Reinvesting cash flow or focus on principal pay down?
Most Popular Reply
Russ SmithPro Member
Rental Property Investor · Clearwater, FL · Member since 2017 · 36 posts · 70 votesThe best way to answer this question is to know yourself. Know your goals, know your investment objectives, and know your risk tolerance. You seem like a pretty conservative investor, so don't let a super-leveraged investor tell you that you're making a bad decision by paying off debt. Of course you can grow faster and achieve higher returns if you're willing to leverage up but you also have to sleep at night. If your objective is to become the next Blackstone or Berkshire, then don't pay off debt. If you just want a half a dozen free-and-clear rental properties to supplement your retirement income, then pay them off (especially if deals are hard to come by or the numbers don't make sense).
There are many people on BP that haven't been in the real estate game long enough to have weathered the 2007-2008 storm with substantial real estate holdings, so be leery of taking advice from these people when it comes to risk and leverage. Everybody looks really smart when the market just goes up and up, but throw a 25% correction out there and many of these highly leveraged people will be busy dealing with foreclosure proceedings and short sale negotiations. Then in a couple of years, Josh and Brandon can do a podcast with them and they can explain to you how they lost it all and had to start over.
Best of luck and do what works best for you!
33 Replies
- Investor · Columbus, GA · Member since 2014 · 2k+ posts · 1k+ votes9y
Both are wise decisions. Increasing your portfolio increases your income (offense) and paying down/off rentals reduces your debt exposure and your debt : income ratio (defense). I recommend increasing your cash flow, then using it to pay off the smallest debt (debt snowball). Ask yourself: What would happen to my cash flow if one of my rentals was completely paid off?
- Investor · Yorba Linda, CA · Member since 2013 · 27 posts · 40 votes9y
Good question and one that I have recently answered for myself. This is a personal decision that you, as an investor, need to answer for yourself. It depends how aggressive you want to be (risk tolerance) and what your personal financial goals are. Personally, I have decided to pay down principal and open a line of credit on the property I am paying down. That way, I still have access to the equity if/when I find a deal I can't pass up.
- Rental Property Investor · Philadelphia, PA · Member since 2015 · 213 posts · 160 votes9y
My view is always numbers and risk based. If you believe you can achieve a higher return reinvesting those cash flows than what you are paying on your debt (which you should be) then do not pay down your debt.
Alternatively, this does open you up to some risk. It probably is not prudent if you own 3 properties, and financed each with FHA loans (if you lived in each for one year) and have only accumulate 5% equity in these properties. Should a downturn occur and for one reason or another you are forced to liquidate, you would want more equity built in so you aren't underwater. Most people though have more equity than this, so my personal view is reinvest those cash flows. It's an exponential effect.
- 9yHanan K.Atlanta · Member since 2017 · 50 posts · 38 votesOP
@Charles Kennedy Good point. I should haveexplaines that the properties have healthy equity positions - 25-35%.
- 9yHanan K.Atlanta · Member since 2017 · 50 posts · 38 votesOP
@Nate Waters That's a really good strategy. I'm so torn. A part of me (the more risk averse part) is more inclined to focus on debt paydown and stabilizing and preparing the portfolio for fluctuations in the market. My entrepreneurial side says keep investing. Your strategy kind of meets me in the middle. Thanks for your input.
- Rental Property Investor · Philadelphia, PA · Member since 2015 · 213 posts · 160 votes9y
@Hanan K. In that case. I would be reinvesting. The tricky part with real estate is there's much higher barriers to entry than the stock market where you can buy some stocks for literally pennies. So you can't immediately take your cash flow from RE and invest in more RE. What I'd do if I were you is put a portion of your cash flows in the market and another portion in a high yield savings (can get 1.3% w/ CIT bank) until you've accumulated enough for you next down payment.
To reiterate my point before, let's give you an example:
Say you get $10,000 in net income from your properties each month. If you took that and paid down your debt, you'd be reducing your principal $10,000 and effectively saving yourself from paying $410 in interest (assuming a 4.1% interest rate based on your spread). A penny saved is a penny earned, so you're making $410 by paying down principal.
