“You should refinance your property and invest the money!”
“You can pay it off and live with no debt!”
There are a lot of well-respected people on both sides of the argument, so who’s right?
Well, it depends.
Before I answer the question, let’s take a look at both sides of the argument.
Should I pay off my mortgage or invest?
It really boils down to two logical arguments. One side says you should invest your savings instead of paying off your loan and the other side says you should minimize your expenses and live debt free.
In order to know who is right, we need to take a deeper look into each strategy and understand the thought process. First, you need to consider a few things.
What type of real estate investment are you interested in?
No matter what type of real estate investment you currently have, you may want to dip your toes into other types.
There are tons of investments to choose from but the top choices include investing in land, flipping residential homes, commercial real estate to rent out office space, or industrial real estate which includes buildings like warehouses.
Go over your choices. You don’t have to keep making the same investment decisions to be successful.
What Is Your Expected Return on Investment?
An expected return on investment is the profit you expect to make from your investment after all the expenses are covered. Depending on what type of real estate investment you’re interested in, your expected return on investment varies.
To calculate your expected return on investment, you need to know your investment gain as well as the investment cost of the property or house. Once you have these numbers calculated, you subtract the investment cost from the investment gain.
Next, divide this number by the investment cost. This expected return on investment is based on a percentage instead of a specific dollar. The final number will be a decimal that you will have to convert to a percentage.
To figure out the percent, multiply the decimal amount by 100 or move the decimal point two places to the right.
It’s often easier to use the out-of-pocket expected return on investment method instead of the standard return on investment formula.
Say you took out a loan or mortgage from a lender for the property. To take out this loan, you have to provide a down payment to this lender. Add this down payment to the extra expenses. Expenses on a piece of property or house can include many different things but the biggest expenses usually revolve around repairs.
Once you have this number calculated, subtract it from the entire property cost. This is your equity amount.
Divide the equity amount by the total cost of the property. Again, you’ll receive a decimal amount that you’ll need to change to its percent equal.
What is Your Risk Tolerance?
Risk tolerance varies from person to person. This is the amount of market risk that you feel comfortable to take within your finances.
There are aggressive risk-takers, moderate risk-takers, and conservative risk-takers. None are superior, it just depends on your financial situation and what you feel comfortable with.
Once you’ve figured out what type of real estate investment you’re interested in, you have to consider some worst-case scenarios.
Can you handle that type of hit mentally?
Don’t confuse risk tolerance with risk capacity. Risk capacity is the amount of risk that you can afford to take if things were to fall through. But it’s just as important, if not more, than your risk tolerance.
Can your finances handle that type of hit? This is something you need to determine through your finances. Crunch the numbers with the help of an accountant so you know that the numbers are correct.
Paying off the mortgage
Let’s start with the crowd that suggest you should pay off all your debt, including your mortgage.
If you have a lot of debt, then you are one accident or mistake away from financial ruin.
Think about it – if you have an expensive mortgage and then lose your job, you may also lose your house.
Problem is, you still need a place to live.
By paying off the debt, you reduce the risk of losing your home should something terrible happen.
Financial Independence is easier when you have no debts
Most people work their whole lives in order to pay the debts they have. Those debts include cars, a house, credit cards, etc. If you are free from these burdens, then you don’t need to work as much.
Let’s just take a quick example of a person who has all those nice things and is paying $3,000 per month just to cover those debts. They still need to pay for health insurance, food, etc on top of all those debts, perhaps another $1-2,000.
To be financially independent, this person would need a passive income of $4,000-$5,000 per month.
A person with no debts only needs to pay those living expenses. In order to be financially independent, they only need a couple thousand per month in passive income. Not quite as difficult a task.
So by paying down the debt, you may have an easier time to achieve financial independence.
1. You’ll Be Anxiety Free About Your Loan Debt
If you pay off your mortgage immediately instead of investing, a giant weight is lifted off your shoulders. Your debt is paid and you own your property.
