As a real estate investor, it was tough for me to write this post. We take pride in how much money we can borrow, and the thought of paying down a mortgage is almost painful, unless we’re selling the property.
But it has its advantages.
In my last post, we covered three reasons why paying down your mortgage is a bad idea, but there are also three equally good reasons that it’s a good idea:
You’re Less Likely to Face Foreclosure
Going into foreclosure sucks.
You’ve spent years paying for your house and something happens where you can’t make a few payments. You get lots of ugly notices in the mail from the bank, threatening you unless you pay them off, but you just can’t do it. You’re forced to sit back and watch your house auctioned on the courthouse steps. Then the sheriff comes and kicks you out. So much for having a home.
The best defense against foreclosure is actually paying off your mortgage. It’s a simple equation. If you don’t owe them anything, then they can’t take your house. Even if you’re just paying down the mortgage by a few percentage points, it can still make a big difference because the properties that go into foreclosure usually have too much debt for the seller to pay it off by selling the property. Otherwise, they’d just sell it.
For example, if you owe $120,000 on a house that’s only worth $105,000, then you’re sunk. It’s unlikely anyone will pay you above market value. On the other hand, if you owe $70,000 on a $105,000 house, you can probably sell it for $80,000 relatively quickly to an investor, avoiding foreclosure and walking away with a little bit of money to get started again. It’s a much better situation.
You’re Able to Buy More Profitable Real Estate
From an investment perspective, the problem with your primary residence is it’s not making you much money. Sure, you might see some appreciation, but it’s hard to predict. You’re better off borrowing money on properties that produce some sort of income or profits. You’ll make more money.
Why not just borrow money on both?
Lenders have a little variable called your debt to income ratio. On average, they’ll only give you a loan with payments that comprise about a third of your gross monthly income. So, if you’re making $3000 per month, the maximum you can borrow is a loan with a payment of about $1000 per month, assuming your credit score, documentation, and everything else is in order. You can technically borrow more, especially as a professional investor, but a third is the general rule of thumb.
The point is, if you’re paying $1000 per month on your primary residence, then the bank won’t want to loan you any money for an investment property, unless it’s also producing cash flow. It limits your options and might prevent you from buying the most profitable properties.
By paying down the debt, you can reduce your payment and use the money to buy other properties that create income for you. For example, you might buy a house and rent it out for a small profit. Not only will you make money from the rental, but you’ll save a little on the mortgage for your primary residence.
You’ll Have Greater Peace of Mind
In the movie Office Space, there’s a great scene where Ron Livingston decides to stop paying his bills. Not because he’s unable; he just doesn’t want to pay them anymore. They’re a headache and he’s tired of worrying about them. So, the simplest solution is to just stop paying them.
I wish we could do this in real estate. Unfortunately, it doesn’t work that way. Whether you’re up or down, making money or not, you have to pay the mortgages. Even if you have the money, it’s still a headache to make sure they’re in on time. Automatic bill payments don’t help, either. It’s still in the back of your mind — something that’s supposed to be taken care of but you continue to fret about anyway.
If you can pay off your mortgage, it’s actually a tremendous relief. As Forrest Gump would say, “And that’s good! One less thing to worry about.”
The Bottom Line: It Depends on Your Lifestyle
What’s the verdict? The tax refund check is sitting there. Should you pay down your mortgage or not?
The answer: it depends on your lifestyle.
If you’re investing to increase your net worth as quickly as possible, know what you’re doing, don’t mind extra debt, have a great debt to income ratio, and so on, then you shouldn’t pay it down. Take the money, invest it, and enjoy the dividends.
On the other hand, if you’re looking forward to a life with less obligations, don’t want to risk losing it all, invest in only low-risk vehicles like CDs, and the reduction in your payments would make a difference in the quality of your life, then go for it. Pay the sucker down.
It’s all up to you and how you want to live.
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Hey, Jon, I told you I’d be back! I could tell by the tenor of this article that it really was a stretch for you.
