Author Topic: Aggressively paying down rental property's principal for earlier cash flow?  (Read 2042 times)

paul_daoust

  • 5 O'Clock Shadow
  • *
  • Posts: 11
  • Age: 38
  • Location: Summerland, BC, Canada
  • My mustache is patchy in places
Please forgive me (and redirect me to a relevant thread) if this discussion has already happened; I'm finding the forums quite hard to navigate.

Last year my wife and I bought a duplex as a rental property, 20% down with a ~2.9% five-year term on a 30-year mortgage. After factoring in PITI, misc expenses, putting away a yearly 1% of the house's value for our contingency fund, and allowing for 10% vacancy, we make a modest cash flow. (We live in a hot real estate market in Canada, but the rental market happens to be equally hot, so that's why we're actually making money on rentals in Canada.) We're looking for another duplex to add to our portfolio.

We'd love to retire early, and one day I realised, "hey, if we tried to aggressively pay down the mortgage principal with some of our money, we'd be making free-and-clear income a lot sooner!" As in, once all the mortgages on both properties are paid off, we'll be able to live off the net income from the rentals. We live an accidentally Mustachian lifestyle, thanks to the fact that we have absolutely no interest in TV and other fripperies, we have a massive veggie garden, and we have obscenely low rent in my in-laws' in-law suite. So it won't take much income for us to have a cushy lifestyle.

This all makes perfect sense to me on paper. I realise that my ROI drops every time I pay down principal with some of my own money, because the investment is less leveraged. But if our goal is to retire early, and we know we'll be making enough money from this investment, does it matter how good my ROI is?

So I need all you seasoned real estate investors to tell me why my idea is horribly dangerous, or horribly inefficient, or simply unnecessary. Let's say we're able to pay off the mortgage in 12 years. Would it make more sense to invest that money in an index fund, then take it all out of the index fund and pay off the mortgage in one lump in 12 years? If so, why?

Cwadda

  • Handlebar Stache
  • *****
  • Posts: 1909
  • Age: 23
Yes, at those interest rates, I don't see much of an argument to rush paying them down. Think about it: when you pay into a mortgage, you can't get that money back easily (you'd have to do a refinance, which has fees). In the stock market, you simply sell the shares and you're left with cash again.

Also, instead of paying a whole bunch extra on the mortgage, why don't you purchase another rental property again? You'll get higher returns than 2.9%, no?

paul_daoust

  • 5 O'Clock Shadow
  • *
  • Posts: 11
  • Age: 38
  • Location: Summerland, BC, Canada
  • My mustache is patchy in places
I agree, 2.9% is stupid cheap and it would make no sense to pay it down if we were optimising for maximum income. But we're optimising for fastest route to retirement instead, and if we hold on to this mortgage for the next 29 years (well, 25 years because we're doing biweekly accelerated payments) the only way we could make a living income would be if rental rates spiked massively and/or the provincial Rental Tenancy Board approved an extraordinary rate increase above the allowed yearly value.

Purchasing another rental property is a good idea in fact, we've just put in another offer on a second duplex. But comparing these two trajectories:

  • Put $40,000 yearly into our mortgages and pay them off in 12 years (back-of-envelope figures; not sure if $480,000 is enough to pay off all mortgages)
  • Bank that $40,000 yearly for 4 years until we have another $160,000 downpayment for our third property

It just feels like, with the latter, we're making more money in the long run but perpetually postponing our retirement as we push mortgage-free cash flow into the far future.

So let's consider a third trajectory: if we invested that same $480,000 into index ETFs, would we have enough to retire in 12 years with ETF revenues + modest cash flow increases thanks to rental rate hikes. Perhaps it's something I should spend some more time researching.

« Last Edit: July 20, 2017, 02:33:30 PM by paul_daoust »

LordSquidworth

  • Stubble
  • **
  • Posts: 122
I wouldnt pay them down quicker. Money is better off accumulating more units or in stock market.

