Years ago I found myself reading one of Dave Ramsey’s books. I can’t remember which book it was, but in it he discusses what he calls the Debt Snowball. Essentially, as I understood it, debt snowball is a method of paying off debt whereby the main objective is to free up cash flow as quickly as possible by getting rid of monthly minimum payments so that this money can be “rolled” into the next step thereby compounding the result.
With this goal in mind, in lieu of starting the ball rolling with the largest debt amount and the most expensive debt in terms of interest, or making simultaneous payments on all of your debt, which most of us would gravitate toward doing, it may make sense to begin with the smallest and therefore easiest to pay off balance. For example, if you have 3 credit cards with balances of $1,200, $4,000, and $7,000, you would throw all of the available to you resources into first paying off the $1,200 card – regardless of what the terms are. This is because:
- You are most likely to “see it through” and not be overwhelmed, and
- Once paid off, the freed-up minimum payment can be applied toward the next debt – in line, making it easier to pay-off larger amounts; and so on and so forth. In the world of compounding, time is of the essence and getting your hands on an extra $80/month within 1 year is better than collecting $300/month after 7 years…so goes the logic.
The Mortgage Debt Snowball
Having read this, it became apparent to me that the same principal could be applied to paying off mortgage debt. Suppose that you own 10 buildings in your portfolio and you have a mortgage associated with each for a total of 10 mortgages. For the purposes of this example let’s just say that each mortgage is for $80,000 for a total mortgage debt of $800,000. Further, suppose your portfolio generates a total of $3,000 per month of Cash Flow under current leverage.
Now – you’ve bought these buildings to provide income for you in your retirement, and now that you are a 49 year old geezer you’ve made the decision to go free and clear as soon as possible. And to this end you allocate $2,000 of your $3,000/month of Cash Flow toward positively amortizing notes.
At this point you are faced with a question: would it be better to put $200/month toward the principal on each mortgage, or would it make more sense to throw the entire $2,000/month toward one of these mortgages? You likely know the answer by now.
Paying Toward Ten Mortgages Equally
If you had $2,000 per month to reinvest, you could contribute a total of $200 per month toward each of the 10 mortgages. All things being equal, this would lead you after 60 months to recapture roughly $12,000 of principal on each of your mortgages, for total equity position in your portfolio of $120,000.
This is not bad, but not particularly useful either. At this rate it’ll take many years for you to own a property free and clear…
Paying Toward One Mortgage
By contributing the entire $2,000 per month toward one of the $80,000 mortgages, you will amortize it to “0” in about 40 months. In doing so, and this is the very important point, you will not only free up laveragable equity, since now you have the option of cash out refinancing this house, but you’ll eliminate the payment associated with the paid off mortgage. If we assume a 30-year loan at 6%, this will free up around $480/month.
At this point, and this is where it gets fun, you can either chose to pay off another one of your mortgages, but instead of throwing $2,000 toward the principal you will now be able to pay an additional $2,480 per month. This means that in only about 34 months you will pay the second mortgage down to $0, and free up yet another payment associated with it, at which point you’ll be able to repeat the process.
Or, instead of moving to the second mortgage, you could chose to re-leverage the paid-off property in the amount and terms such that the debt service associated with the new leverage is equal to or less than the amount of freed-up cash flow. And, if the asset that you are buying throws off considerably more cash flow than the cost of this debt service, then you Income & Loss Statement will have taken a step forward…
Interestingly, relative to that last point, while your cash flow position may have gotten stronger, your balance sheet remained the same. Do you care?
Food for Thought: At this stage in my career the only reason I pay anything off is to free up leveragable equity and money for debt service…
There are two reasons why we ever pay-off real estate debt. One is to create leveragable equity that we can refinance, blanket, or bridge in some other way into additional cash flow. And the other is to simply get rid of the debt and recover the minimum payment associated with it.
With this in mind, there are two serious problems with the approach of paying simultaneously on all of the mortgages. While you do recover equity across your portfolio, the amount is not sufficient or sufficiently centralized to be able to bridge it with ease. Yes, you can work with blanket notes and umbrella mortgages, but those are sophisticated tools that are not easy to come by or to manage. Thus, the inability to bridge (leverage) equity with ease is one problem.
Also, while recovering equity on all properties may seem good, since not one property gets completely paid-off you do not recover any cash flow – all that you are getting for your hard work is equity. Equity, as you know, does not put bread on the table, so from where I sit this entire process is rather meaningless…
Investing is about having options and by utilizing the second method of focusing all of your efforts on 1 mortgage at a time and paying it off you create options for yourself!