If you miss your mortgage payments because of an emergency, you can lose your house. When you pay off your mortgage, you don’t have to worry about losing your home.
Plus, that heavy debt is wiped from your credit report which boosts your credit profile so you have more investment opportunities in the future.
2. You’ll Have Extra Money in Your Pocket Each Month
Once your mortgage is paid off, you have the extra money in your pocket each month which gives you a lot of wiggle room in your budget and some money to play with.
Use this money to save and invest in real estate later or cover new expenses or even treat yourself to something nice.
The options are endless and it’s always a bonus to have the extra money in your bank account.
3. It Reduces Your Debt to Income Ratio
Your debt to income ratio is your monthly debt payments divided by your gross monthly income.
Once your mortgage is paid off, your debt to income ratio drops.
If you’re looking to take out another loan, a lender will go through your financial history, which includes your debt to income ratio. If your ratio is 43% or less, the better your chances are for another loan.
4. No More Interest Payments
The longer it takes you to pay off your mortgage, the more you pay in interest. This takes extra money out of your pocket and adds up quickly.
The faster you pay off your mortgage, the less you’re paying the lender.
Not to mention, most lenders expect you to have private mortgage insurance which is another expense out of your pocket each month. So, when the mortgage is paid off, you’re saving even more money.
5. You Gain Equity
Once you pay off the mortgage on your home or property, you gain equity. When you’re still paying on your mortgage, the lender owns a piece of your home. When you pay off that lender, the home is all yours. So, if the property value rises throughout the years, your home’s value rises, too.
Nobody else gets a piece of that equity. It’s all yours. The higher the equity, the better.
Investing the Money Instead of Paying Down the Loan
A mortgage is very cheap money. Right now people can find loans with an interest rate under 4%.
The thought process is to take the money at a 4% interest, then invest it in stocks or real estate and return more than that.
It sounds like a good idea, right? Borrow at 4% and invest at 7% and you are earning 3% on that money.
1. You Can Borrow More Money to Invest in Real Estate
You wouldn’t think that lenders worked this way but paying off your mortgage early instead of investing in more real estate can make your life more difficult in the future.
If you need a loan a few years down the road for another piece of property, you may not qualify. If you do qualify for another loan, the interest rates may be incredibly expensive.
2. You Won’t Lose Your Mortgage Interest Deduction
When you pay your mortgage off early, you lose your mortgage interest deduction.
Your mortgage interest deduction is a tax deduction that you receive every year you’re still paying off your mortgage. With this deduction, your income is taxed less than it would be without the mortgage.
Keep in mind that the qualifications for a mortgage interest deduction have changed over the years and you might not qualify for this tax break.
3. You’ll Make More Money
It’s no secret that investing in the right piece of real estate can be profitable.
If you rent out the property, you get rent money each month. Your mortgage payment stays the same but the money you collect in rent goes up over the years.
Real estate prices increase every year which means you can raise the rent as needed. Plus, as the years go by, the mortgage payment stays the same but the value of the property usually goes up.
The more property, the more money you’re gaining. It doesn’t matter if you flip a house or you rent out an apartment building. Your cash flow keeps increasing.
4. You Can Increase Your Savings
Having a savings account is important for financial emergencies. You never know what could come up.
Sometimes adding to your savings account can be difficult between all the bills and payments you have to pay from month to month.
When you pay off your mortgage early, you use extra money which could have gone into a savings account.
Instead of putting this money toward paying down your mortgage, you can invest in more real estate and make more money. Then, start saving.
5. You’ll Have a Diverse Portfolio
Owning more than one piece of property grows your portfolio. The more property you own, the more assets you have.
These assets can come in handy if something costly comes up quickly, like a medical emergency.
Plus, if you pay off your mortgage too early, you no longer have liquid assets to access in these types of emergencies. You can’t access that money without selling the property. It can take a long time to find a cash buyer or a buyer who’s been approved for a loan. Then, you have to wait to close the deal.
