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Leverage was always the love language for real estate investors. It was the principle on which the BRRRR strategy was based, and fortunes were made.
However, since the dramatic rise in interest rates post-COVID-19 pandemic, the golden strategy has started to lose some of its shine. Now, even the most happy-go-lucky investors are wondering if they should batten down the hatches and pay off their debts rather than risk another purchase.
A Numbers Game
Ultimately, real estate is all about the numbers: cash flow, liquidity, and risk tolerance. In the current climate of 6.5% interest rates, very few properties cash flow with a standard 20% down payment. If you’re lucky, you’ll break even.
Of course, rents differ, and there are ways to accelerate or increase rent depending on how labor-intensive you want to get with property management. Renting by the room, short-term rentals, and corporate rentals are just some of the ways to boost rents.
Assuming you are OK with making no money because you want to acquire properties, pay down the mortgage over time, put yourself in an advantageous position to refinance if/when rates drop, build equity, and eventually enjoy cash flow, buying and holding might be appealing.
What Is Your Liquidity Situation?
The next important question is: How liquid are you? If you are not cash flowing enough to cover maintenance, vacancies, and any cash flow negative items, you’ll need deep pockets to offset the costs. The more properties you have, the deeper your pockets will need to be.
You might get to a point where you are spending more money on maintenance without realizing much of an equity gain and seeing no cash flow. You will then have to ask yourself if this is really worth it. It might be better to use your liquidity and/or money from your job to pay off your investment property, stop the bleeding, realize 100% of the cash flow, and save your money before buying another investment.
The Lock-In Effect
According to Forbes, at a 6% interest rate (80% of homeowners have this or lower) on a 30-year fixed mortgage for $250,000, the principal and interest payment is just under $1,500 a month. Over the full term of the loan, you will pay $289,595 in interest.
If you liquidated some stocks or happened to have $250,000 lying around, rather than being break-even or cash-negative, you would now be $1,500 better off each month (minus taxes and insurance). By paying off your home in full, you have the entire value of your equity to redeploy into the market once rates drop and cash flow increases.
Taxes and Insurance
If your rate of return from a rental at a 6% interest rate exceeds your mortgage payment and you have some liquidity, you might want to hold on to the property before prices go up, as long as you are comfortable weathering the financial storm of maintenance and vacancies.
Another factor to consider is taxes and insurance. Both have been soaring in recent years, so a $250K property in one part of the country might be break-even, but in another, it might be considerably cash flow negative. In that case, simply paying off the mortgage and throwing the cash flow at the carrying costs might be the best move.
Your W-2 Income
The income from your W2 job is also a determining factor. If you have enough money to pay off your mortgage, sitting on the sidelines but dislike the idea of not being liquid, applying chunks of your W-2 income to the principal paydown would allow more conservatively minded investors to stay liquid to invest in a down payment when rates are more favorable while still paying off their mortgage and potentially increasing cash flow.
The Stock Market
According to Forbes:
“Using a 10% return rate as an estimate, if you invested your extra $250 per month in an S&P 500 index fund, you could grow it to $137,651 over 21 years. Taking this path would give you roughly $37,900 more than if you had applied the same $250 monthly toward your mortgage principal to pay off your mortgage over the same period.”
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There have been some outrageous stock market successes in recent years that have far outstripped anything a real estate investor could have achieved.
The most obvious example is Nvidia, which has powered the AI revolution through its groundbreaking GPUs. Its stock has increased by a stunning 1,390% over the last five years, which means that if you invested the money you were considering paying off your mortgage in Nvidia stock, you would be in a position to buy as many luxury homes for cash around the world as you wished.
The Solidity of Real Estate
Investing in stocks comes with inherent risks—notably, a lack of control. There is no way to know whether a stock will go up or down, which is why many real estate investors shy away from it, preferring the tangibles of real estate: tenant paydown, depreciation, appreciation, rent increases, and the ability to force equity and increase cash flow.
However, it also takes a certain mindset to be a real estate investor, especially if you own only a handful of rentals and don’t have a big nest egg. You need to be comfortable handling maintenance issues, vacancies, and tenant disputes when they arise, even if you have a property manager.
All Roads Lead to the Owner
Ultimately, all roads lead to the owner because you will be the one paying for it. When rates are low and cash flow is high, more investors have the temperament to invest; however, when rates are high and margins are low, the natural instinct is to pay down debt to alleviate stress.
According to Forbes, here’s a look at various scenarios where paying off your mortgage makes sense and others where investing makes more sense.
Paying off your mortgage
You have a high mortgage rate.
You want to save on interest rates.
You can manage without the mortgage interest tax deduction.
You want to eliminate a significant debt amount.
You want the security of outright owning your home.
Investing
You have a desirably low mortgage rate.
You need to catch up on retirement savings.
You expect to stay in your home for a short period of time.
You prioritize easy liquidity over the hurdles of tapping your home equity.
You are comfortable with risk.
Final Thoughts
Paying off your mortgage versus investing doesn’t have to be an either/or scenario. Depending on how much cash you have, you can both pay off some of your mortgage and invest. There’s never a bad time to pay down some or all of your mortgage, especially if you are close to retirement age and want to be debt-free.
However, investing in real estate in the current interest-rate environment requires careful consideration, taking into account all the points we’ve discussed. A savvy approach could be to use the money you’re thinking about investing in another property, with a mortgage, and instead buy an ADU or convert a part of your existing rental to increase its cash flow and thus accelerate your ability to pay it off without the risk of leveraging to buy another home.
Sometimes, peace of mind is priceless.