You're not going to retire off of two units. Keep adding.

waltworks

  • Handlebar Stache
  • *****
  • Posts: 2436
You're making it more complicated than it needs to be. At 2.9% interest, your money will work harder in almost anything else (recognizing that in CA, interest rates aren't fixed like in the US, of course).

Paying the whole mortgage off sounds great in theory, but it's going to make you FIRE *later*, not sooner, because invested in something else (stocks, say) you can expect (no guarantees) that your $300k or whatever will grow a lot faster and hence produce more money for you to spend however/whenever.

Remember that you don't need an "income stream" from a stock investment to live off of it. You just sell a certain amount every year (or whenever) and capital gains takes care of the rest. There is no need to live only off of dividends, or never sell your stock, or anything like that, so long as your withdrawal rate matches up with expected total returns.

-W

SwordGuy

  • Magnum Stache
  • ******
  • Posts: 3286
  • Location: Fayetteville, NC
    • Flipping Fayetteville
You are right to consider getting the mortgages paid off ahead of time so you can FIRE when that happens.

However, at those interest rates, you are wrong to pay any extra on the mortgage until you are ready to FIRE.

Invest the money and then, at the right time, pay off the mortgage with the investments.   You're more likely to end up ahead.

FYI, I wouldn't want to depend on just 4 properties for my income.   A single vacancy would be more than a 25% hit to your income.   That's because you not only lose the profit, you also lose the rent that covers the expenses.  Profit from other units has to cover the losses.

Now, I you could FIRE on 2 or 3 units out of the 4, that would be different.    Ditto if you had other investments providing an income stream.

paul_daoust

  • 5 O'Clock Shadow
  • *
  • Posts: 11
  • Age: 38
  • Location: Summerland, BC, Canada
  • My mustache is patchy in places
Thanks for your feedback, everyone.

@LordSquidworth, I agree; two units won't be enough (but the way we live it almost would be -- if the water heater never broke down, and if the roof never wore out, and if tenants never gave notice ;) ) We're trying to add another two units right now, which would bring our monthly gross rental income up to $5200. Because we live a Mustachian lifestyle, that would be enough for us even after healthy allowances for tax, vacancy, insurance, and maintenance.

@Swordguy what you said about putting the money we'd put into a mortgage into an investment account and paying off the mortgage in one chunk makes a lot of sense to me. It's actually something I realised the other morning in a flash of insight; "oh, so that's why they tell you to put it into stocks instead!" We'd have that mortgage payoff money three years earlier!

Thanks also for your caution about vacancies taking a big chunk out of our income... Something to keep in mind. I've already factored a 10% vacancy rate for all four units into our "can we live off the rental income" calculations, so I hope that would be sufficient...

Sent from my SM-N900W8 using Tapatalk


NoNonsenseLandlord

  • Bristles
  • ***
  • Posts: 396
  • Age: 57
  • Location: Eagan, MN
    • No Nonsense Landlord
The money can be invested elsewhere for more, but with more risk.  Paying down a mortgage is a good way to earn yourself 2.9% interest, guaranteed.  Your cash flow doesn't increase unless it is 100% paid off.  There are many pros and cons.  Leverage is great for building wealth, but bad for a secure retirement.

Here are some thoughts I went through a year ago.

http://www.nononsenselandlord.com/2016/08/pay-off-rental-mortgage-debt/

Capt j-rod

  • Stubble
  • **
  • Posts: 168
I have a dream of fire when I'm 55. All of my debt is on a 30 year note but I make the payment high enough so that the day we fire there is no debt on my private home or any of my properties. The remaining money goes to purchase more properties.

Dicey

  • Walrus Stache
  • *******
  • Posts: 6007
  • Age: 59
  • Location: NorCal
The adage not to put all your eggs in one basket applies perfectly to your question. Diversification is the reason not to prepay your mortgage over investing in equities.

