The Advantages and Risks of Financing an Investment Property With an Affordable 30-Year Mortgage
Updated: Sep 28, 2021
Why I Don’t Pay Off My Mortgage
As a landlord, I constantly struggle between the desire to maximize my return on investment and paying off my mortgages so that I can free myself from debt.
To understand my struggle, you need to know how the debt I incurred actually works in my favor, as well as the general downfall of having debt.
To illustrate my points, I will show you three main reasons I keep my debt and the only reason I would want to pay my mortgage off.
Three huge benefits of a 30-year mortgage
1. Choosing a 30-year mortgage substantially boosts your return on investment.
Financing the majority of the home purchase value with a 30-year fixed mortgage at a low interest rate effectively lowers the investment cost of capital, thereby substantially boosting your return on investment.
To illustrate this point, I will use my first house purchase, back in December 2011, as an example.
I bought my first house for $244,500. I put down the traditional 20% down payment of $48,900. I financed 80% of the house (i.e., $196,500) with a 30-year mortgage at a 4.25% fixed interest rate.
Today, I rent the house out for $2,050 per month (a total of $24,600 each year). My mortgage payment is $1,362 per month or $16,344 per year (including real estate tax and insurance).
What would my return look like if I'd purchased that same house with cash instead? For illustration purposes, I made the table below to compare these two scenarios:
1. Purchasing the house with all cash.
2. Financing the house with a 20% down payment.
As you can see, purchasing a house with a low-interest, fixed-rate mortgage substantially increases the return on your investment.
In my case, if I had purchased the house with all cash, I would have only generated 8.13% simple return per year versus financing my payment with a 30-year mortgage—by financing, my return on investment skyrockets to 27.11%.
2. Having a 30-year mortgage is the best hedge against inflation.
In the past few weeks, you have probably heard that inflation is finally picking up, and you are reading articles advising you to buy gold, Bitcoin, commodities, and stocks (that can pass down the cost to its customers) as a way of hedging against inflation.
But I think better than buying things, borrowing money at a low interest rate locked in for 30 years is probably the best hedge against inflation, especially if the asset you are buying with this borrowed money is an appreciating asset such as a house.
Think of it this way: Let's assume that inflation is only 1% per year (probably going to be a lot higher than 1% in real life, but I am trying to make a point). By only putting a 20% down payment on this house, for every dollar you put into this asset, you effectively leveraging five times the value increase of this asset.
Here is the illustration using my first house purchase:
a. Purchase price: $244,500
b. Inflation rate : 1%
c. One-year inflation value (a x b) : $2,445
d. Initial investment amount : $48,900
e. Return on investment (c / d) : 5%
As you can see from the table above, if I financed this purchase with a 20% down payment, my return on investment based on a 1% inflation increase would be 5% (i.e., five times the inflation rate of 1%).
Hopefully, you are getting the idea that leveraging a 30-year fixed interest rate loan can really supercharge your return on investment.
3. You can invest the extra cash and get a better return.
Mortgage rates are historically low. I recently refinanced my rental property to 3.5%. Instead of paying off my low-interest mortgage, I would rather invest the cash in the stock market or buy another rental property; both will give me a higher return than 3.5%.
Also, the interest rates will undoubtedly increase in the future. Although CD rates are still low, if in a few years CD rates jump back to 3.5% or higher, it is still definitely a better idea to save the cash in a CD than of paying off the mortgage.
The big pitfall of a 30-year mortgage
Higher returns will typically correspond with higher risk(s). There is one huge risk when holding a 30-year mortgage that could destroy my rental property if I am not careful.
Thirty years is a long time, and many things can go wrong.
Look at 2008. There were plenty of landlords who held mortgages when their tenants stopped paying. In those situations, the landlord was still on the hook to pay the monthly mortgage payments.
If the landlord overleveraged with loans without any rental revenue, it was just a matter of time before he/she was forced to sell the property at potentially undesirable prices or, even worse, go bankrupt.
And this could just as easily happen to me.
Here's the bottom line
Honestly, I feel like I am always going to struggle between keeping or paying off my debt.
I am always fearful of the worst-case scenario of going bankrupt. But I am glad I've been thinking and struggling with this choice—because through this struggle, I have developed a road map on how to protect myself against overleveraging.
I will write this road map down in separate blogs to help everyone protect themselves from another financial recession.
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