@Joel Johnson @Armin Nazarinia @Christian Rojmar @Tiffany Faulknor @Derrick E. @Mac F. @Alpesh Parmar @Nate Bell @Alonso Escalante @Marcus Johnson @Ashley Gish @Jonathon Weber @Shahene Nili @Derek Joyner
I'm really concerned with the lack of understanding on BP in general, especially on this thread.
I want to say upfront that I mean absolutely no disrespect to anyone on this thread, but I feel a moral obligation to try to "show the light" to as many people as possible. For many years I thought Paul Krugman had destroyed more American minds than anyone else...I'm now thoroughly convinced it's Dave Ramsey.
(We'll assume there's not a 30% chance the student loans will be forgiven.)
First, the number one issue I see on this thread is people conflating rental property with a bond, annuity, or any fixed income instrument. Meaning, you take money from your bank account, buy the fixed income instrument, you get a fixed monthly payment, and in the end you get your principle back along with the interest.
The reason people make this mental error is they don't consider/understand inflation. In other words, over the long term, rents go up, the debt payments stay the same. See chart
As an example, lets say there's a 2.5% annual rate of inflation. You buy a 20 year, interest only, fixed income asset for 100k, with annual 10% interest. At the end of the 20 years you have 300k (200k interest + 100k principle.)
THAT IS NOT HOW RENTAL PROPERTIES WORK.
If you buy a 100k rental property, with a yield of 10%, and there's 2.5% inflation, at the end of the 20 years you have approx 363k. Why is there a 63k difference? Because inflation increased yield by 2.5% per year. In first example, inflation had no effect on yield because the rate of return is fixed.
Just to drive this home let's use a different example.
Many on this thread have suggested @Ashley Gish would need a higher rate of return on the investment than the rate of return on her student loans. Again making the mistake of assuming a 100k rental property is the same as having 100k in the bank.
Obviously the 100k in the bank would need to have a higher interest rate than the rate on the student loans, or if both rates were the same it would be a wash, or if the rate on the bank account was lower, it would be better to pay off the loans.
But what if the interest rate on the 100k in the bank increased by 2.5% per year? (interest rate x .025 not plus 2.5). Assuming both the cash in the bank and the student loans started with the same rate, will the cash in the bank make more than the amount of interest paid on the student loans? YES!
So that's how the cash flow works, now we'll discuss the price of the fixed rate asset vs. a rental property. In other words, the capital gains.
Again assuming 2.5% annual inflation, and assuming you put 100k in a bank account, at the end of 20 years what would the value of your original 100k be? Answer: 100k.
Under these same conditions, what would the value of your 100k rental property be? Answer: 163k.
Next, remember the renter is paying the mortgage. We haven't even discussed how debt increases returns. But I'll skip that for now, and go straight into a final example which will undoubtedly put an end to the Dave Ramsey insanity once and for all.
In this hypothetical let's say you have 200k in student loans and 200k in cash. Option #1 is paying off the debt so you would have zero cash and zero debt. Option #2 is putting 200k down on 500k in rental properties, using 30 year fixed rate debt at 5%, and keeping the 200k in student loan debt.
Now let's assume the positive cash flow collected from the properties is the exact amount as the monthly student loan payments. And the total rent and total student loan payment was $1500 a month.
With a average inflation rate of 2.5% over 20 years, at the end of 20 years this is how the 2 options would play out.
Option #1 - 0 cash and 0 debt
Option #2 - 114k in cash, 673k in equity, and 0 debt
Which would you choose? It's literally the difference between being completely broke and almost being a millionaire.
So how did I get those numbers? Remember the 2.5% inflation rate. If rent increased by 2.5% per year for 20 years it would go from $1500 to $2457. Of course $1500 goes to student loan payments but the difference, over 240 months (20 years) of rent payments is approx 114k.
How about the equity? You start with 200k in equity, the renters pay off 154k of the original loan amount, and the 500k in rental properties goes up each year with inflation (2.5%) so at the end of the 20 years the value of the properties is 819k, a 319k difference. So 200k + 154k + 319k = 673k
In all seriousness arguing to pay off the student loans now is akin to arguing for the flat earth theory...it's truly that level of irrational thinking.
And I want to stress this is not my opinion, this is math, plain and simple. If you dispute the conclusion you're not disagreeing with me, you're disagreeing with math.
I want to reiterate that I mean NO disrespect to anyone on this thread. I'm in no way doing this to be negative, or heckle people, I'm only doing this because I want everyone on BP to understand how inflation affects real estate investing. And how dangerous the ideas of Dave Ramsey are to real estate investors.
Debt for consumption is bad...absolutely 100%!
Debt for productive investment is very good...100%!
I leave you with food for though. If debt on net balance is negative, how and why does the world have fractional reserve banking? And what would the world wide standard of living be without fractional reserve banking? Or simply compare the standard of living in countries that have a developed credit/banking system and those that don't.
George
