Put cash flow towards principle?

Accountant · Fargo, ND · Member since 2016 · 24 posts · 17 votes

This is something that I haven't seen yet as far as an investment strategy. I've thought about taking the cash flows from the rental and putting it towards the principle on the loan in order to expedite acquisition of equity as well as mitigate perhaps thousands of dollars in interest payments over the shortened term. Is this a sound practice, or is it not talked about because there is a better strategy?

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Joe VilleneuvePro Member

Plymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes

The quick answer is "no". You're an investor, not a property "babysitter". What you propose defeats the purpose of buying a rental.

1) You buy rentals for cash flow. If you're going to give the money right back, why bother?

2) Equity is a trophy on a rental. What is it good for...nothin'. You can't access it unless you sell it, or refi.

3) Here's the big one. You are not making the payments on the interest...the tenant is.

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Matt Finneseth
OP
Accountant · Fargo, ND · Member since 2016 · 24 posts · 17 votes
9y
Originally posted by @David Zheng:

Heres a simple example. assume values/rents don't rise or fall unless of a crash
scenario 1:
I have 100k
I invest all of it in a 100k SFH, and make $500 CF/month off of it after all expenses. in like 3.33 year I'll have 20k to put down on another 100k house and since this one is on a mortgage, I'll only make $150 CF/Month. This along with my fully paid rental will take like 10 years before I pay that one off. Now after almost 15 years from my initial investment, Ill have 200k equity in 2 properties with only 1k/month in CF.

damn the market popped in 15 years and my houses are only worth 50k each. shoot, now I only have 100k in value, and 1k/month CF
scenario 2 (leverage):
I have 100k
I buy 5x 100k properties and make $150 CF/Month per house. that's $750 Total/Month off the bat and overall I still have 100k of equity (5x 20k). After just 2.22 years, I'll be able to afford another 100k rental at 20% down. my CF goes up to $900 now and I still have 120k+ equity (obviously a little gets paid off over 2 years in the other 5 places). In only 1.85 years, I'll buy another at 20% down and my CF goes up to 1050 and I have around 140k+ in equity. Rinse and repeat! You'll hit your cap of 10 mortgages before 15 years and have at least 200k in equity, but ALSO CF of at least $1500/month.

crap the market pooped like in scenario 1, so your equity dropped to 100k but look you're still cashflowing 500 more per month than scenario 1.

sure there's more risk in vacancies with more properties, but honestly if you don't trust yourself to fill vacancies, you shouldn't be in this business in the first place.

Hope that helps :)
Thanks Dave! I appreciate your input.
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Justin Fox
Software Developer · Vidor, TX · Member since 2015 · 922 posts · 639 votes
9y
Say you buy a 120,000 home and rent it out. Your down payment is going to be ~24,000. It will take you ~11 years to pay off the remaining principal with only the positive cashflow (best case).
These examples don't include any appreciation and assume no rent increases.
The next month after payoff, you'll have 120,000 in equity, ~$850 in cashflow account and ~$850 per month in income from the property. You'll soon be looking for lenders to refi that equity out.
If you would have saved the cashflow and put down on another home at year 5.5, another year 11 (assuming same cashflow and no appreciation), you would have 125,691 in equity, $1,212 monthly income and ~$29,992 in CF account ready to invest.
I think of it in terms of the tenant is paying for the house plus income for me. The income the tenant paid me is technically their money, so they're also paying for my down payments and subsequent returns on both income and equity at no cost to me personally.
No one is saying to never deleverage. But paying off a property every 11 years to eventually refi into funds to put down on another property versus buying more properties and increasing your income and equity while diversifying your risk along the way doesn't even compare.
Your first two posts about fear of multiple properties due to vacancy and paying the loans off 20+ years early lead me to believe you were talking about SFH rentals (conventional financing), not large commercial apartment buildings.
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Jeff B.
Buy & Hold Owner · Redlands, CA · Member since 2015 · 5k+ posts · 2k+ votes
9y
Originally posted by @Matt Finneseth:

Originally posted by @Jeff B.:
Mortgage interest is tax deductible so figures based upon interest paid is nonsense.
I'm an accountant so I understand this. However, the keyword here is deductible. It is not tax free.
Don't MAJOR in the minors. Again, the axiom is to acquire assets. I'll not go further with you as your opinion is just that, your opinion and there's no merit badges in Opinions 101.
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Shawn Breyer
Rental Property Investor · Atlanta, GA · Member since 2016 · 37 posts · 9 votes
9y
The return on equity is zero. Your money would just be sitting in a property providing no returns. If you allocate those funds to save up for another property and can get 15% ROI, that would be the ideal thing to do, assuming you have reserves and assuming that you're in acquisition phase. If you're in own and pay down phase, obviously pay it off.
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Franklin Romine
Visalia-Fresno, CA · Member since 2009 · 1k+ posts · 863 votes
9y
Principle isn't a write off. A good balance between interest and principle payments is healthy...
Franklin
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Jack B.
Rental Property Investor · Seattle, WA · Member since 2014 · 1k+ posts · 1k+ votes
9y
If you're looking for a quantiative decision making point, you need to calculate ROI, IRR, etc. Putting more equity into a property reduces your rate of return. The rate of return also drops drastically when the house is paid off. To the extent you can in most cases make more money with 10 year treasury bonds than with a paid off rental house, dollar for dollar, with less risk and headaches.
Also, holding houses for decades is a bad idea IMO. If you are not flipping them every 3-7 years you will start to run into major capex that will eat a ton of profits. What you instead want to do is ride the equity up then trade the unit for a bigger and better deal using that equity, thereby releveraging to maintain the high ROI of say, 10% or 20%.
Also, there is still room for appreciation in this market (at least where I live) as supply is still tight. Using the cash flow to buy more property is more prudent as you can make more money off additional cash flow AND appreciation. This is what I've done over the last 6 years and on appreciation alone I made 150K this year unrealized capital gains. Add rental income, loan pay down, and my job to the mix, by myself I made over 350K this year. Why? Because I use money to make more money. Rather than buying houses cash or trying to get them paid off like I used to, I use my cash to buy bigger and better deals. Right now I'm letting my houses fatten up to buy apartment complexes.
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Jay HinrichsBusiness Member
Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
9y
Not to get into the fine points of the math... however I just look at some of my most well off business partners and associates and many of them have zero debt.. and they own substantial assets as in 5 to 10 million dollar multi families with Zero debt. 50 to 100 million net worths areas..
So really depends on where your at in your investment cycle risk tolarnce etc etc.
Totally protected from a melt down event that took down so many highly leveraged landlords back in 08 to 2010... I think there is a fine line there.
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Mike Dymski
Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
9y
Return on paying down debt = 5% (varies by investor)...pretty low return for an investor.
IMO, direct real estate investing is too much work to not earn leveraged returns. You can invest passively in others' deals or in other asset classes outside of real estate and earn a similar return for much less work.
As Jay mentioned, the strategy may change as you near retirement or critical mass and have already benefited from the accelerated returns due to leverage.
None have mentioned appreciation. You can own one $100,000 property free and clear or four $100,000 properties leveraged worth $400,000. With 3% annual appreciation, property #1 is worth is $175,000 after 20 years. The four properties are worth $700,000 after 20 years. The power of leverage.
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Phillip Kawecki
Fairfield, CT · Member since 2016 · 6 posts · 2 votes
9y
As many have mentioned, cash has an implicit opportunity cost. Paying down that extra 500 each month will generate you the return of your mortgage interest rate times (1-effective tax rate). At current rates that'll get you a pretty measly return. Instead of paying down your mortgage what else can you do with the cash? Most people here expect double digit CoC returns for their time in real estate so that is one viable option. If you're concerned with being over-leveraged, then I would argue using that money to invest in low-cost index funds or ETFs is a better employment of your free cash flow then pre-paying down your mortgage balance. Heck, I'm invested in several REITs that yield between 4-10%. There are other options available to you to invest that don't require increasing your overall leverage and are also quite liquid that I think you're better served in investing in than paying down debt. Also, as others have mentioned, the only way for you to access those pre-paid funds is either by re-leveraging yourself via refinancing or selling of the asset, which then requires you to invest in a new asset to generate some form of return.
