Years ago I found myself reading one of Dave Ramsey\u2019s books. I can\u2019t remember which book it was, but in it he discusses what he calls the Debt Snowball<\/i>.\u00a0 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 \u201crolled\u201d into the next step thereby compounding the result.<\/p>\n
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.\u00a0 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 \u2013 regardless of what the terms are. \u00a0This is because:<\/p>\n
Having read this, it became apparent to me that the same principal could be applied to paying off mortgage debt.\u00a0 Suppose that you own 10 buildings in your portfolio and you have a mortgage associated with each for a total of 10 mortgages.\u00a0 For the purposes of this example let\u2019s just say that each mortgage is for $80,000 for a total mortgage debt of $800,000.\u00a0 Further, suppose your portfolio generates a total of $3,000 per month of Cash Flow under current leverage.<\/p>\n
Now \u2013 you\u2019ve bought these buildings to provide income for you in your retirement, and now that you are a 49 year old geezer you\u2019ve made the decision to go free and clear as soon as possible.\u00a0 And to this end you allocate $2,000 of your $3,000\/month of Cash Flow toward positively amortizing notes.<\/p>\n
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?\u00a0 You likely know the answer by now.<\/p>\n
If you had $2,000 per month to reinvest, you could contribute a total of $200 per month toward each of the 10 mortgages.\u00a0 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.<\/p>\n
This is not bad, but not particularly useful either.\u00a0 At this rate it\u2019ll take many years for you to own a property free and clear\u2026<\/p>\n
By contributing the entire $2,000 per month toward one of the $80,000 mortgages, you will amortize it to \u201c0\u201d in about 40 months.\u00a0 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\u2019ll eliminate the payment associated with the paid off mortgage.\u00a0 If we assume a 30-year loan at 6%, this will free up around $480\/month.<\/p>\n
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.\u00a0 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\u2019ll be able to repeat the process.<\/p>\n
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.\u00a0 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\u2026<\/p>\n
Interestingly, relative to that last point, while your cash flow position may have gotten stronger, your balance sheet remained the same.\u00a0 Do you care?<\/p>\n
Food for Thought:<\/i><\/b> At this stage in my career the only reason I pay anything off is to free up leveragable equity and money for debt service\u2026<\/i><\/p>\nFinal Analysis<\/h2>\n
There are two reasons why we ever pay-off real estate debt.\u00a0 One is to create leveragable equity that we can refinance, blanket, or bridge in some other way into additional cash flow.\u00a0 And the other is to simply get rid of the debt and recover the minimum payment associated with it.<\/p>\n
With this in mind, there are two serious problems with the approach of paying simultaneously on all of the mortgages.\u00a0 While you do recover equity across your portfolio, the amount is not sufficient or sufficiently centralized to be able to bridge it with ease.\u00a0 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.\u00a0 Thus, the inability to bridge (leverage) equity with ease is one problem.<\/p>\n
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 \u2013 all that you are getting for your hard work is equity.\u00a0 Equity, as you know, does not put bread on the table, so from where I sit this entire process is rather meaningless\u2026<\/p>\n
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!<\/p>\n
Thoughts?<\/p>\n