Pay off mortgage or use leverage
Hi everyone. I was just curious your thoughts on the pros and cons of paying off mortgages early on investment properties vs using leverage and scaling to a larger amount of properties quicker.
#1 All Forums Contributor
- Investor
- Northern Virginia
@Brady Ascheman
The way I look at it is what’s the best use for that money. If my interest rate was 3% on that investment property I would not pay the mortgage off early because you cannot get $ that cheap and you should be able to invest and make more than the 3% you just paid off
If my rate was 8% then that’s a different story - I would pay off the debt so I have no debt on it
Depends on your personal situation and again - best use of funds
#3 General Landlording & Rental Properties Contributor
What is the interest rate and how much would you get if you invested that money elsewhere?
@Brady Ascheman, I think it's not that simple. Here is something that touches on it (because they often are optimized at the expense of the other): https://www.biggerpockets.com/forums/12/topics/1130689-how-t...
Quote from @Brady Mullen:
@Brady Ascheman, I think it's not that simple. Here is something that touches on it (because they often are optimized at the expense of the other): https://www.biggerpockets.com/forums/12/topics/1130689-how-t...
More precisely, it's a comment in that post that addresses the income/appreciation dilemma we all face. Here's the text from it:
This is a simple way to look at it. Think of wealth in real estate in two categories.
Equity and Income (no surprise there).
What you have to come to terms with is that in most cases, you have to optimize for one at the expense of the other at any given time. This is especially true when interest rates are not in the 3's.
The name of the game will always be income eventually. Otherwise how can you stop trading your time for money? But the art is in planning when you want to optimize for income.
The best "returns" on your investment in real estate will likely come from appreciation using some leverage. For example, if you put 20% down, and the property appreciates by 5%, then you've achieved a 25% return on your investment ($100k down on a $500k property that appreciates to $525k turns your $100k investment into $125k of equity), and we haven't yet counted income or debt reduction. That's just the appreciation.
One might look at that and conclude that leverage is better than having properties free and clear.
But this is not the case. It's a question of timing.
Optimizing for appreciation (with leverage) will almost always create the best "return", but it doesn't usually create the best cash flow in the present. And you can't easily take monthly retirement income from equity, so you have to plan to optimize for income at the time you want the income.
When I'm 80, I don't plan to be aggressively building my RE portfolio. I'm guessing I'll want to be enjoying the income (maybe sooner). But I'm planning for income from quality debt-free real estate to be maybe 5% (this is a doable cap rate in desirable markets).
This is not the best "return" I can get, but when I optimize for income, the best return is not my focus.
So, in my humble opinion, the trick is to focus on overall return (best achieved by focusing on getting more equity using leverage) with an eye on when you want to focus on income. Grow the portfolio with whatever level of leverage I'm comfortable with, so that when I implement my mortgage reduction strategy to shift over to income, I'm doing so on a larger portfolio than I otherwise could have by trying to focus on income too early.
It's very common for people to want to invest in real estate with leverage and enjoy fantastic income right away. This is a generally a myth. But if you invest $500k into real estate with leverage, you could very easily turn that into a very healthy income later.
I pretty much agree with @Chris Seveney but would also say that even if your rate is a little higher than you would like but the property still cash flows then I would use my money to scale. Once that property is paid off that capital is "locked up" into that property and may be hard to get out until you sell.
#3 All Forums Contributor
- Rental Property Investor
Depends on risk tolerance, and when you want to make sure you're setting sail.
For the average person in the (ages 25-35), I would definitely re-cast and pre-pay a portion to get down to a 7-15 year mortgage all combined under an amount of monthly income you have already 15 months for reserves set aside. Then you're still able to pay that amount monthly without issue. Irrespective of rates, too. You're not an interest rate arbitrage trader; you're managing your livelihood. At that rate in your mid 30s to early 40s, your portfolio should be paid off. And you can decide how to get into retirement(20-30 years) later. If you want to sell some for reserves, keep the cash flow, etc. This whole let your tenant pay it for you, no let your tenant pay you. This is behavior, not entirely math.
Go see how much a $400k house with 25% down at 5.5% interest rate is in it's entirety of a 30-year note.