Never Pay Off The Mortgage on a Rental Property
Standard personal finance and FIRE advice is to throw every extra penny possible at the principal balance of a rental property and celebrate the day the mortgage is finally paid off. Yeah, you are at max cash flow! But is it max cash flow? Is it really a cause for celebration?
Well, this video shows you why it's the worst way to get additional cash flow, the worst way to increase your asset and portfolio value, and the worst way to increase your equity. So sorry to rain on your happy day, but if you do this, it's $100k that has been poorly spent.
People generally invest in real estate because they feel like the value will rise over time. Similarly, the same reasons people invest in stock market. So if you also feel the same way, then you should be in the process to accumulate as many rental properties as possible (or as many stocks as possible.)
So let's say you have a $100,000 mortgage and you have $100,000 of cash to be spent in the best way possible.
You have 3 options:
1) You can pay off your rental, which has a $100,000 mortgage balance. This would change your cash flow from $200 a month to $1200 a month.
2) You can buy a second property in call cash for $100,000. This makes you $1000 in cash flow plus the $200 you have from the first property for a total of $1200 of cash flow a month.
3) You buy a second property with a mortgage and use the $100,000 as a 25% down payment on $400,000 property. This brings you $1200 in cash flow plus you have $200 cash flow from the original property.
So if your goal was to to increase cash flow, leveraging the $100,000 is your best case scenario as you will earn $1400 total in cash flow across the two properties.
But what if your goal was to increase your portfolio size? Or if you want your tenants to pay down a large chunk of principal paydown of your mortgage so you can cash flow even more in the future?
Well, that of course means having as big as mortgage as possible. And the more leverage you have, obviously, the more assets you can acquire and the more your tenants can pay down. With the same $100,000 look at the difference in your portfolio size and value of your total assets, even though your equity remains constant.
So some would stop here and say, "Yes, Alan, I get it. But I wouldn't be able to sleep at night with that much debt. I just want one house paid off." But I would respond, "Well, I couldn't sleep at night if I was losing that much money each night. I would want to put it to work while I slept."
What do I mean by that? Let's fast forward to the day our houses have increased in value 10%. Typically a home appreciates in value 3.5% a year, so this could be 3 years in the future. But it can also be 5 years or 10 years in the future. It doesn't matter, let's just look at our future where rental income went up 10%, our houses appreciated 10%, and our mortgage balances were paid down equally over this time. What does that future look like?
Ok, so maybe the attention getting headline should have been:
Would you rather turn $100,000 into $154,000 in equity and $1320 of cash flow a month or turn $100,000 into $334,000 in equity and $1840 in cash flow a month?
The image above shows you it its crystal clear how best to spent that $100,000. You can 4 x portfolio value and you get $520 more a month in cash flow by leveraging it.
With that extra income, you can even get a property manager to cover the additional work a second property brings. It's a win-win-win.