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Updated over 9 years ago, 07/03/2015
cash flow vs paying down mortgage
hey everyone,
I just had a general question that I've often thought a lot about and thought I'd pose it to the BP community.
Before deciding to get into real estate, I had always considered the real benefit of owning and renting out properties to be the fact that you have your mortgage paid off for you. After a couple years of renting a place out... POOF! you have some equity that you didn't have to pay for yourself (assuming a stable market).
But after having gotten into the community, it seems like the only thing anyone ever talks about is cash flow. The large majority of investors seem to completely avoid a property that won't cash flow decently. The idea of having a mortgage paid down isn't even an afterthought. It's like that benefit doesn't even really exist! I have come up with my own answers to this question but i wanted to hear peoples thoughts.
You cant spend equity. The grocery store or the local restaurant doesn't take it. They take cash. Cash is king, having cash flow for expenses, cash for reserves, cash to do deals are all important concepts. Having net worth ties up in equity in a relatively illiquid investment may do you no good when you need it.
Of course mortgage pay down is an advantage in real estate. It can be a real wealth builder over time. However if the choice is equity build up or cash reserve build up, cash reserves win every time. Only you can make the decision of how to weigh mortgage pay down vs cash flow, given your unique financial situation.
Money received today, is worth more than money received tomorrow.
I personally agree that mortgage debt reduction is one of the great benefits of owning income property. And combined with depreciation, this allows us some great tax benefits.
Because of the way loan amortization works, most of our interest charges are paid early in the mortgage and very little principal is paid until late in the loans term. So unless you keep a property for a long period of time, and never refi, you won't see tremendous principle reduction. If you do commercial loans, with 5 yr renewals you will never see more than a minimal principle reduction.
Because of this I would not count loan principle reduction when analyzing a buy and hold deal. But either way we still get to realize this benefit at some point in ownership. I just don't use this as a metric to analyze a deal.
Lets look at it this way, if you had the option to purchase a property with a 20 yr conventional mortgage, or a 20 yr interest only loan, assuming the same interest rates. The 20 year conventional property would cash flow around 200/month, and the interest only loan would cash flow at nearly 400/month. ( I can spreadsheet this if you like, its my quick morning math) Now the 20 yr conventional would have principal reduction, which you could realize someday. But the I/O loan is giving you nearly twice the monthly cash flow. Which creates an immediate opportunity for you to reinvest the additional cash flow elsewhere today, whereas the equity from principle reduction can only be accessed if you sell or refi. At which time you will usually be paying closing cost that will eat up some portion of your realized gains.
At the end of the day each investor has different requirements, some will care more about cash flow than others. My current goals have changed from when I started 4 years ago.
But lets not confuse this with appreciation. These are 2 completely different animals. I do not give any consideration to appreciation.
Thanks @Chris Adams and @Ned Carey that definitely makes sense. For whatever reason it's taken me a while to completely understand that. I've realized there isn't really any middle ground there...you're either cash flowing, or you're negative each month. So the emphasis on cash flow makes sense as well if anything to just avoid going negative.
@Ned Carey Not sure why your tag didn't pick up.
What do you guys think about applying all your profit from one year of rental income to the your mortgage with the highest interest rate the following year?
I would also add that equity from rental properties can often be fictitious particularly when you consider the equity build required to pay selling costs. Also selling a rental is not as easy as an owner occupied. Valuations are all over the place. Cash flow is in your pocket today and can be reinvested tomorrow.
@ Chad Lopes
Do you think its better to use the cash flow for another investment rather than pay down principal? There has got to be a mathematical formula to this...
Originally posted by @Brandon Pearsons:
What do you guys think about applying all your profit from one year of rental income to the your mortgage with the highest interest rate the following year?
I'm not a fan of this unless you are completely paying off the mortgage. If you pay down the balance on a fixed-rate mortgage, you are shortening the note. However, if you find yourself in a crisis, you won't have the cash to get out of it. Instead, you should save up the full amount before paying off a mortgage. This preserves your security and it gives you options to attain further cash flowing properties. Either way, set a floor on the amount of cash you hold. You always need that emergency fund.
Originally posted by @Brandon Pearsons:
@ Chad Lopes
Do you think its better to use the cash flow for another investment rather than pay down principal? There has got to be a mathematical formula to this...
