In Part 1 of this series, I mentioned the first component of return on investment (ROI) for your property was cashflow. A second element in your ROI relates to the financing of the property.
Mortgage paydown is the amount of the mortgage principal you pay off each month with your regular payment. It varies by size of mortgage, interest rate and your chosen amortization schedule.
An amortization schedule defines the period of time over which you will pay off the entire mortgage. Most lenders like to start with 25 years amortization. I have amortizations as long as 40 years. Today, due to various lending rules, a 30-year amortization schedule is usually the maximum most lenders will allow.
The benefit of taking a longer term to pay off the mortgage, is that the payments are smaller, which means a greater opportunity to cashflow on the property. Money in your pocket today is always better than money in your pocket tomorrow. You want to do everything in your power to give your property the greatest chance of cashflowing while maximizing the amount of mortgage you can afford to take on. A simple way of aiding that scenario is to take on the longest amortization term you possibly can. You will find that in this business you can easily become very equity rich and cashflow poor which means a lot of money is tied up in the properties which it is difficult to get assess to on a daily basis.
I know what you’re thinking– but over the life of the mortgage aren’t you going to be paying waaaay more in interest payments, if you stretch the paying back over a longer term? This was supposed to be about the various ways to make money in real estate, right? Are you about to profess that you should actually pay more in interest payments than required? Are you sure?
I hear this a lot and the reason for this confused logic is that we have all been taught to pay off our mortgages as quickly as possible. We’ve been told that debt is bad.
Ahh, but I did promise I would be teaching you things that are completely counter intuitive to everything you have been told…didn’t I?!
I agree that consumer debt is bad. That’s money that you borrow to pay for your lifestyle. Yes, your personal home fits into that category, as do your credit cards, car loan and any loans you take on to pay for something on a personal level. However, mortgages and loans for investments of any sort, or using other people’s money to build our own portfolio is not only a suggestion but greatly encouraged in the real estate investing world. The big difference is that in an investment property it is not YOU working to pay off that loan. It is your tenant(s) that is (are) working to pay off the loan. If our tenant is paying both the principal and interest anyway, does it matter how long it takes to pay the mortgage off or if it ever gets paid off at all? I would suggest the answer to that is No! As long as we have a tenant we aren’t working to pay it off and that is a good thing.
Sophisticated investors understand that using leverage, (and cheap leverage at that), in the form of bank mortgages is an excellent way to continually build your business. We also understand, as experienced investors that investing in real estate is a game of moving your personal capital (the original amount of money you put in) around as often as possible. So, not only are we going to take on the longest amortization schedule we can get but, (hold on to your hats folks)…we are also going to increase the mortgage as often as we can to as much as the bank will allow us to increase it to. So that every time our property value increases due to forced or natural appreciation, we are going back to the bank to refinance the property in order to get a hefty cheque back.
This works provided we have increased rents to accommodate the increased mortgage rate. Ideally, we want to take the lump sum of money–our original down payment and put it in another property. So now, instead of one property, we have two, without having to come up with more capital. Two properties that our tenants are covering the cost of for us. They are doing the heavy lifting in paying for our real estate portfolio.