You’re Leaving Money On The Table Paying Down Your Student Loans

A common question among new investors is one asking whether you should pay down debt ie. have less risk, improved credit position, etc or use the extra money to invest in real estate. The correct answer is always- It depends.

The dependency of the answer is based upon the investors current credit position, total amount of money to invest, motive behind investing and risk profile among the items noted below. While there is no one right answer for everyone, there are some general guidelines to use in order to maximize your return on capital- either OPM (other people’s money) or your own.

Return on investment (ROI)

You need to carefully calculate what your expected return on investment will be once your capital is deployed. This will be influenced by the type of investment you choose (turn-key, value-add, flip, syndication, multi-family, house-hack, etc). Some of these tend to produce higher returns than others.

Ex. You may only earn 8-12% on a turn-key single-family rental while earning 20%+ on an apartment syndication or value-add deal.

Leverage

We need to understand what leverage is, what is costs and what benefits it contains. Ultimately leverage is using borrowed capital (money) to enhance the potential return on investment. Leverage is one of the amazing key concepts of real estate investing. How many other investment vehicles do you get to borrow someone else’s (passive investor’s or bank’s) money to invest? Utilizing leverage allows investors to obtain a return on the investment of their cash, while simultaneously earning a return on borrowed capital.

Ex. You obtain a mortgage for $75,000 on the purchase of a duplex costing $100,000 and producing $700/month or $8,400/yr cash flow. Your cash-on-cash return using leverage is 33.6%. If you hadn’t been able to use leverage to buy the deal, using $100,000 for the purchase your cash-on-cash return would be 8.4%, a 25% difference.

Debt to Income Ratio

Your debt to income ratio is a standard measure that almost all lenders will use to asses the risk of loaning to you. This is simply the amount of monthly debt payments (car note, student loans, credit cards, mortgage payments, etc) divided by your monthly gross income. If you are applying for a new loan, lenders often consider the new debt payment when calculating and approving you. While many lenders have different thresholds, they typically like to see 43% or less. Your debt to income ratio also has a big impact on your credit score, so even if you are using a lender that doesn’t qualify based on income, this will have an indirect impact on approval through your credit.

Ex. If your income is $60,000/yr or $5,000/month, a lender would prefer to see total monthly debt payments $2,150 or lower.

Debt Type

1.      Paying off variable high interest debt like credit cards is significantly different than paying down a personal residence mortgage or low interest student loans. When deciding what items to pay down, you should always attack the variable high-interest debt first, as that is costing you the most money. These types of debt are typical to credit cards, personal loans and “payday” loans. It’s my opinion that the balance of these type of debt should be very low before you begin to invest. The interest rate on these types of debt are often 20%+ and can tie up a significant amount of monthly cash just on the interest payment alone.

2.      Next are shorter term fixed rate loans such as car loans and some personal or student loans, as well as some HELOCs (home equity line of credit). These loans often range from 0-10% interest and are fixed rate, meaning the interest rate doesn’t change over the life of the loan. This adds security as you always know what your payment will be.

3.      Lastly are long term, fixed-rate loans that would be the mortgage on your personal residence (assuming you didn’t get an adjustable rate). These are often 15-30 yr loans and lower rates, 2-6%. These loans are the last areas of debt you should focus on paying down due to the longevity of the loan and low interest rates.

Summary

In combining all these aspects of debt and investment, only you can decide what is the best route. It’s my belief that you are leaving money on the table if you decide to pay off debt types 2 or 3 above and forego an investment with a significantly higher ROI. To be clear, I am NOT saying that you should not make you minimum monthly payment on any debt, just that any incremental cash might have a better use. This is the whole concept behind Rich Dad's (Rich Dad, Poor Dad) theory that you buy assets to pay for liabilities- buy a rental property to pay your car payment.

As an example, say you pay $25,000 cash for a new car. You could have financed the full amount of the car for 6 years @ 4% interest. If you had financed the care and invested that $25,000 in a syndicated apartment purchase or value-add deal you could have made a 20% ROI. In this example you forego 16% ROI on the $25,000 to own a car free and clear. The 16% missed ROI is the opportunity cost of the cash purchase. The actual gap is even larger when you consider the tax benefits of real estate.

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