Learn Why Paying Extra On Your Rental Property Mortgage Hurts You In Long Run
As the owner of Wesley Chapel property management company, I meet a lot of owners over the years who believe paying down a mortgage early is a great investment strategy. What could be better than a free and clear rental property?
Paying off a rental property mortgage early can be quite sound if you are near or in the retirement age range. The goal at this point is not to increase your retirement capital but to preserve it. Free and clear rentals are a very stable and conservative asset.
However, if you are not nearing retirement, I would strongly recommend you never pay a dime toward reducing the mortgage payment by making extra payments. The reason for this all centers around the concept of ROI or Return On Investment. If you have a 3.5% mortgage and send in an extra couple hundred bucks above your normal payment, you in effect making a 3.5% return on your money.
Let me show you some numbers. Let's say you put 10% down on a $200,000 home and have a mortgage of $180,000 at 3.5% for 30 years. You live in it for 3 years and get a job transfer out of state. You hire us to manage the property and turn it into a rental.
The monthly payment is $808.28 before taxes and insurance. We rent the home immediately, and a tenant moves in. You make your 38th payment. You are paying down the loan by $315.51 and paying interest of $492.77.
Let's assume you break even on cash flow after all expenses over the next 12 months. You pay down the mortgage balance by $3847.46.No big deal right? Well if you divide $3847.46 by $20,000 (down payment) your ROI = 19%.Where can you make 19% on your money?
If you add in appreciation say of 2.5% that means you had a theoretical profit of $5000.Add $5000+$3847.46 = $8847.46.If you broke even on the rent collected vs expenses your ROI would be $8847.46 / $20,000 (downpayment) = 44%.
I know this is hard to believe, and I'm making certain assumptions to explain it. Some years you are going to lose money on cashflow. As the years go by and rents increase, you should consistently make positive cashflow after 7 to 10 years of owning the property on average.
When I buy a rental property with 30-year financing, my goal is to simply break even at first. If there are years where I'm losing money, I'm okay with it because I know time is on my side. The real magic is happening behind the scenes with principal paydown and appreciation.
I never pay extra on a 30-year loan now because I understand a key point. If I saved the extra payments and bought an additional rental property when a good deal became available, I would end up with a lot more money than if I had just paid extra on the first loan.
There is a reason why so much wealth is created through real estate. The concept of leverage used wisely can radically alter what you have available for retirement. Where people get into trouble is buying marginal deals with high leverage. The next recessions cause them to lose everything.
However, you could buy a good deal every few years. Fannie Mae allows you to have up to 10 rental properties with 30-year fixed financing. Achieving that goal would set up anybody for a very comfortable retirement.