Congrats on having such a great start!
I did it! I have a journal!
A Lot Like This
And hell yes, I am still moving confidently in the direction of my dreams...

paul_daoust

  • 5 O'Clock Shadow
  • *
  • Posts: 11
  • Age: 38
  • Location: Summerland, BC, Canada
  • My mustache is patchy in places
Your cash flow doesn't increase unless it is 100% paid off.  There are many pros and cons.  Leverage is great for building wealth, but bad for a secure retirement.

That's exactly what I'm thinking. I actually found your article shortly after I started this thread, and it confirmed some of my thoughts on building wealth vs actually getting some cash flow out of your investment. It's nice to accumulate a large portfolio, but if in doing so you keep on postponing your retirement, what's the point? As Jesus said,

Quote
What does it profit a man to gain the whole world and yet lose his chances at FIRE?

(Or something like that; I may be misquoting.)

Sent from my SM-N900W8 using Tapatalk


Goldielocks

  • Magnum Stache
  • ******
  • Posts: 4583
  • Location: BC
You're making it more complicated than it needs to be. At 2.9% interest, your money will work harder in almost anything else (recognizing that in CA, interest rates aren't fixed like in the US, of course).

Paying the whole mortgage off sounds great in theory, but it's going to make you FIRE *later*, not sooner, because invested in something else (stocks, say) you can expect (no guarantees) that your $300k or whatever will grow a lot faster and hence produce more money for you to spend however/whenever.

Remember that you don't need an "income stream" from a stock investment to live off of it. You just sell a certain amount every year (or whenever) and capital gains takes care of the rest. There is no need to live only off of dividends, or never sell your stock, or anything like that, so long as your withdrawal rate matches up with expected total returns.

-W

Great answer.

I no longer have rental properties, but when I did, I would ensure that I had at least $150 per month free and clear cash flow from each one, (after vacancy, tax, and the maintenance expenses savings), and that I had income elsewhere to cover if I ran into a bad tennant / bad spell.  I only had 2 properties, so maybe getting more doors would cover the "bad spell" issue.

A buffer on cashflow for each property is highly valuable to overall management, so make sure you keep that strong.

One thing that strikes me with some of the other answers -- if you can get better returns on the market, why even have a RE / rental portfolio?  At some point, you need to optimize your rental business on its own, and focus on doing that with whatever portion of your investments you choose... and make decisions within that business separately from the overall stock market.

hucktard

  • 5 O'Clock Shadow
  • *
  • Posts: 75
At such low interest rates, I would not pay off those mortgages any faster than required. You don't need to have paid off properties in order to FIRE. You just need enough positive cash flow to pay your expenses. You will most likely be able to FIRE faster if you don't pay down your mortgages, but instead use the spare cash flow to purchase other cash flowing properties or stocks. The ability to get low interest financing is one of the major reasons you can make a lot of money with real estate. Take advantage of it.

I have several mortgages that are slightly higher interest rate than yours, and I may never pay them off. I might continually cash out refinance them as long as I am confident that I can invest the money and make a significantly higher returns than the mortgage rate. I might pay them off though to make my wife happy.

sequoia

  • Bristles
  • ***
  • Posts: 360
You're making it more complicated than it needs to be. At 2.9% interest, your money will work harder in almost anything else (recognizing that in CA, interest rates aren't fixed like in the US, of course).

This ^

I know nothing about Canada's interest rate. But unless I am missing something here, 2.9% interest is very low. Buy more properties!

jooniFLORisploo

  • Magnum Stache
  • ******
  • Posts: 2831
  • Location: helping challenged people keep a job by doing their work for them
I think one MAJOR caveat when talking Cdn real estate on these (US-heavy) boards is this: The term of that rate. It seems most folks in the US are locking in their super low rate for the entire 30 years. Then their strategy makes sense.

You're in Canada, so you need to consider:
What happens when the term ends? In Canada, that's always relatively soon.
What kind of rate hike do you have room for?
What's your plan if your stocks happen to be in a dip when it's renewal time?

