Should I pay off my rental property or make minimum monthly payments? Today on Financial Freedom Friday, Matt Theriault explains the pros and cons of both approaches through a practical example! Find out what strategy is better if you want to create wealth, understand the importance of leverage and amortization, and learn how to speed up a debt payoff to preserve and protect what you’ve built.
What You Will Learn About Should I Pay Off My Rental Property or Make Minimum Monthly Payments:
- Why it is crucial to set your goals
- The pros and cons of both approaches through a practical example
- The importance of leverage and amortization
- Which method is better if you want to create wealth
- Why it is necessary to identify a monthly cash flow goal
- How it is related to minimum monthly payments
- How to speed up a debt payoff to preserve and protect what you’ve built
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Speaker 1: This is Theriault Media.
Matt Theriault: Hey, Matt Theriault here and welcome to another episode of Financial Freedom Friday.
Speaker 1: It’s time for Financial Freedom Friday, with Matt Theriault.
Matt: Okay, so the question that came in this week was, “If I buy a rental property, should I pay it off, or should I just make the minimum monthly payments?” I’d have to say, like most real estate questions, that’s a big fat it depends. It depends on what your goals are, it depends on what you’re looking to accomplish. Maybe if I, I’ll write out the scenario here, and just kind of show you the difference, and the outcome of both. Then you can make the decision based on what you want to do, all right?
Let’s say we’ve got, we’ll call this scenario one where we’re going to pay off the house. Then we’ll call this scenario two, where we’re going to take out a loan, purchase it, and just make the minimum payments. Let’s say both houses, a fair market value is $100,000. Let’s say they both rent for $1,000, that’s a month. Then let’s say the expenses, we’ll just minus, say 40%. That’s a good round number rule of thumb. That’s going to stand for your taxes, your insurance, your maintenance, your vacancy factor, and your property management. We’ll say this nets, all things being equal, rents … No, no, no, excuse me, nets $600 a month, all right?
Now, if we come over here, and we take this, so $600 a month. That’s going to give you $7,200 a year. We’re going to divide that by the amount of money that you have invested in the property, which is $100,000, right? Divide it by 100,000. That’s going to give you a 7.2% cash on cash return with the cash flow, okay? That’s what you have there.
Now, let’s say you come over here and you are going to borrow 80%, so you’re going to put 20% down, so we have a debt of 80,000. Let’s just say we have it at five percent. Our monthly payment is going to be 429. We still have our $600 a month from over here. We have to pay for the debt on this property, 429 which gives us $171 a month. There’s our net cash flow there, okay? This one pays us $600 a month, this one pays us 171. If we look at that over a year, that’s $2,025 a year of net income. We’re going to divide that by how much we have invested in the property. Over here we had all 100,000. Over here, since we’ve leveraged 80%. We have 80,000 that we’ve borrowed. We only have $20,000 into this deal, right? We’re going to divide that by 20,000, make those equal. What that’s going to give us is just about a 10% cash on cash return, all right?
You can see over here, you cashflow may be bigger. You have $7,200 a year in cash flow. But, your money’s not working as hard for you as it could be. Over here with the use of leverage, it’s working 30% or so harder for you then it is over here. But, your cash flow, your actual dollar amount is only $2,025 a year. That’s what I was saying, it depends on what your goals are. If you really need the cash flow and you don’t care about this $100,000, and having that to use in other places, then maybe you do want to pay it off. If you’re looking to build wealth, and you want to take advantage of all the profit centers of real estate, and you know this is a long-term vision. Then, maybe this is better for you, ’cause let me show you what you can do.
What you have over here is, you only put $20,000 in. That means you have $80,000 left to play with, right? What you could do, is go buy four more houses in the same fashion, right? What that would give you is this 171 times five. That’s going to give you $855 a month. Over here you have the $100,000 working for you on five houses, paying you 855. Over here you have the $100,000 working for you, paying you the 600, right?
I don’t know, you just kind of look at that. Then you decide what you want, what it is you want to do. One thing that you lose over here, or let me show this, ’cause all the profit centers of real estate, you’ve got leverage, you’ve got appreciation, you’ve got cash flow, you’ve got amortization, and you’ve got depreciation. In this scenario, you have all five profit centers working for you. Over here, what’s happening is you’re giving up leverage. Probably the biggest wealth building factor of real estate, the biggest wealth building factor that’s available to the average person that’s not available really in any other investment. That’s what’s really important there.
The other thing that you’re giving up, is you’re giving up the amortization. Meaning, you paid for this house. That was your money that you used to buy it. Over here in this scenario, who’s buying this house for you? Yeah, you put $20,000 down, but who paid for the rest? The tenant, right? Because, you got $600 a month, and then you paid $429 from that $600 towards the purchase of the house. You lose out … Over here, you lost out on the leverage, and you lose out on the amortization. Then, you also lose out because of the interest payments, you lose out a little bit on the depreciation. But, I’ll just leave that alone. That’s a tax question or a tax issue, and that’s going to be a little bit different for everybody.
But, if you look at that, you can kind of see over here, you miss out on two of the biggest reasons that you want to invest in real estate. That just kind of makes it like a regular old investment now, I mean like an annuity or something like that. Over here, you’ve got all this wealth creation happening for you. You’ve got it happening for you times five, right? This is if wealth creation is important to you, and building wealth is important to you, I would definitely look over there. If you want to be ultra-conservative and just park some money, and have it spit off a little bit of a return, and maybe diversify your portfolio a little bit, maybe you do want to pay it off. I don’t know, it’s totally up to you. But, now you know the difference.
This is what I would recommend, is that … Let me find a different color over here, there we go. Rule of thumb, identify what your monthly cash flow goal is, right? Your monthly cash flow goal that you can live off of. This is the number here that you’re getting right now with this scenario. You’re getting this 855. Keep purchasing houses in this manner, until this number gets to where it’s a number that you can live on, right? Say it was $5,000. Once you’ve hit that number of $5,000, then circle around and start using the cash flow to pluck off one of these houses one at a time, and paying off the debt, okay? ‘Cause then once you do that, let’s just say in this scenario. If we just use these five houses, started paying off this debt, this just went from 855 bucks a month, and now you come over to go ahead and take six times five to $3,000 a month.
Now you’ve got the cash flow, and that’s something that can have an impact on your life, on your monthly, your livelihood, right? Your lifestyle. My rule of thumb and you can choose whatever you want to choose. But, my rule of thumb is leverage as much as you possibly can, until you reach your monthly financial goal so you can escape the rat race. Once you’ve built this, start eliminating the debt to preserve and protect what you’ve built, all righty?
That’s it for today’s Financial Freedom Friday. Whether you pay off your house, or you can make the minimum payments. Entirely up to you, and it depends solely on your goals. I will see you next week on another episode of Financial Freedom Friday. Take care.