If you are trying to achieve your dream of financial independence by owning your rental property free and clear of all debt, then you may have considered the rental property debt snowball method.
Perhaps you own several rental properties and realized if you pay off the mortgages you can retire. Or, perhaps, you want to lower your leverage to protect yourself during retirement. Regardless of why you want to pay off the debt, the real estate debt snowball method may be one solution.
- What is the Debt Snowball in Real Estate?
- Compare Rental Property Debt Snowball to Basic Paydown
- Rental Property Debt Avalanche vs Debt Snowball
- Should I Pay Off Loans or Use Leverage to Buy More?
- Rental Property Snowball Frequently Asked Questions (FAQ)
What is the Debt Snowball in Real Estate?
The debt snowball is a popular strategy used to pay off debts more quickly. It’s softened used to pay off student loans and credit cards, but it can also be used to pay down a portfolio of rental property mortgages as well.
The Rental Property Debt Snowball works like this:
- Own several rental properties
- Finance or refinance into long-term low-interest rate debt
- Figure out how much cash you want to pay extra each month (perhaps use the cashflow)
- Put all of the extra principal payment toward the smallest balance loan
- Pay off the loan
- Apply the original monthly payment + the entire mortgage payment you just completed toward the next smallest payment
Rental Debt Snowball Plan Example
Let’s say you own 3 rental properties and plan to increase your overall payment by $250 to pay the loans off faster. The loans are all 30-years with a fixed rate, They have the following rates and balances:
- $100,000 loan at 4% – $477 payment
- $120,000 loan at 4.25% – $590 payment
- $150,000 loan at 4.5% – $805 payment
Under normal circumstances, you would spend 30 full years paying this and at the end have 3 houses fully paid for. In the end, you will pay:
- 1st House: $171,868
- 2nd House: $212,517
- 3rd House: $273,609
- Total: $657,994
Using the debt snowball method, you would apply the entire $250/month payment to loan #1 because it is the smallest balance loan and you will pay it off the fastest.
In this example, you’ll have house 1 paid off in 14 years and 7 months for a total payment of $133,981. That’s an overall savings of $37,881 over what you would have paid otherwise.
Once that loan is paid off, you will take the entire principal and interest payment that you no longer need to pay, and you will apply it to loan #2.
So, now you’re paying $250 per month plus $477 per month in additional principal to loan #2 each month. The $727 additional monthly payment will help pay that loan down extremely rapidly. In fact, you’ll have it paid off in just 70 months with total payments of $192,148 which is a savings of $20,369.
You’re now 20 years and 5 months into payments and own 2 properties free and clear.
Once that loan is paid off, you’d do the same thing for loan #3. In this situation, we’ll be paying the normal mortgage plus $1,317 which is the original $250 plus the total payment of loans 1 and 2 combined.
The mortgage will be paid off in just 37 months which manes you’ll have all 3 paid off after 23 years and 6 months. Additionally, you’ll save $12,390 in payments.
$20,369 + $12,390 + $37,881 = $70,640
Compare Rental Property Debt Snowball to Basic Paydown
The most common way to do a debt paydown is to simply take the additional monthly payment and break it down across all the properties. So, in this case, $250 would be about $83/month per mortgage.
- # 1 House: Total payments $152,131 Save $19,737 and 7 years and 4 months
- #2 House: Total Payments $189,973 Save $22,544 and 6 years and 5 months
- #3 House: Total payments $247,825 Save $25,784 and 5 years 6 months.
- Total Savings: $68,065
As you can see, the rental property debt snowball strategy works better than the traditional debt paydown method.
Rental Property Debt Avalanche vs Debt Snowball
The debt avalanche is a slight variation where you pay off debts with the highest interest rates first. It doesn’t matter if the loan is smaller or larger and the monthly payment doesn’t matter.
Pros of the Real Estate Debt Avalance
The debt avalanche will save you more money in the long run because it is paying off the highest interest rate debt first. Intuitively, you know you will save more by paying higher interest rate debt off first.
Cons of the Rental Property Debt Avalance
The biggest drawback to rental property debt avalanche is it will generally be a bit slower to see results than the debt snowball. The debt snowball is psychologically better for most consumers because they can see faster results. So, if consistency is an issue for you when trying to pay down debts, stick to the debt snowball.
Should I Pay Off Loans or Use Leverage to Buy More?
This is a common question in the real estate industry. Most of the gurus strongly push high leverage methods to acquire as much rental property as possible as quickly as is feasible.
This is a great thing to do if you’re looking to grow rapidly. But, if you’re looking to retire, then high leverage poses risks to goals.
In that situation, you should want to deleverage in order to reduce the risk of losing your portfolio and retirement. In this situation, you should want to pay the loans off rather than utilize more leverage for growth.
Rental Property Snowball Frequently Asked Questions (FAQ)
Yes. It does work and will pay down your debt faster and save you more than a standard debt paydown strategy
The debt avalanche will factually save you more money. But, people tend to be irrational with money. So, psychology plays an important role when determining money habits. As such, the debt snowball tends to work better for the average person because they can see the results faster and are more likely to maintain that behavior modification.
Saving is important, but it’s also important to pay down interest-bearing debt. In general, you want to pay down as much debt as possible, but don’t forget that every payment you make cannot be taken back.
So, if you pay down half your mortgage then lose your job, it doesn’t matter how much you paid off. What matters is you make the next payment.
You need to make sure you have enough savings to cover anything that might come up, or all that debt paydown will go to waste if you get foreclosed on for non-payment.
Mathematically it makes sense to pay down large balances first. This is because most of the monthly payment tends to be interest and not principal. So, paying down the principal on large balances snowballs the paydown effect faster.
But, we cannot forget about the psychological impact of making a quick win. If you can pay one mortgage off very rapidly, it motivates us to work harder on the next milestone. So, it may work better for you individually to start small and work your way up.