Now alternatively, I don't know what your return targets are, but say you make 12% on that instead by investing in RE: you've made $1,200 instead (both of these examples are over a year's period of course).
Just view paying down debt as another way you are "investing" and it's easy to see the clear choice.
- 9yAmy KendallBusiness MemberReal Estate Broker · Lehi, UT · Member since 2016 · 397 posts · 318 votes
@Hanan K. I think it really depends on what your long term goals are. Before I had a specific goal in mind for my rental income, I was focused on paying down my first two properties. Then, I discovered BP and decided I wanted to increase my portfolio and returns. Leveraging is the quickest way for me to achieve my long term goals for now. I will, however, start paying down my loans again once I reach the cash flow/month that I want. So, if you have reached your cash flow goals and are happy with your portfolio, then I would recommend starting to pay down your loans. You could always access that equity later if you change your mind and decide to grow your portfolio again.
- 9yAnthony GaydenPro MemberRental Property Investor · Omaha, NE · Member since 2014 · 2k+ posts · 3k+ votes
I don't see the benefit of principal pay down. To me it is just one of those things where people want some sort of feeling of security. There is no such thing as total safety and security and leverage/appreciation will accelerate your wealth building.
It might be that my cash flow and wealth goals are much higher than the average person's.
- Member since 2016 · 13k+ posts · 12k+ votes9y
Reinvesting your cash flow will increase returns. Paying down a mortgage reduces a properties "true" cash flow ultimately turning the property into a liability.
If you do not want to reinvest in real estate you should still keep you leverage as high as possible and reinvest your cash flow in some other passive vehicle such as income funds. Leaving cash sitting dead and buried in a property is not a investment.
If maximum returns are of no interest or concern then parking cash in a property is as good as a safety deposit box aside from the potential lose due to a market shift.
- Orange County, CA · Member since 2017 · 36 posts · 24 votes9yI would look at all of your assets as a portfolio with a target asset allocation mix. Create a net worth statement. There's a pretty good tool for this on the Dough Roller website. Sounds like you have about 500-600k in equity in real estate. Look at what you have in stocks, bonds, 401ks, etc. Look at what you have in other assets (businesses, any valuable art, etc). And, of course, look at cash on hand with a target rainy day number in mind. Re-evaluate your asset mix at a set interval (perhaps twice a year) and invest excess cash to "rebalance" to your target mix. From the perspective of debt paydown versus leverage, I know a lot of people on this site will always say to leverage to the hilt. In theory, that is the best way to add velocity to income growth. It can become a house of cards at a certain point if/when there is a correction in both housing and equities markets. There is nothing wrong with paying down debt, if that is what you choose to do. You could also consider capital improvements to one or more of the properties that will increase income and value rather than adding more properties to the portfolio at this time.
- Real Estate Investor · Encinitas, CA · Member since 2016 · 3k+ posts · 3k+ votes9yHanan Kim In your situation I wouldn't do (extra) principal pay down. Your rates are low, they are 30 year fixed, etc. Keep your "cheap money" as long as you can. It's a little different dialogue if you had a commercial loan that was going to reset in 5-7 years. Lowering the balance does help future cash-flow when inevitable refinancing occurs.
- Member since 2016 · 13k+ posts · 12k+ votes9y
To put Andrew's statement into black and white. If we assume the opportunity value for investors is 10% ( a reasonable expected return) on cash then paying down a mortgage of 3.5% - 4.65% is costing the investor a lost income of 6.5% - 5.35%.
If on the other hand you deduct a 10% return on your equity directly off the top of your rental income before any other expense deductions it is apparent any property will become very quickly cash flow negative as a mortgage is paid down turning the property itself into a liability.
It is a win/win instead to reinvest the cash flow anywhere else with a reasonable return especially if that cash is accessible in the event of a future need.
- 9yHanan K.Atlanta · Member since 2017 · 50 posts · 38 votesOP
@Charles Kennedy Thanks for the detailed response. My husband and I both earn good W2 income and are essentially house hacking - so our expenses are very low. We are saving around 10-12K per month and could essentially come up with a 25% down payment every 10-15 months (depending on the price of the home). I just worry we may be putting too many eggs in one basket if that makes sense. We do max out our 401K options at work but other than that have stayed out of stocks.