1 Reply
Llewelyn A.
Investor / Broker · Brooklyn, NY · Member since 2016 · 665 posts · 1k+ votes
9y
@Matt Finneseth
Hi Matt. I just thought that I would go ahead and build a somewhat sophisticated Spreadsheet to continue your discussion. I will put it into several parts so I can clarify each part.
I thought that I would first Build the Scenario which sort of fits into your comments where you would take $500 of your Cashflow and put it towards your Mortgage. This is what I built for this scenario:
Now, we can refer to Columns and Rows and talk about Numbers which can easily be tweaked.
In this example, we Buy a Property for $100k for a Total Investment after some Renovations of $30k.
It generates $2k month Rents and has $1,064 of Monthly Expenses giving you an NOI of $936.
The Loan is for $80k at 5.125% for 30 year fixed so you are paying $436 per month.
The NOI minus the Debt Service of $436 = $500 EXACTLY.... what a coincidence!
Now, in order to demonstrate the reinvestment into the Mortgage Payment the full Cashflow, I built a fully Amortized Loan with a Pre-Payment of $500 per month:
We can calculate the FULL PAYMENTS by taking the $436 payment x 360 Terms and we get $156,812 which is in Cell P10. That would be IF you did not have ANY Pre-Payments.
Next, we will look at the calculations where we add the Pre-Payments.
In Cell P12, I summed up the entire V column or the Payments. We get $46,608.
Similarly, in Cell P13, I summed up the entire W Column and we get $53,147.
The Total of the Pre-Pays and the Payments AFTER applying the $500 per month Pre-Pays is $99,755. It will also take us only 8.9 Years as calculated in P18.
The Savings is $57,057 by taking the $156,812 of what would have been your full 30 year payments and only paying $99,755 in order to finish the loan in 8.9 Years.
I did it this way so I can show the Readers the calculations. This kind of Math is a GREAT Help.
Once we do this, we need to go a little bit further.
We need to ASSUME that AFTER the loan finishes, 9 Years into the Future, you will Sell the Property and receive a Sales Proceeds:
,
Just to summarize, let's say Matt bought the property in 2017. His initial Investment was $30k.
In 2026, 9 years later, Matt then sells the Property with ZERO appreciation for $100k, the price he bought it.
We can see that his total ROI is 303% in Cell O37. His Simple Average Annual ROI is 34% in Cell O38.
I don't like these Metrics particularly. I prefer the Rate of Return (RoR). His RoR will be 13%, still a really good Investment. (For those who want to see my Discussion on why CoCR should not be used over RoR, see this discussion: Cash on Cash Return versus Rate of Return )
Now this discussion can be continued and you can debate the Numbers by reference on the Spreadsheet snapshots I put in.
However, you can't complain about this Investment. It's a really good strategy if you wanted to Achieve a above 34% Average Annual ROI (or 13% RoR).
Now, if some of you can give us examples where you have done better, that would be helpful.
In my case, I do better but that's because my strategies are for both Cashflow and Appreciation. If you wanted to see how well I have done, then you should add me as your Colleague and then review my posts.
But there was a lot of discussion on the thread. However, I think I needed to clarify it as much as I can. If Matt wants to make some corrections, just add my name to your comment and I'll adjust the spreadsheet numbers and then this discussion can continue with some organization.
Investor Llew
2 Reply
Ralph R.
Investor · Bethel, AK · Member since 2013 · 1k+ posts · 852 votes
9y
Matt Finneseth Why do you want to increase equity? You can't spend it you can't invest it and your rate of return drops when a property is paid off. Use your existing property. Put the numbers in the BP calculator and see what your COC return is. Now take the loan out of the calculator and leave all the other numbers alone. You will see a HUGE drop in the COC. The goal isn't to own property but rather to generate wealth by putting your money to work for you. If we both had 100k. I would buy 5 property's using 20k down pmnt each. You buy 1 property and pay cash. In 30 years Imy properties will be worth 5 times what yours are. But if I keep pulling the equity out and reinvesting I will have a great many more property's than you. As to saving interest who is paying the interest you or your tenant?? If my property is netting me a 7% return and the bank is charging me 5% interest than I am still making 2 % on their money right? Equity is a double edge sword. Too much equity cost you opportunity. Too little and a market/rent downturn can wipe you out. RR
2 Reply
Brett Sorenson
Investor · Minneapolis, MN · Member since 2016 · 57 posts · 36 votes
9y
It all depends on alternative investments. If you are going to put that money in a savings account then yes...pay down principal.
If you have other purchasing opportunities worth taking advantage of then take advantage of those.
It is likely we will have interest rate increases followed by inflation so holding debt at less than 4% is a very strong investment strategy. As inflation goes up the "real debt" goes down because you are paying it back with inflated dollars. Of course this involves speculating on future inflation, however holding debt is definitely a strong strategy in the near term.
1 Reply
Matt Finneseth
OP
Accountant · Fargo, ND · Member since 2016 · 24 posts · 17 votes
9y
Originally posted by @Llewelyn A.:

@Matt Finneseth
Hi Matt. I just thought that I would go ahead and build a somewhat sophisticated Spreadsheet to continue your discussion. I will put it into several parts so I can clarify each part.
I thought that I would first Build the Scenario which sort of fits into your comments where you would take $500 of your Cashflow and put it towards your Mortgage. This is what I built for this scenario:
Now, we can refer to Columns and Rows and talk about Numbers which can easily be tweaked.
In this example, we Buy a Property for $100k for a Total Investment after some Renovations of $30k.
It generates $2k month Rents and has $1,064 of Monthly Expenses giving you an NOI of $936.
The Loan is for $80k at 5.125% for 30 year fixed so you are paying $436 per month.
The NOI minus the Debt Service of $436 = $500 EXACTLY.... what a coincidence!
Now, in order to demonstrate the reinvestment into the Mortgage Payment the full Cashflow, I built a fully Amortized Loan with a Pre-Payment of $500 per month:
We can calculate the FULL PAYMENTS by taking the $436 payment x 360 Terms and we get $156,812 which is in Cell P10. That would be IF you did not have ANY Pre-Payments.
Next, we will look at the calculations where we add the Pre-Payments.
In Cell P12, I summed up the entire V column or the Payments. We get $46,608.
Similarly, in Cell P13, I summed up the entire W Column and we get $53,147.
The Total of the Pre-Pays and the Payments AFTER applying the $500 per month Pre-Pays is $99,755. It will also take us only 8.9 Years as calculated in P18.
The Savings is $57,057 by taking the $156,812 of what would have been your full 30 year payments and only paying $99,755 in order to finish the loan in 8.9 Years.
I did it this way so I can show the Readers the calculations. This kind of Math is a GREAT Help.
Once we do this, we need to go a little bit further.
We need to ASSUME that AFTER the loan finishes, 9 Years into the Future, you will Sell the Property and receive a Sales Proceeds:
,
Just to summarize, let's say Matt bought the property in 2017. His initial Investment was $30k.
In 2026, 9 years later, Matt then sells the Property with ZERO appreciation for $100k, the price he bought it.
We can see that his total ROI is 303% in Cell O37. His Simple Average Annual ROI is 34% in Cell O38.
I don't like these Metrics particularly. I prefer the Rate of Return (RoR). His RoR will be 13%, still a really good Investment. (For those who want to see my Discussion on why CoCR should not be used over RoR, see this discussion: Cash on Cash Return versus Rate of Return )
Now this discussion can be continued and you can debate the Numbers by reference on the Spreadsheet snapshots I put in.
However, you can't complain about this Investment. It's a really good strategy if you wanted to Achieve a above 34% Average Annual ROI (or 13% RoR).
Now, if some of you can give us examples where you have done better, that would be helpful.
In my case, I do better but that's because my strategies are for both Cashflow and Appreciation. If you wanted to see how well I have done, then you should add me as your Colleague and then review my posts.
But there was a lot of discussion on the thread. However, I think I needed to clarify it as much as I can. If Matt wants to make some corrections, just add my name to your comment and I'll adjust the spreadsheet numbers and then this discussion can continue with some organization.
Investor Llew
Thank you for contributing the due diligence! I am interested in running the numbers on using the CF to purchase more rentals to see just how better (or worse) it is to maximize the quantity of properties CFing in your portfolio.