6. You’ll Have Asset Protection
Once you pay off the mortgage on your home or property, you lose that asset protection.
If you owe money to someone else and a creditor comes after you, they can take your property without a care in the world. But if you’re still paying off the mortgage, you don’t have to worry about losing the property.
Since you don’t own the home outright, a creditor can’t take it away from you.
Comparison: pay off the mortgage vs investing
First, let’s take a look at the potential interest you are losing by paying off by paying cash for a home. For simplicity, let’s say the choice is between having $100,000 to pay for a house, or having a 30-year mortgage at 4% and investing the $100,000.
If you could get 8% in the stock market, you would turn $100,000 into $1,006,265 in 30 years.
You have to pay off that mortgage as well – a 30-year mortgage at 4% would cost you a total of $171,869.
So your total return is $834,396. Pretty good!
Option 2: use the interest to pay the loan
8% interest on $100,000 is $8k per year or about $666/month.
The loan on that mortgage is only $477/month.
So in theory, you could withdraw enough money each month to pay the loan and still save an extra $190/month.
After 30 years you would have roughly $371,000 saved. You save a lot less because you aren’t reinvesting that interest.
What about cash flow?
Clearly borrowing money and investing it at a higher rate is what makes sense for maximizing your net-worth.
But the argument against it isn’t about net-worth. It’s about financial independence.
And FI is about cash-flow.
So it’s important to note that your mortgage requires principal and interest payments. The investment get’s all the money reinvested back into it, meaning the cash-flow from it is 0.
A $100,000 mortgage will cost roughly $477/month that you have to pay for the next 30 years.
With option 2 above, what happens during years that the stock market doesn’t return enough to cover the expenses? Do you draw down the account regardless, or do you pay it out of your own pocket?
Your choice depends on your goals
Before anyone even started reading this article, we already knew that on paper it’s better to borrow the money and invest it.
But, on paper you always earn 7 or 8%, you always make great investment decisions, and you never dip into your savings to do something silly like buy a car or go on vacation.
On paper, we also never die or get sick. Our notes never come due, and our children can inherit our properties without having to deal with bank loans, burial expenses, and death taxes.
Goal – to grow
If your goal is to grow your business, then it makes sense to leverage your property and invest the money.
Instead of investing the money in stocks, just invest it into more real estate. In theory, it’s pretty safe too.
The money from property 1 is invested and secured by property 2.
It can be risky, though. If you have a cash-flow issue, both properties would be at risk. Then again, if you have cash-flow problems, everything is at risk.
Goal – to retire
If your goal is to retire, you may be in a position to simplify your investments and maximize your cash flow.
Paying off loans does exactly that.
You won’t be growing your business anymore, but by paying off that loan, your cash flow jumps by that $477. You have less risk and higher cash-flow. That’s a win-win for a retiree.
Goal – to become financially independent
This is a tough one.
Some people can achieve financial independence by buying more property, or by paying down the property you already own.
Your $3,000/month in passive income might jump to $5,000 if you pay off all the debts. On the other hand, you could take that money and buy a few more property to reach your goal.
If your goal is to become FI, then I’d see which path gets you there faster. If it will take 5 years to pay off all the loans, but you can buy more and become independent in 3 years, then definitely go that route.
If you have the cash to pay down debt and reach FI, then I’d pay everything down and have low-risk financial independence.
Eric Bowlin has 15 years of experience in the real estate industry and is a real estate investor, author, speaker, real estate agent, and coach. He focuses on multifamily, house flipping. and wholesaling and has owned over 470 units of multifamily.
Eric spends his time with his family, growing his businesses, diversifying his income, and teaching others how to achieve financial independence through real estate.
You may have seen Eric on Forbes, Bigger Pockets, Trulia, WiseBread, TheStreet, Inc, The Texan, Dallas Morning News, dozens of podcasts, and many others.