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Should You Pay Off Your Rental Properties Early?
When I started buying rental properties a few years ago, I financed them all with 30-year mortgages. I wanted to create the highest possible cash flow so that I could continue to buy more rental properties. If I financed the property with a 15 year mortgage it would eat into the cash flow and not give me the money I wanted to buy for the next business. Buying real estate in Denver four years ago, using the Hard Money and Refinance Strategy, I was buying a property that was $700/month in cash with a 30-year bond; in most cases with less than $5,000 out of pocket. So this meant I could buy another property using the cash flow every few months. Prices were low, finding tenants was easy and my cash flow increased with each purchase, life was good! While preparing for my taxes this year, I was reviewing mortgage statements for rental properties and saw that my average monthly principal was about $125 per door. I currently have 10 properties so the payout is slow. When I bought a property with 100% financing on a 30 year mortgage, I didn’t expect the principal to pay off overnight, nor did I expect to be paying the same mortgage at 60 years old.
When the money in the property is flowing so well, I start thinking about how things would look if I started investing all the cash flow in rental mortgages and whether that would be a good investment strategy. Keeping in mind that all of these mortgages are between 3-5.5% interest, most investors immediately think, “Why would I invest my money at 5.5%?”
Everyone’s answer to this question is different, depending on your personal situation. Let’s look at a typical investor with four properties; the details are below, as well as a few questions that might provoke thought.
Here is an example of a landlord situation.
4 properties for rent; all balances at $100,000
Mortgage Payment ($100,000, 30 years, 5%, $125 per month for taxes and insurance) $625 per month
Everything rents for $1,250 a month
Gross monthly cash flow: $625
25% charges, $315 per month, per property
TOTAL NET CASH FLOW: $1,240
What are your goals?
Create a cash flow for income today. In the example provided, the net rents would add $1,240 to your monthly bottom line. This could pay your mortgage, fund a few nice vacations a year, or send a child to college.
Use cash flow now to create more cash flow in the future. Pay off your mortgages and have one free and clean lease in just 6 years. Add the payment you were making on that property, $500 a month, making $1,740 a month and the next one will be paid off in 4 years, and the next two in just 6 years. Payoff acceleration delivers 4 free and clear rental properties in just 16 years, with a monthly cash flow of $3,240 (not including rent increases).
Other Investment Options: If you are looking for multiple offers, it makes sense to save that cash flow to invest in another offer. In the example of $1,240 net per month that’s about $15,000 a year or $30,000 over two years to buy another business or two. It’s harder to find deals in the Denver market now than ever before, so you may have to work harder to get that cash. Some of our Minnesota clients are buying homes for $30,000, making it easy to use cash flow in your next business.
Debt Tolerance: Your personal debt tolerance could be your deciding factor. Some buy-and-hold investors buy with cash only, while others prefer financing. Each has its advantages. When you pay cash, a change in the market or an increase in vacancies is unlikely to cause you to lose sleep. Financing allows the investor to buy more properties with less money. An investor might be embarrassed to look at their balance sheet and see $400,000 in mortgage debt, for others it’s just part of the job.
Time horizon: In my opinion, this is the second most important decision to make when considering a rental mortgage. Your time horizon could be crucial to your decision. If the investor is in his 30s, he may not be in a rush to pay off the rent as there may be more opportunities on the horizon to continue acquiring real estate. Although based on the example in “what are your goals?” this investor could be 46 years old with a good monthly rental income.
At age 45, the investor may or may not be comfortable carrying that debt until age 75. This investor would not have as much time to enjoy the cash flow they have created. However, if the intention is to use it as a pension, it would be an excellent choice.
Income Needed: How much do you need to live? This is the most important question you have to ask yourself. Some investors use rental income as a supplement or all of their income. Obviously, if you’re using your cash flow to pay bills, using it to pay mortgages isn’t an option. Although, if you don’t need the cash flow; it could be easy to use the extra money to pay for rental properties.
What makes sense to you? When buying rental properties do you ever think about 30 years from now? Will you transfer your wealth to your family, give it to your Alma mater, or liquidate everything and live off the profits? Sometimes as real estate investors we spend so much time looking for the next deal rather than why we are actually chasing those deals.
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