So, maybe you set out some numbers, then decide something like:

I will invest the difference in stocks.
At the five year point, if rates are horrid, I will use my stocks to pay off the mortgage.

OR

...I will go variable rate with no early-payment penalty, wait for my stocks to come back up (maybe 1-5 years or more), then pay off the mortgages.

OR

...as above, but when mortgage rates drop to 2.9 again, lock in for another five years.

NoNonsenseLandlord

  • Bristles
  • ***
  • Posts: 396
  • Age: 57
  • Location: Eagan, MN
    • No Nonsense Landlord
Your cash flow doesn't increase unless it is 100% paid off.  There are many pros and cons.  Leverage is great for building wealth, but bad for a secure retirement.

That's exactly what I'm thinking. I actually found your article shortly after I started this thread, and it confirmed some of my thoughts on building wealth vs actually getting some cash flow out of your investment. It's nice to accumulate a large portfolio, but if in doing so you keep on postponing your retirement, what's the point?

Exactly.  Paying off a rental maybe as good for an increase in cash flow as buying another one.

snacky

  • Magnum Stache
  • ******
  • Posts: 4995
  • Location: Hoth
  • Professional Rat Undertaker
I have a paid-off rental property, and keeping (most of) the rent cheque is awesome! I recognize, however, that my net worth would be growing more quickly and my financial security would be greater if I had a mortgage on the place and more money in investments and/ or another property. Emotionally I love having the place paid off, but the numbers don't support that.

Don't FIRE when your income depends on a single property and your cost of living depends on living with your MIL. There are too many big things that can go wrong.
Enjoy what comes
Be amazing at everything
Stomp on the hearts of the unworthy

paul_daoust

  • 5 O'Clock Shadow
  • *
  • Posts: 11
  • Age: 38
  • Location: Summerland, BC, Canada
  • My mustache is patchy in places
You don't need to have paid off properties in order to FIRE. You just need enough positive cash flow to pay your expenses.

Ah, therein lies the rub. The other major difference between US and Canada rental markets is that, because of the crazy real estate prices here, you won't be seeing any cash flow worth living on until you either have zillions of dollars' worth of units, or you pay off your mortgages.

Being that we only had $200,000 to buy real estate with, and we could only do 20% down, we can only buy two duplexes at $500,000 each, which all together bring in $5300/month. For single family houses the numbers don't work at all. We've searched markets near and far, and the numbers are similar elsewhere -- prices are lower, but so are rents. (we prefer near, because we've discovered that property managers are charging too much for a mediocre service)

Sent from my SM-N900W8 using Tapatalk


paul_daoust

  • 5 O'Clock Shadow
  • *
  • Posts: 11
  • Age: 38
  • Location: Summerland, BC, Canada
  • My mustache is patchy in places


So, maybe you set out some numbers, then decide something like:

I will invest the difference in stocks.
At the five year point, if rates are horrid, I will use my stocks to pay off the mortgage.

OR

...I will go variable rate with no early-payment penalty, wait for my stocks to come back up (maybe 1-5 years or more), then pay off the mortgages.

OR

...as above, but when mortgage rates drop to 2.9 again, lock in for another five years.

Thanks for the reminder to work options into our plans. I guess I get stuck on figuring out the 'most perfect-est' plan but forget that reality doesn't give a creep about my plan. Those are some good options based on different trajectories. I could probably think of a few more.

Clarification question: for your option A, what's the 'difference'? As in, the difference between income and expenses on the rental? Thinking of doing that for a contingency reserve fund, in fact.

Sent from my SM-N900W8 using Tapatalk


paul_daoust

  • 5 O'Clock Shadow
  • *
  • Posts: 11
  • Age: 38
  • Location: Summerland, BC, Canada
  • My mustache is patchy in places


Don't FIRE when your income depends on a single property and your cost of living depends on living with your MIL. There are too many big things that can go wrong.

