It is interesting how many times you are reading an article in a magazine or a newspaper, or when you are reading a book on Real Estate Investing, and the author focuses on one of two ways to get a return on your investment:
- Cash Flow (the life blood of any real estate investment) OR
- Appreciation (the speculation in real estate investment)
I want to talk about the third, sometime forgotten return in real estate investing, and that is:
Debt Reduction on your mortgage (thank you Mr. or Mrs. Tenant!)
Debt reduction is a key factor to take into account when you are analyzing the total return for a potential real estate investment you are looking at. You can thank your tenants for this return, as they are the ones who create it the moment they begin paying their rent.
When you pay your mortgage every month, the payment consists of two pieces: Principle and Interest, sometimes referred to as P+I. Interest is what you pay the bank, mortgage company or private lender in return for the risk they take on by lending you the money to buy the house. Principle is the part of your monthly payment that actually reduces the amount outstanding on your mortgage every month.
Let’s look at an example:
Mortgage Amount: $100,000
Interest Rate: 5%
Amortization: 25 years
Term: 5 years
Payment Frequency: Monthly
Based on these inputs, your monthly mortgage payment would be $582 per month. Of that $582, part of it pays the interest and part pays the principle. How much you ask? It breaks down like this for the first month:
- Interest: $412
- Principle: $169
Now, you may be saying that $169 is not that much, but remember, you aren’t paying it down.
Your tenant is!
They are reducing the amount of the mortgage outstanding just by the act of paying their rent.
A year later, the break down looks like this:
- Interest: $404
- Principle: $178
The amount of principle in every payment has gone up! As you (your tenant) chips away at the mortgage amount outstanding, the interest portion of each monthly payment is reduced because there is less of a mortgage balance to pay interest on.
Let’s look at a sample property (all numbers are fictitious) I’ve analyzed using IPCOnline.
The 20yr Returns section shows the break down of cash flow, debt reduction, and appreciation every year so you can see your total return on a potential investment.
After 5 years, when the mortgage term is up and it is time to renew, even with a 0% appreciation in your property value, you can refinance back to 80% LTV, pulling almost $72,500 out of your property to use as a down payment on another. This is in addition to the over $42,000 in cash flow this property generated, even with a 5% vacancy allowance.
As you can see, debt reduction should not be forgotten when running the numbers on a potential investment.
Do you always factor in debt reduction when analyzing the total returns on your real estate investments? Let me know in the comments below.