Pros and Cons of Paying Off a Loan and Not Paying off a Loan

4 Replies

Hi all, my name is Michael and I am a new member here on BP. 

I have a question that I am hoping someone can answer- 

Why do some people advocate that you never pay a loan down because a loan is a wealth generator? I know that a benefit of paying off a loan is increased cash flow, but I am curious how not paying down a loan can also generate cash. 

In Brandon Turner's book "The Book on Rental Property Investing", he states that you have your tenants paying your mortgage for you, and that he could work a minimum wage job for the rest of his life and still retire a millionaire because of the tenants paying down the loan. I don't understand though? 

Hi, I am on the learning track right now and in looking for my first deal. But here is how I understand it.

Option one: Pay down your loan. You will have a much larger monthly cash flow. You will accumulate from your cash flow to make a down payment for your next deal. Minimal leverage.

Option two: leverage the loan. Make a smaller down payment on the house. Instead of rolling the cash flow to pay off the property sooner as in option one, you will save that cash flow to buy your second property, sooner than it would take you to pay off the loan and save for the second property in option one. Now that you have multiple properties, each adding up to a small cash flow then if they were all paid off, but you let the tenants pay off the property over time.

Many houses at smaller cash flows may take less time to snowball into few houses with the same house. Yes, more debt and leverage, but tenants pay that. Either way, you will build up the equity in the house sooner or later, creating your portfolio.

Hope this makes sense. Hope I explained it well.

@Eddie Aviles

I think that as long as you keep a positive arbitrage, the math will always work out in favor of higher leverage. Or in other words if your ROI is higher than the amount you borrowed (Borrow at 5% to make a 10% ROI) your net worth will always be bigger in the end.

However, If you are in need of cashflow now, then constantly leveraging is going to kick the 'cash flow' can down the road even further and may work against your goals.

Also leverage only works if you are actually getting the returns you need so it is higher risk.  I would only be aggressive with leverage if you were really comfortable with the actual investment and it was a lower risk opportunity otherwise it could all blow up in your face.

So if you go by the math alone- leverage, leverage, leverage. But some may want to take the safer road and be okay with not making quite as much.

The first rule of real estate investing (ok maybe not the first) is that paying down a mortgage does not increase cash flow it buy's cash flow. It buy's it at a very high cost.

You save the prevailing mortgage rate of say 5% but lose out on the opportunity value of investing it elsewhere at a higher return. It can never earn a penny more than the mortgage interest rate you paid off. If that mortgage was 4%  it is even a worse return/higher cost to buy that cash flow.

$100,000 borrowed at 5% costs $5000/year paid for by your tenants. If you paid down the mortgage you would be buying that $5K at a price of $100K. I personally do not invest for a 5% return.

If you invest that $100K in say a income fund you can earn 8, 10, 12% returns annually. Invest that $100K as minimum DPs on multiple properties and who knows what your returns will be. Certainly far greater than the prevailing mortgage rates. 

Here's more info on just the difference in paying cash versus leveraging, and why loans/leveraging is the ticket to wealth (just look at the numbers)-

And then for Brandon's comment, this article is specific just to that point but it talks about the streams of income on a rental property and references tenants paying down the mortgage for you. Might help put the concept into perspective?

If that doesn't answer it, reach out anytime and I can help.

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