1 Reply
Justin Fox
Software Developer · Vidor, TX · Member since 2015 · 922 posts · 639 votes
9y
@Matt Finneseth
Just use the CAGR for each hypothetical. One for a single home paid down aggressively with the CF and another where the CF is banked and used to put down on similar properties when you reach the same or more for a 25,000 DP amount
You'd take the initial investment, any paid down principle and cash-reinvested, sum it up and the end of the term and plug it into CAGR = [(Ev/Bv)^(1/years)] - 1.
I ran some numbers on a 125,000 house, 20% down. The cash flow was 400/month. Year three there was a #20/mo rent increase (no expense increase) and same for year eight.
The example with only one house with aggressive pay down was 14.25% and the example with reinvestment into other streams was 17.81%. The differences are not only 3+ percentage points higher, but $26,530 ready to invest for the 11th year, a higher monthly income (~800.00 vs ~1300), $7,896.69 more equity from tenant pay-down and much more risk diversity going to the reinvestment strategy.
If the first example sold (no closing/commission included), there would be: $94,716.00 (87,966 after 3% comm and 3500 closing)
If the second example sold (same), there would be: $128,772.95 (108,522.95 same)
Wouldn't this be a better metric to use since there is no risk or known loss break down during the term and since the cash flow is being re-invested back into the same asset class by principal pay down (regardless of amount of properties)?
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Joe VilleneuvePro Member
Plymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes
9y
It's not about how much you save on expenses each month, it's about how much you move forward each exponentially each month.
When you pay off your property, you will have saved all that interest over a period of maybe 30 years (I know, you paid it off faster, the interest cost was factored over 30 years, thus setting the total saved amount). There's a limit...and a small one at that, that you can save, and that savings isn't realized until the END OF THE LOAN PERIOD.
Now, here's the most important part. You are not saving anything. You are spending it. All you have to do to understand this, is follow the direction your money is going. It's going away from you. When you took it as cash flow, it was coming towards you.
1 Reply
Michael Lee
Investor · Coppell, TX · Member since 2008 · 2k+ posts · 646 votes
9y
Hello and welcome to BP! All you need is another opinion from another person but I have some thing to say. I am 60 years old and have a bunch of opinion. Of course, your goals, if any exists, will advise on what to do. If you are open to other's opinion then here it is. Using any money saved that you do not need over your personal expenses for a while should be used to get another real estate investment using all the money of others that you can to buy real estate. Yes, take advantage of the low rates and make long time decisions by owning more rental units. Any rental complex that puts money in your pocket and business that adds equity to the bottom line is a good investment. There are many tax options and benefits in owning real estate.
Again, your goals matter in your planning. Tracking everything that you do and reviewed regularly will help your business grow and do better by decreasing expenses and gain income on what you allready have. Keep it simple and do not try anything different. I hope this helps.
Good luck to you!
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