I hadn't really thought about it in terms of interest savings vs. investing opportunities and you laid out a good point. I was more focusing on risk elimination since we are undoubtedly due for a market correction at some point. I think I may follow your advice and just wait for the next killer deal. Thanks again!
- Investor · Pulaski, WI · Member since 2015 · 5 posts · 6 votes9y
What is your smallest loan amount on your rentals?
- 9yHanan K.Atlanta · Member since 2017 · 50 posts · 38 votesOP
@Vitaliy Bondar 450K on a SFR with an ADU valued at 725K - purchased 2.5 years ago.
- Investor · Pulaski, WI · Member since 2015 · 5 posts · 6 votes9y
I'm a firm believer in minimizing risk (paying off debt) and therefore going slower route in building wealth ... I know how it is to not have debt- frees up a lot of possibilities and you sleep better. (I know I could be odd ball here)
- 9yHanan K.Atlanta · Member since 2017 · 50 posts · 38 votesOP
@Vitaliy Bondar Not odd at all! I've always been taught to avoid it and have been able to get the properties I have specifically because of my low DTI and the equity positions in our homes. You are correct that it fees up possibilities and helps us to sleep better. Thank you for your input.
- Rental Property Investor · Philadelphia, PA · Member since 2015 · 213 posts · 160 votes9y
@Hanan K. Best of luck! Keep me updated. I love the fact that you guys are saving 10-12k per month and still house hacking. Too many people have their expenses rise with their incomes, you guys seem to be setting yourselves up well.
- 9yRuss SmithPro MemberRental Property Investor · Clearwater, FL · Member since 2017 · 36 posts · 70 votes
The best way to answer this question is to know yourself. Know your goals, know your investment objectives, and know your risk tolerance. You seem like a pretty conservative investor, so don't let a super-leveraged investor tell you that you're making a bad decision by paying off debt. Of course you can grow faster and achieve higher returns if you're willing to leverage up but you also have to sleep at night. If your objective is to become the next Blackstone or Berkshire, then don't pay off debt. If you just want a half a dozen free-and-clear rental properties to supplement your retirement income, then pay them off (especially if deals are hard to come by or the numbers don't make sense).
There are many people on BP that haven't been in the real estate game long enough to have weathered the 2007-2008 storm with substantial real estate holdings, so be leery of taking advice from these people when it comes to risk and leverage. Everybody looks really smart when the market just goes up and up, but throw a 25% correction out there and many of these highly leveraged people will be busy dealing with foreclosure proceedings and short sale negotiations. Then in a couple of years, Josh and Brandon can do a podcast with them and they can explain to you how they lost it all and had to start over.
Best of luck and do what works best for you!
- Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes9y
This is a great pay down vs growth discussion!
Although I am very debt-adverse with no consumer debt and 19 paid off doors, I draw the line with fixed residential debt at 5% or below. I can just beat that return too easily. I'm refinancing into a 15-yr @ 4.25% on one rental as we speak. Could have just paid that off, but golly jee. 4.25%? Sure, I'll take the extra $40k cash-out if you want me to.
The ones I paid off were commercial loans that are higher risk and kept bothering me for my financials every year and older residential ones above 6%. One was 7.9! Others were seller-financed deals with older sellers. I was locked in and secure, but didn't want to deal with confused heirs someday on top of the higher rates.
I'd keep this sweet long-term, fixed rate debt that doesn't bother you. You can always save up the cash and pay it off if you don't find a better use for the money @Hanan K.!
- 9yHanan K.Atlanta · Member since 2017 · 50 posts · 38 votesOP
Thank you for adding balance and clarity @Russ Smith. I was there in 2007-2008 and watched my real estate investor friend's portfolios collapse one by one. It's a scary thing to witness first hand and it really motivates you to try to be conservative while not inhibiting growth at the same time.