Good point. We have a great relationship with my in-laws (i.e., the kind where we don't let problems fester), but what if the house burned down, or bandits took the in-laws away, or the other kids wanted their inheritance, or...

Sent from my SM-N900W8 using Tapatalk


jooniFLORisploo

  • Magnum Stache
  • ******
  • Posts: 2831
  • Location: helping challenged people keep a job by doing their work for them
Quote
Clarification question: for your option A, what's the 'difference'? As in, the difference between income and expenses on the rental?

I meant "any available cash."

And, while my example options imagined choosing stocks vs paying down the mortgage during the current rate term, I'm equally for paying off the mortgage in Canada in plenty of cases, so those were meant as example options only. Another could of course be "pay off mortgage ASAP, start investing all available cash after that in stocks." And, like you noted, heaps of other potential path as well.

Goldielocks

  • Magnum Stache
  • ******
  • Posts: 4583
  • Location: BC
I think one MAJOR caveat when talking Cdn real estate on these (US-heavy) boards is this: The term of that rate. It seems most folks in the US are locking in their super low rate for the entire 30 years. Then their strategy makes sense.

You're in Canada, so you need to consider:
What happens when the term ends? In Canada, that's always relatively soon.
What kind of rate hike do you have room for?
What's your plan if your stocks happen to be in a dip when it's renewal time?

So, maybe you set out some numbers, then decide something like:

I will invest the difference in stocks.
At the five year point, if rates are horrid, I will use my stocks to pay off the mortgage.

OR

...I will go variable rate with no early-payment penalty, wait for my stocks to come back up (maybe 1-5 years or more), then pay off the mortgages.

OR

...as above, but when mortgage rates drop to 2.9 again, lock in for another five years.

Nicely put, and spot on!

totoro

  • Handlebar Stache
  • *****
  • Posts: 2062
Hello neighbour.  I own a rental in Penticton.

I'd agree that it might be better to invest and when you are ready to pay down the principal in one go when you retire - do it.  In my case as I am retired now we are paying off the Penticton house next spring.  It provides more income than a 4% withdrawal would, and hopefully some continued appreciation, and if you retain the mortgage you pay income tax on the principal pay down amount which does affect your after tax income if you have other sources of income.

hucktard

  • 5 O'Clock Shadow
  • *
  • Posts: 75
You don't need to have paid off properties in order to FIRE. You just need enough positive cash flow to pay your expenses.

Ah, therein lies the rub. The other major difference between US and Canada rental markets is that, because of the crazy real estate prices here, you won't be seeing any cash flow worth living on until you either have zillions of dollars' worth of units, or you pay off your mortgages.

Being that we only had $200,000 to buy real estate with, and we could only do 20% down, we can only buy two duplexes at $500,000 each, which all together bring in $5300/month. For single family houses the numbers don't work at all. We've searched markets near and far, and the numbers are similar elsewhere -- prices are lower, but so are rents. (we prefer near, because we've discovered that property managers are charging too much for a mediocre service)

Sent from my SM-N900W8 using Tapatalk

So why did you buy these properties? If they don't cash flow, are you counting on them appreciating? That may or may not happen. If you completely paid them off you would have ~1M of real estate returning $5300/month BEFORE taxes, insurance, maintenance, and management expenses? What would your net cash flow per month be? This doesn't seem like a very good return on your money with or without a mortgage unless there is going to be high appreciation.

waltworks

  • Handlebar Stache
  • *****
  • Posts: 2436
Indeed, your returns are horrible, even with no mortgage. A million bucks should be working a lot harder than that (and with less risk/more diversity).

-W

powskier

  • Stubble
  • **
  • Posts: 246
Wait, you said 2.9% 5 year term on a 30 year mortgage.
So you have a tiny payment of which hardly any is toward principal. What is your plan in 5 years?
Is it to sell in your hot market?
Refi? Interest rates assumed to be higher?