of any kind of debt?
The best way to overcome fear is with knowledge. How could you get more knowledge and learn how to invest with confidence, knowing that you know how to manage good debt effectively?
This extract was taken from the “Debt-Busting Chapter” of
Nicola’s book “The Money Gym : Wealth Building Workout”
The Money Gym Wealth Building Workout
By Nicola Cairncross
Includes a forward by C4’s Secret Millionaire Gill Fielding
Gill Says: “This book is a template for anyone who wants to create wealth. It will tell you the path to take and what do do… There is no better teacher and mentor than Nicola.”