- Rental Property Investor · Sioux Falls, SD · Member since 2015 · 9k+ posts · 18k+ votes9y
@Hanan K. great question and I love hearing all different views on this subject!
if you are worried about risk, then I would recommend putting money into an emergency fund. If the fund is large enough to carry mortgage payments for a period of time, then the loans are little risk. The disadvantage of paying down/off your mortgages is that the cash is lost. Lets say you have a $1500 payment and you pay off half the loan, the payment is still $1500. So that means in an emergency you don't have cash and still have a payment.
Another thing to consider with rental property mortgage interest is the tax deduction. Lets say your tax bracket is 25%, then with the deduction it essentially reduces a 3.5% interest rate to 2.625%. Of course don't take out a loan just for the deduction, but it does need to be considered when paying off loans, because your taxable income will increase.
Annual inflation rate ranges from 1-3%, which means a 3.5% loan is close to getting free money. Inflation decreases the value of your dollar, so you are paying back your loan in the future with dollars that are worth less. For example, if inflation is 2%, a dollar loaned today paid back next year is paid back at $0.98 buying power. What does that mean? On a $100,000 loan at 3.5% over 30 years you will pay $61,656 in interest. Based on 2% annual inflation, $100,000 today will be equal in buying power to $177,000 in 30 years. Consider that when rushing to pay off low interest loans.
It is also important to evaluate where the money would go if it wasn't being used for mortgage pay down. If you are reinvesting it into another rental property down payment, you can probably expect double digit returns. If you are holding it in your checking account, you can expect under 1% interest rate. Something as simple as high yield dividend stocks can easily get you over 5% annual return. I am not even talking about risky companies. For example, I own ATT which returns over 5% annually since I purchased it. I am just saying it is pretty easy to get over 5% return with low risk, so it makes it hard to justify paying off any loan under 5% rate.
In the interest of disclosure, I have three properties paid off through mortgage acceleration. It feels great to own something free and clear, so from an emotional standpoint I see the value. However, using leverage has been the greatest tool to increase my wealth. There is no right answer. Just try to look at it logically and make the best choice for your situation.
- 9yHanan K.Atlanta · Member since 2017 · 50 posts · 38 votesOP
Thanks for the thorough response and analysis @Joe Splitrock and @Steve Vaughan. You both brought up very good points on interest rates, inflation and tax deductions!
It's been very interesting reading and considering all of the of the different views on this subject. In the end, I've realized my goals are 1) Financial stability 2)Growth. With that being said, I like the idea of creating a larger emergency fund we can draw upon if we find another killer deal that we just can't pass on. Also, should we endure another market correction, atleast we would have the funds to carry out any mortgage obligations in the unlikely event we face increased vacancy (very uncommon in my area). We will also be in a better position to take advantage of lower prices. Thank you both for your input! Much appreciated!
- Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes9y
Sure @Hanan K.. It's tough to wade through all the opinions sometimes on this issue.
It's weird having 6 figures+ in an account earning nothing, but your options blow up. Talk about choices! I was originally waiting on a couple specific sellers to get off the fence is how I got there, but then decided to pay off a small mortgage with a high rate and leave the rest for dry powder in case an opportunity came along.
I was refinancing a rental house out of a seller-financed deal like I mentioned when the lender said "you know, if you were to pay off that $64k commercial loan you have over there, I can get you a much better rate and term + cash-out with no additional costs." It had a $1696/mo payment and was affecting my DTI a little bit.
So I stroked a check for that and gave the satisfaction to my wife for our anniversary. Freedom. Still have plenty in reserves. I wouldn't have had as many options if I'd sunk all into a great mortgage all along. A half-paid off mortgage still has the monthly obligation as @Joe Splitrock mentioned.
Maybe save it all to pay in one lump-sum. At that time you'll know if it's the right decision or not.
- Rock Star Extraordinaire · Northeast, TN · Member since 2015 · 10k+ posts · 16k+ votes9y
@Joe Splitrock's post is a great explanation of your considerations! I'm pretty conservative financially but that is the same way I approach any kind of low-interest, fixed-payment debt: amass the funds and then do what you want. Back when I had student loans, I let the subsidized balance sit and gathered up funds, and when I was finished with school and lost the subsidy I payed them off in full. Best of both worlds!
Skyline Properties
Join the conversationCreate a free account to reply, vote on answers and follow this thread.