While you could always compare the different returns on investments, this is ultimately a matter of knowing what your goals are. You have to determine what is better for you. If you are undeterred by that logic, then go with whatever yields the higher return.
@Josh Butler I agree that it seems very counterintuitive!
@Paul Wurster I agree with That it depends on your goals. If you are planning on continuing to grow your business then it makes sense to have as little of your own money in it and let other people's money (tenants and banks) work for you. That way your money is there to live on and fund other deals with. Many people refi out equity every few years to do more deals - our hope is to let the equity grow and have paid off properties that will have high cash flow in retirement.
I like the idea of a hybrid approach throwing a HELOC in the mix for down payments and available reserve funds, plus, as you pay it down your monthly payments go down as well. (And your cash flow increases)
I think it's crazy when you hear realtors and other real estate professionals tell you that the goal on an investment property is to "break even" in my mind breaking even is losing money!
I like some mortgage paydown as part of the equation but you need to consider what does the money cost you? There is no point in paying down cheap money even if you can. It is better to take the cash flow now and do something with it that yields a better return. However, I don't like interest only loans. They count on appreciation to let you recoup your money if you sell a property. Also they don't let me sleep at night. In the end that comfort level is a deciding factor.
Hello,
I know what you all are saying cash is king, but here is the the equation.
I owe 70k on this particular property at a 5.2% interest rate . . If I pay it off from cash flow from other properties in the next 6-7 years. Then I will be seeing an extra $500 a month in rent because I have no loan. Does this make sense to do?
Hi all,
Reading this I think it all depends on your goals when purchasing the property. When we bought the 4 unit (now 5) multi-use building, it was to live in it for awhile. Now after 14 years, a couple of Refi's & paying extra on principal, we will have a paid off a now 7 figure valued building.
During almost the entire time, we have paid from $325 - $1,500 extra on principal, and have also had Cashflow ranging from $700 to now about $1,600 AND we still live in the 2 bedroom unit with all utilities paid by the tenants. Mortgage balance on a 30/7 - 5.15% is about $65k. Will have it paid off in about 2 more years and this will free up the $907 mortgage payment plus the $1,500 extra on principal - for a $4,000 a month steady chunk of change.
SO it can be done, but NOT if you put 5% down - we originally got a property on a Double 1031 exchange - he got our small 1 bedroom condo & we got the full value of it toward the purchase price, about. Complicated but cool. we were lucky in some respects, but ultimately, hard work, nose to the grindstone & living simply well within our means does it for us. I might add we have a house on the coast also for getting away from the busy & noisy city.
JQ
@Brandon Pearsons Personally I would buy a few more properties, get them all cash flowing to some extent and then start paying off the smallest balance. As each loan is paid off it frees up more cash to put down on the next property. The idea is to pay them all off in a few years then start buying more with cash.
If you always buy more and never reduce debt then any economic downturn becomes very stressful. If you pay a few of you have enough cash that the economic downturns become opportunities.
@Bob E. describes the school of thought that I subscribe to. This is for one reason only; I only use RE as a supplement to retirement savings, thus I prefer a lower risk option. I fully understand that by keeping properties paid for, I limit the amount of available cash to put to use on a moments notice, but my preference is long-term equity, not immediate cash flow. Managing risk is a priority for me, so I like the debt pay down strategy.
Cash flow can be BS. Networth is all that matters.
I can't speak for everyone but I've personally known a lot of investors that invest in garbage properties because they can cash flow them. What I consider a garbage property is a property in a location that won't allow for much appreciation, or a property so screwed up that it will hardly appreciate (a property with a major flaw such as totally screwed up structural issues)
Networth can be created by 3 things.
1 Cash flow that is saved.
2 Appreciation
3 Equity through paydown of a mortgage
Some investors only focus on #1. The fastest way to real wealth is to focus on all 3 at the same time.
The only time I'd recommend buying a garbage property that will cash flow is if you have immediate short term plans to reinvest that cash flow into a property that will appreciate and you should me moving as quickly as you can into building equit through mortgage paydown. Eventually you should move totally away from any properties that will not appreicate. If the cash flow only properties are a short term stepping stone that's fine, but wealth is only measured in equity.
At the end of last year my partner and I looked at a lot of ways to grow our business and what our end goal was.
