Is your budding real estate empire built on a solid foundation? Or is it just a house of cards?

After a rough patch over the past five years or so, real estate seems to be making a comeback these days. Home values are going up, and more and more investors are  wanting to get back into real estate. Even a lot of people that I know, who are not wealthy or accomplished investors by any means, are making noise about getting into real estate themselves. The ones that plan to do it on borrowed money worry me a little bit.

Some of those people I know — even friends of mine — will disagree with what I write here, or may even be upset with me for writing it. That’s a chance I’m willing to take, though, because borrowing money to invest is a really, really bad idea. And I owe it to my readers to warn them about it.

Real estate is a tricky investment subject. People who have the means and the smarts to do real estate investment right can make a whole lot of money at it. That big money, which seems to come easily to experienced investors, tends to attract a lot of amateurs into the market. Buying rental homes or flipping houses out of foreclosure seems easy. But it’s not as easy as it looks, and there are big risks involved. If you don’t know what you’re doing, you can lose a lot of money in real estate. And if you borrow money to dive into this adventure, you can really wreck your financial life.

Understanding the Fundamentals

Let’s start with some fundamental principles. The first is a refrain that will be familiar to frequent readers of this site: Debt is a form of financial slavery. Any time you borrow money, you give up your financial freedom, and make yourself a slave to the person or institution that you borrowed it from. Debt always increases the risk in your life, and it has been tripping up everyday people for thousands of years. It’s the same the problem that is strangling the modern American family (as well as the American government). Plain and simple, it’s never a good idea to borrow money.

Here’s fundamental principle number two: When you own a home, stuff goes wrong. A lot. If you own your house, you probably know this to be true. In the house I’ve owned for eight years, I’ve replaced the roof, the water heater, parts of the electrical system and my entire heating and air system. None of those replacements were planned — they were all emergencies that cost me a lot of money. No matter whether your home is old or new, it’s going to have problems, and those problems have to be fixed. Those fixes, in turn, will always cost you money.

And here’s the third fundamental principle: If you’re a real estate investor, your success will be influenced by forces largely beyond your control. If you own rental homes, you’re going to deal with some bad tenants that don’t pay their rent on time and damage your property. You’re going to go through stretches where you can’t get any renters into the property at all. And if you’re thinking of holding a home for a while and then selling it to make a profit, consider this: Home values don’t always go up. In fact, sometimes they decrease suddenly due to macro-economic factors that you can’t control. And selling a home isn’t always easy — some real estate owners have struggled for years to offload investment homes in this difficult economy, with little success.

Compounding Risk

Now, let’s put all of these fundamental principles together. The expenses involved in maintaining a home, along with the unpredictable and uncontrollable nature of the economy and the real estate market, make real estate investing a risky business. If you can buy properties with cash, the potential rewards make these risks largely worthwhile. But because borrowing money makes us slaves to someone else, using borrowed money to invest in real estate actually compounds the risk of your proposition.

Let’s put it this way: Whenever you invest with cash — whether in the stock market, mutual funds or real estate — you know there’s a risk that you could lose your money. If you do this, the very worst-case scenario is that you lose all of your seed money. But if you borrow money to invest, you extend the risk beyond just your seed money. If you borrow money and then your investment goes bust, the bank isn’t going to simply forgive your debt. You’ll be on the hook to pay the money back to the bank, which is putting your personal finances at risk. When you lose cash in an investment, that’s money that you can afford to lose. When you lose borrowed money in an investment, though, that’s money that you can’t afford to lose. If you could afford it, you wouldn’t have to borrow it in the first place.

Good, Bad and Ugly

I know what you’re thinking: You know people who have made a lot of money in real estate using mortgages and debt, and you think that proves me wrong. I know those people too. But I also know that there are many, many more people who have lost their shirts with this strategy. They go bankrupt, they ruin their credit, they lose their personal homes and some even end up in jail. The fact that some people get away with taking a big, dumb risk doesn’t make the risk any less dumb.

I could go on and on about the reasons why borrowing to invest is dangerous, but nobody has time for that. Maybe we’ll do it in a future article. For now, though, I want to leave you with this thought: There are lots of ways to make good money in this world that don’t involve gambling with your family’s financial future. Investing is a great thing to do, but borrowing money to do it isn’t worth the risk.

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Photo by Images of Money. Used under Creative Commons License.