It is estimated that more than 189 million Americans have credit card debt, and the average household with a credit card carries $8,398 in credit card debt. While it may provide support and relief to many, it can prove to be detrimental to the aspiring real estate investor. In this article we will identify why credit card debt can be so damaging and provide evidence on how it can hinder one’s business development.
Credit Card Debt Can Prevent an Investor from Obtaining a Loan
Often in order to purchase real estate, unless you have hundreds of thousands of dollars in the bank, you will need to utilize debt for the purchase. This means you will use a specific amount of capital for the down payment – cash you already have immediate access to – and then finance the remaining balance of the acquisition.
When a lender assesses if you qualify for a loan, the first thing they will review is often your credit score. Your credit score is a numerical expression between 300 and 850 depicting a consumer’s creditworthiness – the higher the score, the better your credit. It is the representation of how likely a borrower will repay his or her debt. However, there is not only one factor that contributes to a credit score but instead is a cumulation of your credit history. Factor’s impacting this number include number of open accounts, repayment history, length of credit history, an individual’s total debt, to name a few. Your loan amount will also be impacted by your debt to income ratio, or DTI, which compares the amount of debt you have to your income.
The higher DTI (which means you have higher debt), decreases your chance of obtaining a loan. In fact, the craziest thing I often see is that with high credit usage even as little as $10,000 in credit card debt can prevent you from getting a $500,000 loan. This is because the lender may not believe you are capable of repaying the loan because you might have high credit utilization. While a small amount of debt that gets paid quickly and smart debt management can bolster your credit score, that same amount of debt can ultimately hinder your purchasing goals if you are not keeping your balances very low (0-10% of credit card usage), have a good mix of types of credit (car,mortgage, multiple credit cards), have enough credit history, and very importantly have a great history just to name a few.
Credit Card Debt Can Reduce Your Approved Loan Amount
If you have credit card debt, not all lenders will turn you down, but the amount that you qualify for can drastically be impaired if you are required to make monthly payments on existing debt. In other words, having monthly debt on your credit can make your allowable backend ratio a lower payment, and therefore you qualify for a smaller loan. A back end ratio takes all your monthly debt obligations and divides that number by your income. Real Estate loans use this number when they look at you have guidelines that dictate what they determine as “affordable” for you.
Let’s look at an example.
Say you bought a boat and borrowed $20,000. Let’s assume you are paying a $400 minimum monthly to pay down that debt.
Now, let’s say you want to purchase a property for $560,000. When conducting your due diligence, you assume you can obtain a loan under the following terms: 30 years at a five percent interest rate. This would make your monthly payments roughly $3,000 per month.
However, let’s say you did not calculate the impact of your boat payment, and the lender, considering your additional responsibility, only wants your mortgage to equal $2,500 per month. This would reduce your loan amount to $465,000, $95,000 less than your expected amount all because of your existing debt.
Now, this is only one variable of debt that would impact your loan. What if you had multiple credit cards with debt? Remember, this is an overly simplified example, but overall, the monthly payments can have a compound effect on how much you may qualify for when applying for a loan.
Credit Card Debt Prevents Opportunity !!!
Not only does credit card debt impact you when you are seeking a loan, but it can also prevent you from pursuing opportunities in which you could have used a personal loan to obtain a profit.
We do not always have capital on hand, and having access to a personal loan can allow you to pursue an acquisition by utilizing a that for a down payment. However, personal loans come with their own challenges. They tend to have higher interest rates and less favorable terms; therefore, it is essential to have good credit to get terms that make sense for the deal. If the loan is offered at 20 percent interest, your return on the investment may not make sense. On the other hand if you have good credit and are able to obtain a personal loan for the down payment at 10 percent interest, then qualify for a conventional loan for the existing value, the return may be favorable.
More importantly, you may need money to tie down a deal you found. Once you get the equity for the deal from your investors, you may want to pay the money you had borrowed back. If your credit is bad, you aren’t going to be able to use this tactic. Put yourself in a position to succeed.
Avoid Debt at All Costs
While this may be news to some, I am not alone in this thinking. In fact, some of the world’s most recognized billionaires preach the same mindset including Warren Buffett and Mark Cuban. Credit card debt prevents opportunities and causes people to lose profit on their paid interest. There is rarely an investment opportunity that can give you a 24% return, which is the common APR on credit cards today. Adding debt upon debt is never a good idea, and you will pay more in the end, every time. Simply put, it is always best to reduce your debt (really, have zero credit card debt), and start utilizing that position to begin growing your wealth rather than preventing you from getting it.