We decided that we wanted 50 properties or notes cash flowing $400 a month each, 20k net, split two ways. Our plan said we could do it by 2018/19 with some additional investment this year. Due to some personal issues we decided we would have to hold off on putting the additional cash into the business for at least a while.
At the end of last year we had 6 1/2 properties in this pipeline. Two were cash flowing the others were coming on line over the next several months. Our goal for this year was to double that number to 12. So far we are on track to do so WITHOUT the additional investment and with the only debt being 28k split between a Visa Card and a Business LOC (mostly going to support an aggressive rehab schedule). It is a huge relief not to have a huge loan hanging over us, we can flip some of the higher priced properties that would not meet our rent / ROI criteria and we will have the cash to hit our growth target for this year. If things free up for us an we put in the additional capital latter in the year we will triple this year without debt.
I won't say that we don't worry about an economic downturn but with the limited debt and the cashflow coming on we hope to have it paid off by the end of the year. If there isa slowdown we don't have a half dozen or dozen mortgages to pay every month. If things get tight we can slow down the rehab schedule or put in a limited amount of additional capital (less then our original plan but enough to keep things going).
The math would tell you that as long as you have positive leverage and you can reinvest at the same rate (meaning that your net return is > cost of debt), you should always take the cash flow vs. paying down principal. That being said, I really think you have to balance your desire for the cash flow and to acquire more properties with the benefits of not being over levered. Since I have a day job and am not reliant on real estate to pay bills, I am willing to take more of a risk because if I have a hiccup for a couple of months, I can pay the notes on my properties with income from my job. That being said, I pick cash flow (B/C, not D) all day.
@Mike F. I appreciate your comments, but you can essentially build net worth through cash flow properties as long as you put the cash flow in the right investments. The #1 issue I have with appreciation investors is the fact that a significant component of your model is built on on a forecast (housing price movements) that no one can predict and the average investor is not going to be wise enough to pick the right areas and houses for appreciation (look no further than 2008-2010 period). I am not advocating buying D properties, but the certainty of cash flows that comes with B and C properties (if you have a good game plan) is much higher and more controllable than the certainty of appreciation.
I totally agree with you on appreciation.. It is like timing the stock market. Its hard to time right it (More of a luck game) ..
When you do time it right and make big money on appreciation, your more than likely going to dump the $ back into the marking thinking you can do it all again....With the RE cycles ( 10 year RE cycles?) it seems hard to wait 10 years to do make a good return with the help of appreciation.
Investment-wise, isn't your profit made on the day of purchase (ie. you have only bought it because you were able to negotiate a price less that 70% FMV - and even though you bought it at wholesale price or better, why SELL it for less than FMV)? Therefore, appreciation IS important, and is ALREADY in place from day one! Also, the second reason you bought it is because it IS for positive cash flow. As far as paying off the loans early, I agree with those who say it depends. eg. on the interest rate and length of loan vs the alternative deal/opportunity rate available to you. Cheers...
Originally posted by @Brandon Pearsons:
Hello,
I know what you all are saying cash is king, but here is the the equation.
I owe 70k on this particular property at a 5.2% interest rate . . If I pay it off from cash flow from other properties in the next 6-7 years. Then I will be seeing an extra $500 a month in rent because I have no loan. Does this make sense to do?
If you are still in the growth phase of your business, then no it does not make much sense to pay it off unless you are past your personal debt tolerance levels.
If you have enough properties to meet your goal, then yes consolidating your wins is probably okay.
Very interesting thread for me as I have been trying to determine whether or not to continue paying additional principle on a property. Went through the analysis and here are my conclusions:
This is on a 30 year fixed at 4.5%
- Stop paying additional principle today:
- Receive a ROR of 2.45 for the money I already invested toward principle (started making extra payments very early on.
- Continue at my current rate of paydown:
Receive a ROR of .98 over the life of the loan
When you do the math it makes drawing a conclusion very simple. As has been said many times, this is all related to your personal goals and tolerances. This property is in a very stable area with a solid rental base and will realize steady appreciation, so my decision is easy.
Glad I found this thread and took the time to work this out, for me, I'm much happier putting my money to work elsewhere. If you are wrestling with a decision like this as I was, take the time and do your homework.
