Are you a wealthy person who can afford to buy your next property in cash? Many wealthy people don’t actually need mortgage financing for real estate investment, but choose to take it out. Why do they do that? It’s because of the opportunity cost.
Why cash out investments earning 8%-10% rate of return, when you could borrow money a lot more cheaply? It just doesn’t make a lot of sense in most cases. But that’s not the only thing to consider.
Here are 3 advantages and 3 negatives of paying off your mortgage early, when it comes to real estate investment, so you can choose the right decision for you.
Real estate investment: 3 advantages of paying off your mortgage early
1) Saving on interest
The simple argument is that you’ll save money on interest.
If you’re someone who’s risk adverse, you may prefer the guaranteed rate of return paying down your mortgage early provides.
When you put extra money against your mortgage, it decreases your mortgage balance and saves you interest immediately. If you make an extra $3,000 prepayment against your mortgage, it will reduce your mortgage balance by $3,000 and you’ll no longer be paying interest on this $3,000 amount.
Paying off your mortgage early could save you hundreds or thousands of dollars in interest, but it could also end up costing you a lot more; tens or hundreds of thousands in interest. We’ll talk more about that in the next section on why you may not want to pay off your mortgage sooner.
2) Freeing up your cash flow
By paying off your mortgage entirely, you’ll free up your monthly cash flow for other purposes like investing.
This only holds true if you fully pay off your mortgage. If you make extra payments against your mortgage, your mortgage payments will remain the same (unless you refinance your mortgage and stretch out the amortization period). It’s only if you pay off your mortgage entirely that your mortgage payments are completed eliminated and you’ll free up excess cash flow to invest.
However, if you have to cash out investments earning between 8% and 10% rate of return to do that, it probably doesn’t make sense.
3) You can borrow to invest
If you have the right type of mortgage, you can borrow to invest. With the right type of mortgage, when you pay it down, you can re-borrow the extra payments that you made and invest it. This is known as a readvanceable mortgage. You can re-borrow any principal you pay down immediately from a Home Equity Line of Credit (HELOC).
If you’re a wealthy person, in terms of real estate investment, I highly recommend that you take out a mortgage that’s readvanceable. Sure, the mortgage rate may be slightly higher, but it lets you have access to the principal you pay down in your mortgage right away. With that, you can re-borrow it via a HELOC and earn a lot higher of a rate of return. It’s a win-win situation in most cases.
3 negatives of paying it off early
1) You’d be better off investing
The biggest and most obvious negative of paying off your mortgage early is that you’d be better of investing your extra cash flow. With mortgage rates as low as they currently are, it just doesn’t make a lot of sense to pay off your mortgage early. Sure, mortgage rates could go higher in the future, but even then investing is still likely to come out ahead. It helps to go through a simple example to better understand the argument.
Let’s say you have an extra $500 in monthly cash flow. You could put it towards your mortgage or invest it. By putting it against your mortgage, it would provide you with a guaranteed rate of return. Let’s say your mortgage rate is 1.5%. Then you’d get a guaranteed rate of 1.5%. However, that’s pretty paltry, especially when you look at the alternative.
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Instead of paying off your mortgage, you could invest the extra $500 per month in the stock market. You could put it in a low cost investment like an ETF or index fund. If you keep your money invested long-term, you’re likely to earn between 8% and 10% rate of return.
I don’t know about you, but 8%-10% return seems a lot better than 1.5%, doesn’t it? That’s why the case for paying down your mortgage early is a tough one.
Likewise, if you run your own business and you could keep the money invested in your business or reinvest it in your business to earn a lot higher of a return; does it really make sense to pay down your mortgage sooner? Again, look at the opportunity cost of putting the money against your mortgage versus investing it.
2) There may be penalties associated with It
If you want to really aggressively pay down your mortgage, there may be penalties and fees associated with it.
Most closed mortgages let you prepay up to a certain amount a year. You’re usually able to prepay up to between 10% and 20% of your original mortgage amount a year, depending on the lender. However, if you’re a wealthy person, you can probably afford to prepay more than that. But when you do that, the penalties could be pretty steep.
Make sure you understand the prepayment privileges of your lender before you make any extra payments. Otherwise, it could end up costing you a lot more in the end.
3) Lessen your mortgage interest tax deduction
If you rent out part of your primary residence or you own a rental property, you’re able to claim some or all of the mortgage interest as tax deductible. It’s a nice perk of being a real estate investor. However, when you pay off your mortgage sooner, you’re lessening that tax deduction.
You’re paying off a mortgage at a rate of maybe 1.5%, while reducing your tax deduction on this property. In terms of real estate investment, you’re hurting yourself in two ways at the same time. Now can you see why it doesn’t make sense to pay down your mortgage sooner for the vast majority of wealthy people?
The bottom line
With money as cheap as it is to borrow these days, it almost always make sense for wealthy people to take out mortgages. However, in most cases, you shouldn’t be in any hurt to pay yours down.
By getting the right type of mortgage, a readvanceable mortgage, you can benefit from your mortgage and grow your net worth at the same time, as you pay it down at the bare minimum, while investing the extra cash flow at the same time to grow your net worth even more.
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