This blog article was written from episode 58 of Business by the Numbers, go here to listen: https://paarmelis.com/business-by-the-numbers/
The ultimate question: What debt should I tackle first, how much extra should I be paying towards debt, and what pitfalls to look out for?
There are two extreme viewpoints regarding debt: Dave Ramsey believes all debt is bad and you should get rid of it completely. On the other side of the spectrum are people who leverage debt and only care about cash flow. Most small business owners began with debt to start their business. To understand how to structure and pay down debt, you need to understand how to analyze and look at it.
Debt is about 2 things; return on investment and cashflow. Return on Investment (or ROI for short) refers to how much you stand to gain. You want ROI to at least cover interest on the loan. Cashflow refers to having the ability to cover this loan every month. Let’s say you buy a $500,000 garage and you’ll be paying $3,000/month on the mortgage. If you can generate $4,000/month in rental income, you’re making $1,000 every month in passive income. Let’s pretend you get the deal of the century and don’t have to put money down at closing. You sign paperwork and automatically start generating income while the garage is rented out. While there are risks to this, it is a simple example of positive ROI and cashflow.
ROI (Return on Investment)
For an SBA Loan, let’s say a borrower puts down a typical 10%. They spent $50,000 to buy this $500,000 property. This investment will produce $12,000/year in returns. This is a 24% return on investment. Wait, how is this a 24% ROI? This refers to a “cash on cash” return on investment, where the borrower doesn’t care about how much they promised to pay back to the bank or loan entity, they care about how much cash was put out, and how much they’ll get back. Ultimately, they only spent $50,000. So, if they make $12,000/year, they’ll have their money back by year 4!
There are a lot of real estate investing strategies, but the general idea is B-R-R-R-R (Buy, Rehab, Rent, Refinance, Repeat). Buying: what most real estate investors are looking for is a value-add property, something that is either not being rented out at its true value or that can be repaired to charge more in rent (Rehab). Because the value of the property has gone up, the investor will Refinance as much money as the bank will give them. They will ultimately try to get their $50,000 out, plus the money they put in for rehab and renovations. The bank will appraise the property at a higher value and allow a cash out Refinance. They’ll get $50,000 back out of the property. It’s possible that the mortgage will also go up, but either way, they got their money back and are still making a passive income while renting it out.
Another example of ROI: Let’s say you have a $10,000 credit card with 20% interest. If you pay that at the end of the year, you will owe $12,000 dollars. If you pay them off today, you owe them $10,000 and are saving that 20% interest.
On the other hand, if you have a $10,000 loan with 2% interest, paying it off today guarantees a 2% rate of return. Instead of paying down that loan with $10,000, you could put that cash into a money market or CD with a 4% return on investment. This is an example of how trading with margin works. The idea behind traders using margin is making smart financial investments to get a higher Rate of Return. This can be risky because if investments don’t go as you hope, you can lose quite a bit of money. This is also very time dependent. Two years ago, 2% was good but now we’re looking at 4% and higher ROI’s. If you have opportunities to deploy money to offset interest expenses, it can be very helpful to do so. It can also allow you to have availability to use that money (if you have a reliable income stream).
An example of this is EIDL Loans. While it costs interest, it is a rather cheap loan, usually the interest is around 3.7%. It’s not really costing any money because investing is covering the interest. You could take that money (say $100,000) and invest it in a money market to get the interest covered. Now, you have the $100,000 available to you in case something happens, and it didn’t cost you anything. Even if you have a small interest, some people consider that a premium they are willing to pay to have that money available. The important thing to remember is not to use this money on frivolous things, or if you know that you have a hard time being responsible with money, to simply get your debt paid down.
Cash is King
Okay, now we understand how to look at debt, let’s talk about paying it down. Where do you start?
The reason people get into debt is because they don’t have the cash reserves to keep up with business. One of the worst things people do is take a short-term loan out because cash is tight, and then try to pay it off as quickly as possible and strip money out of their business. While they got out of debt quickly, they may not have the money to build their cash reserves back up in case anything happens, such as a roof repair, equipment breaks, etc.…
Before you start paying down debt, the first question should be, “Do I have the reserves I need so I can make sure I don’t have to go back and get more money?” The general rule of thumb is 3-6 months operating expenses. How much you should have depends on your business, your goals, your upcoming expenses, down months, etc. Generally, I would say it’s better to have $100,000 in the bank and owe the bank $100,000 than to have $0 in the bank and be debt free.
Pay it down!
There are a lot of strategies when it comes to paying down debt but here’s mine. Attack the highest interest rate first. This simplifies things because it goes back to ROI. If you have an 8% car loan, but you owe 24% interest on an American Express card, you’ll make 24% ROI by paying down Amex first.
Sometimes it can be helpful to clean up debt by attacking low balances first, but sometimes liquidity is what you should be thinking about. For example, if you have a $50,000 line of credit from Wells Fargo and a $50,000 truck loan, it would make more sense to pay off the line of credit first. The reason I say this is because if something happened such as an audit, it would be very easy to transfer that $50,000 out of the line of credit back into an operating account and use it for whatever you need. If you pay off the truck, you are not going to get the money back unless you refinance your truck and even then, it will likely come back with a much higher interest rate. Another tie breaker that can make a difference is secured versus unsecured loans. The line of credit doesn’t have an asset or collateral attached to it. The loan on the truck is a liability but it is attached to an asset of similar value.
Tax considerations are the last thing to think about and relate to personal versus business debt. Most shop owners are their business. Let’s say you have 2 credit cards and they both have 20% interest with the same balance, but one is personal and one is your business card. Which one should you pay down first? The correct answer is the personal credit card. The reason is tax considerations. The interest on the business credit card is a business expense and a tax write off. So if you’re paying 25% interest rate, the business card is only actually costing less than 20% on interest because of the tax breaks.
Overall, it’s useful to understand how to analyze your debt so you can attack it when appropriate. Hopefully this gives you some tools to do so. Make sure you have cash in the bank and that you’re getting a good ROI on the debt you pay down.
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