When I came here from GRS the other day, I didn’t realize that this blog really is aimed at aggressing RE investing. Understandably that requires a different mindset than the average Joe and Jane, whose home will probably be the biggest asset they ever own.
I’d say for people in that situation–most of us–paying ahead on a mortgage, ESPECIALLY in the early years when most of the scheduled payment goes to interest, the biggest advantage is that it’ll shave years off the mortgage on the other end. I ran some numbers on the example “Common Sense” put forward in the comments for that last article; putting $100K toward paying off a $500K mortgage would shave a whole 9.5 years off the debt (assume $500K still owed on $525K total mortgage at 6%) and save the borrower $262K in interest. That could mean the difference between being able to retire at 65 or at 56…nothing to sneeze at!
I’m a RE investor, too, but definitely have more modest ambitions than you do–and different motivations, to be sure. I think you’re quite sensible to aim so high, and wish you luck in reaching all your goals!
To give you an idea of my local residential market, this recent newspaper article describes an extreme fixer not 4 blocks from my home that recently sold. Note that the it sold for over $300K–that was at least $35K over the list price. And this is certainly NOT the most desirable neighborhood in town.
We’ve got one rental house, with a bunch of equity and 10 years left on a 15 year mortgage at 5.75%. You bet we’re keeping it as is. The loan will expire the year before my first kid is slated to go college, and her little sis is 4 years behind her. We’re foregoing cash flow now for cash flow then, when we’ll need it more…and retirement, when we’ll need it most of all.
I can guess that you’ll argue pulling out the equity would let us buy more propeties, grow a business, etc. and I can see that point. It’s a possibility to ponder for the future, but in our superheated market it’s not clear how well it would all pencil out. I’ll keep reading to see how you high-rollers do it, and maybe one of these days we’ll try to join your ranks!
Angie,
Glad to see you back again! Yes, the interest charges and other expenses of a home are amazingly expensive, and you can save a lot of money by paying them down in advance. I don’t think you’re wrong about your strategy, either. It’s just not the direction I’m going, so it’s hard for me to imagine.
It’s just not the direction I’m going. For example, I’m preparing the paperwork right now to borrow $60 million over the next year. So, it’s hard to imagine paying down my mortgage
Indeed! That’s quite a few zeroes you’ve got there, young man.
Didn’t I read somewhere on this site that you were in high school during the tech boom? That’d put you in your early thirties, yes? How does a young pup like you convince someone to hand over that much money?
Doubtless the answer is because you’ve got some experience to back it up. The thing that interests me is how people get started. The people I know who can make a living out of RE investing started out with parents with deep pockets, who bankrolled them (or at least provided a secure safety net) when they got started. Nice work if you can get it!
I’ve got some experience, but I’ve also got a brilliant father. He’s the Donald Trump of the land business, and he’s trained me since birth. So, yeah, I was born with a little bit of an advantage.
Oh, and I’m 24.
Judicious choice of parents, to be sure!
I look forward to you sharing the wisdom you’ve inherited, though I think you’ll lose most of your readership if chapter one is “be the offspring of a real estate mogul”…
That makes me wonder why your dad isn’t the one writing a book?
Jon
I’ve just come across your blogs and found them very interesting. I am no where in the league of investment that you are. I’m a simple woman in early 40’s with my primary investment (besides 401K and some stocks) being my home.
Originally when I bought my home in 1995 I had a 30 year. In 2003 I refinanced for 5% for 20 years. I’ve been paying down principle for the last year every quarter (not much but adding an extra payment when I can).
The goal for me was to pay off early so that I could invest in a second vacation home along a golf course some where. I couldn’t afford to have two mortgage payments. Having read your two articles (why good and why bad) I’m thinking its still the right choice for me but thought I’d just ask for your input anyway.
So…if my goal is continue working until retirement but enjoy it a little more by having a place by the lake/golf a few hours away - is my thinking sound?
No, vote Democrate so we can get your money in taxes to Washington so we can use it properly.