Real Estate Debt

To have a debt is to owe someone something. A debt may be a service, may be money or goods. May even be of gratitude.

In the finance world, however, it usually is a way that institutions came up with to encourage people to spend and, with that, push for an economic growth of the eco-system. Here’s the thinking behind the concept of debt:

Roger has only $5 in his savings account to buy a real estate that costs $10 and will make him $3 a month once he starts renting it.

Lilly has $20, so she gives $10 to Roger and assigns to him a real estate debt starting at $10. But that’s the beauty of the real estate debt; it starts at $10, but it is rolled with interests over time.

Lily and Roger agree to a certain interest percentage that might make the whole thing become good for the both of them. Roger doesn’t have to pay it back in one shot; he can control the amount he pays (principal) to obtain cash flow and never go down his initial $5 savings. Since he’s making $3 a month with rent, he might have paid to Lilly more money than he would have paid the former owner directly, but he made enough money with the rent to make it worthwhile and painless. Not to mention that, since real estate has its value influenced by external factors, at the end, when Roger finishes his real estate debt with Lilly, it’s possible that the home’s neighborhood is on a good moment and the house is worth much more than it did when he bought it. On Lilly’s part setting up a real estate debt was just $10 she turned into $15 (a $5 profit) by way of the magic of interest.

So the concept of debt naturally breeds loans. And, in real estate, those are vital because it makes it possible for people to buy new houses without suffering a big drop in their living standard, or worse - going bankrupt. All they need to do is get a mortgage loan from a bank - or an institution who makes money of the collection of hundreds of debts (some small, some huge) – and pay a monthly principal that is much smaller than the total sum.

Having a real estate debt is not a crime. However, there are contracts determining a time frame for the payment of principals, and the default of it will hurt your credit score and might incur in other penalties. Most of the times, a real estate debt can be entirely paid at any time, or the borrower can pay a higher amount than the principal in order to amortize the total value of the asset. The ideal for a lender is that the borrower takes a little bit to pay it back, but not too much so they waste too much energy and efforts on collecting it. What’s interesting is that some institutions do have the financial strength to hold on and enforce the collection of the real estate debt, so they turn into a trade asset. What does that mean?, you ask. Well, sometimes, a bank makes an offer to buy the real estate debt from another bank, believing the amount will only grow and they will be able to get a return over the investment they make when the borrower finally pays the whole amount he owed.