The real estate market is currently on fire and all the talk is about either the gains investors have gotten through appreciation or debates over whether we’re nearing a 2008-esque cliff. Zillow, for its part, is estimating “annual home value growth will rise as high as 13.5% by mid-2021” before cooling off a bit “to end 2021 up 10.5%.”
I won’t venture into predictions about what housing prices will do over the coming years, but the laser-focus on appreciation lately has obscured the many other advantages real estate investment brings. One advantage that gets the least attention even though it is the most trustworthy is principal paydown.
What is principal paydown?
Principal paydown is simply the part of the mortgage you pay each month that is applied to the loan balance instead of interest. On an interest-only loan, that amount is zero. On an amortized loan, the higher the amortization, the less principal is paid down each month and vice versa.
So, for example, a $100,000 loan at 4.5% interest amortized over 20 years will have a $632.65 monthly payment, with $375 going to interest and $257.65 going to pay down the mortgage in the first month. Thus, the loan balance will be $99,742.35 going into month two.
With a loan amortized over 30 years, the interest payment is still $375 in the first month, but the amount going to principal goes down to $131.69, making the total mortgage payment $506.69.
So while there is more money out of pocket with a lower amortized loan, all the additional money goes to pay off the mortgage faster.
This may not sound like much of an advantage since you pay down the loan with cash you could have otherwise kept in your own pocket. Indeed, principal paydown would seem to make for smaller pockets.
Therefore, many investors would prefer to have interest-only loans and keep all of the cash flow if they could. Banks, however, don’t allow that. Even still, most (including us) prefer longer amortizations to shorter ones to keep cash flow as high as possible.
That being said, the advantage is that principal paydown acts as a form of forced savings. When purchasing rentals, it’s critical to aim for them to cash flow over and above the loan and all expenses. That loan includes the principal you are paying down each month.
So if a rental cash flows at $100 per month over all of the expenses and the $100,000 loan amortized at 20 years mentioned above, you would also have made an additional $257.65 in forced savings by paying down your mortgage.
A $100 profit turns into $357.65.
More on mortgages from BiggerPockets
The “rate of return”
Many already know all of this, of course, but few seem to take this advantage into consideration when discussing real estate investment. This seems odd to me. Indeed, it was looking at an amortization schedule that originally inspired my dad to get started in real estate in the first place.
To illustrate this point, let’s look at what the internal rate of return (IRR) would be with only principal paydown. Now, strictly speaking, this is not an actual rate of return. Principal paydown builds up equity, and in order to convert that equity to cash, it would require a refinance or sale. Even still, the illustration will show how beneficial principal paydown can be.
So for this example, we will use the following assumptions:
- $100,000 purchase
- $20,000 down payment
- $80,000 loan
- 20-year amortization
- Rental income pays for all expenses on the property and debt service but not cash flow (break-even)
- The property does not appreciate at all
Using the CCIM Financial Calculator, we can find the internal rate of return (which is a better metric than a simple return on investment or ROI, as it accounts for when you receive the cash, not just how much).
With a holding period of 20 years, this would show a 7.18% rate of return.
While a 7.18% return isn’t going to make you rich, it’s not bad at all, especially given it’s only one of the advantages of real estate investment.
With a 15-year loan, the IRR goes up to 9.68%.
It’s relevant here that historically, the stock market has returned about 10% a year. Thereby, just breaking even on a rental property that doesn’t appreciate at all with a 15-year loan is close to being equivalent to investing in a diversified stock portfolio.
It should, however, be noted that with a 30-year loan, the IRR is only 4.73%. Furthermore, the IRR would also be lower if you paid the loan off early, as the early payments are mostly interest. This can be seen clearly from an amortization chart.
Even still, principal paydown by itself makes for quite the return. This is one reason that it’s not a good idea to sit on the sidelines because “the market is too hot.”
First, there’s no way to know when the market will correct or how much it will correct when it does. And second, the other advantages of real estate investment can help mitigate the risk of a market correction—most notably, principal paydown.
Are you ready to invest?
One of the most frequently asked questions in the BiggerPockets forums is “How can I start investing in real estate with no money and bad credit?” The answer? You shouldn’t. You need to fix your situation and invest from a position of financial strength.
Principal paydown and the IDEAL advantages of real estate
I’ve often cited the IDEAL acronym to explain why real estate investment is so powerful:
- I: Income (cash flow)
- D: Depreciation (tax advantages)
- E: Equity Building (principal paydown)
- A: Appreciation
- L: Leverage (ability to use bank financing to exponentially increase returns)
In addition, real estate is an inefficient market, which means you can buy at a discount to get built-in equity upfront while mitigating the risk of real estate values going down.
Cash flow is the advantage that gets a lot of people interested in real estate to begin with, but it shouldn’t be seen as much more than the cherry on top. Even $100 per month in cash flow only amounts to a fairly pathetic 1.8% IRR over 20 years.
Even accounting for 5% annual growth in cash flow doesn’t reach the rate of return of principal paydown.
The biggest benefits of cash flow are that it keeps you solvent and banks require it to lend to you.
The biggest advantage of real estate is probably appreciation. Of course, appreciation rates vary widely by time and place. Overall though, according to SF Gate, real estate has had national appreciation values average around 3.5-3.8% per year.
Using the lower 3.5% rate, a $100,000 home would appreciate to $198,979 in 20 years. That $98,979 gain is an 8.32% IRR.
When you put them all together though, the IRR spikes to almost 16%!
That’s going to beat almost any other secure investment. And this analysis assumes having bought the property at market prices and doesn’t account for any of the tax benefits that come from real estate.
Real estate investment, particularly buy-and-hold real estate investment, has a lot of advantages. Oddly, principal paydown (or equity buildup) is rarely considered amongst them. But it’s another powerful mechanism to gain wealth with real estate that you should account for.