Scottish tradition holds that homeowners paint their front door red to signify they just paid off their mortgage. And who wouldn’t want to show off that major financial milestone?
One of the best ways to pay your mortgage off is to make extra payments on it. Even just two extra payments a year can make a huge difference.
But how do you know if you should make extra payments on your mortgage or keep the cash for another investment?
I have a finance degree, and I’ve been investing in real estate and helping finance real estate investments for other people for over a decade. I understand the pros and cons of both methods.
But you can’t account for emotions on a spreadsheet!
Let me explain.
In college, we would run all kinds of analyses on how to optimize liquidity while optimizing your returns on investments (aka putting that cash to work). What we didn’t analyze in college is a family ski trip.
Right now, my wife and I are diligently saving for another rental or a property to flip. However, we really want to take our kids skiing and snowboarding, and they aren’t getting younger.
Even if you are single with no kids, you might be having similar debates choosing between investing in another property or going on a vacation.
So the mortgage payment question isn’t an easy one to answer, but let’s discuss the pros and cons.
Reasons to Pay Down Debt
1. Lower Interest Expenses
Interest is mitigated when you pay down debt. Over the life of a loan, you will save a ton of money by making extra principal payments. For example, if you had a $100,000 30-year mortgage at 4.5% and paid an additional $100 per month, you would save $26,377.36 in interest expense over the life of the loan.
2. Faster Equity
In the example above, you would also save 102 months worth of payments, which of course, gets your house paid off faster.
3. More Flexibility
When you have a paid-off house, you have options such as a line of credit. Generally speaking, you cannot get a home equity line of credit (HELOC) on an investment property. If it’s your personal house, you can get a HELOC. This can be a great tool if you need cash fast.
If your rental home is paid for, you also have flexibility with whom you rent to. For instance, you could let someone stay in a rental for free as part of a mission project.
4. More Cash Flow
This benefit comes only after you pay off a property. However, if you make extra payments, you can refinance a lower balance and also receive the benefit of more cash flow. The most benefit will come from having a property paid off. However, you can enjoy an incremental cash-flow benefit if you refinance a lower principal balance with a lower interest rate.
Downsides of Paying Down Debt
1. Sacrifices Liquidity
There is comfort in holding onto cash.
Let me use an example. Say you have $10,000 in your investment property checking account, and all your properties are rented out. You have a total of $600,000 in total debt, but the smallest loan is $30,000. Do you want to use that $10,000 to try to pay one-third of the balance on the $30,000 note? If it’s a fixed-rate note, the payment will not change, so you are using all of your liquidity for something that won’t give you any cash-flow benefit.
2. Fewer Tax Benefits
You can write off the interest expense on your taxes. You cannot write off the principal payments.
3. Slower Growth
By paying down debt, you are using your cash that you could put down on another property. This is the biggest negative in my opinion, especially if you’re trying to build a real estate investment company fast.
Essential Things to Do
Regardless of what your personal strategy is, I highly recommend all real estate investors do the following:
1. Establish an Emergency Fund
This should be an entirely separate account. I highly recommend you have at least three months of expenses in this account.
2. Pay All Bills
Your reputation as a landlord will diminish quickly if you don’t pay your subcontractors, taxes, and utility bills.
3. Pay Off High-Interest Credit Cards
I actually have some friends that buy real estate with credit cards (this is another blog post!). However, you shouldn’t leave these outstanding balances. Credit cards are meant for short-term credit needs. If you need a longer-term solution, try refinancing your real estate debt to include your credit card balances so you can pay off your credit cards.
What about Re-leveraging or Refinancing?
You aren’t really growing equity if you keep re-leveraging a property.
Also known as a “cash-out refinance,” typically, you buy a property with some cash down and some debt. You spend money renovating the property. This is when a lot of investors get another appraisal on the property and put more debt on the property, since the property typically appraises higher. I’ve used this strategy to grow my rental portfolio. However, years after I did, a fellow real estate investment warned me to stop.
He had a good reason. He bought a duplex in Los Angeles in the early 1980s for $200,000. Two years later, the property was worth $400,000, and his investment partner wanted to do a cash-out refinance. The market tanked soon after, and all of their equity was wiped out after they did the cash-out refinance. They ended-up selling the house and breaking even. He told me today the property would be worth well over $2 million.
This is an extreme example (as most case studies are with California real estate), but his point was valid: you aren’t really growing equity if you keep re-leveraging a property.
Have a Written Plan
I highly encourage you to write out a plan for your real estate investing. Begin with the end in mind. For instance, if your goal is to have 10 paid-off rental properties, write that down at the top of the page.
Then give yourself a timeline to achieve this goal. Have a yearly goal to achieve the ultimate goal.
I’ve chosen a combination of the strategies above. Right now, I am committed to growing a rental portfolio, and I understand that is going to take capital—both cash and debt. However, I have also given myself a deadline. When I turn forty, I’ll start paying properties off as fast as I can.
For me, this strategy is optimal because it combines the growth that debt provides, and the equity and cash-flow in my retirement years that not having debt will provide.
I really look forward to hearing everybody’s comments and critiques in the comments.