Are you wondering whether to pay down debt or leverage up to buy more property? It’s a good dilemma to have given interest rates are at record-lows. Meanwhile, the value of real estate is going up. We’re all spending more time at home and having a nice house rocks.
Let me offer a framework on deciding whether to pay down debt or leverage up to buy more property. I’ll use my own situation as an example. Then I’ll explain what I ended up doing at the end.
Real Estate Is A Great Asset Class
Real estate is my favorite asset class to build wealth.
I just love being able to live in my investment, do things to improve the value of my investment, and wake up 10 years later with a high probability of holding an appreciated asset with a lower mortgage. The tax benefits aren’t bad either.
A deep dive assessment of all my assets shows that real estate has provided the highest return on capital invested with the least amount of stress. I have a tendency to speculate in stocks. I was to find that multi-bagger return that has eluded me since 2000.
Many of my speculative bets have turned sour. I don’t want the temptation to speculate with larger amounts of money. The last thing I want to do is use my risk-free money to invest in stocks.
I absolutely hate losing money and I’ve already got 25% of my net worth in the stock market. (See: Net Worth Allocation Recommendation By Age)
Pay Down Debt Or Leverage Up To Buy More Real Estate
I know it seems funny to narrow the use of my CD proceeds to pay down debt or leverage up. However, that’s what I’ve decided unless you can convince me otherwise.
The second safest asset to holding cash under the FDIC guarantee limit. The limits are $250,000 for singles and $500,000 for couples is paying down debt. Going into debt is not safe, but I’ll explain my position soon enough.
The Case For Paying Down Debt
The only debt I have is mortgage debt. I do’t mind because it’s deductible. Further, it is tied to an asset which has a high probability of appreciating over time. Leverage is a wonderful thing on the way up. But not so much on the way down as we saw doing the 2008-2009 financial crisis.
My main rental property has a mortgage rate of 3.35% that is fixed for the next three years (5/1 ARM). 3.35% is not quite the 4.2% I was receiving from my CD. But its sure better than the 2.2% being offered for another 5 years in a CD.
1) Increase cash flow.
The rental mortgage amount is $277,000. Therefore, I would increase my cash flow by roughly $774 a month. This is equivalent to the interest portion of my mortgage ($277,000 X 3.35%).
I would actually free up more cash flow because my mortgage is amortizing. Which means I would also pay down roughly $540 in principal with each mortgage payment for a total payment of $1314.
Even though I would no longer have to pay $774 a month in interest, I’m losing about $196 a month in cash flow because this money was making 4.25% in a CD instead.
I just don’t see any other risk-free assets that can provide 3.35% given the 10-year yield is under 2%. The only thing that comes close to buying Treasuries is perhaps muni bonds. Munis are tax free and can yield 4%.
2) Slay the annoyance.
Besides no longer having to pay a $1,314 a month mortgage, the other great benefit of paying off debt is that it simply feels wonderful having no debt. When I decided to pay off my business school loans, it felt magical – like a snuggling with a fluffy golden retriever puppy.
It’s nice to know that a bank is no longer making money off me. I’ve noticed that the older I get, the more annoyed I am with having debt.
3) Lower tax payments.
Finally, I’m no longer making as much as I once was. Therefore, the income earned from my rental property is being taxed at a 11.6% lower marginal tax bracket (39.6% vs. 28%). I’ve still got amortization to shield me from paying taxes on most of my income as well.
The Case For Buying More Property
Although property is expensive in San Francisco, I believe just like every other international city in the world with a thriving economy (London, NYC, Hong Kong), prices will just keep on getting more expensive. I’m bullish on big city real estate as we reach herd immunity. The herd will come back in force.
Just one look at the job listings on Angel.co/jobs. You’ll see that basically every single startup job is between $80,000 – $200,000, and there are thousands.
1) Higher Return On Equity.
If I decide to pay down the $277,000 mortgage the return on my equity goes down. The property is currently valued by Zillow at $1,045,000. Let’s cut that value down by 15% because Zillow is often wrong to get a value of $888,250.
If the property appreciates by 10% ($88,825), the return on my $611,250 in equity is $88,825 / $611,250 = 14.5%. If I decide to pay down the mortgage, then my return on equity declines to 10% ($88,825 / $888,250). On the other hand, if I only had 10% equity in the property, my return on equity would be 100% ($88,825 / $88,825).
Let’s say I utilize $200,000 of the $277,000 for a 20% downpayment on a $1 million property instead of paying down debt. If the property appreciates by just 3% ($30,000), I make a 15% return on my down payment ($30,000 / $200,000).
A 3% appreciation rate in San Francisco does not seem unreasonable given the robustness of the technology and internet sector in the area. AirBnB went public recently and a host of other companies will go public over the coming years and flood the real estate market with liquidity. Too bad the 5% selling commission rate still exists. Ridiculous, really.
2) New Adventure.
I’ve lived in my current home for a little over nine years now. It would be fun to purchase a new property in a new neighborhood in San Francisco to live. Some places such as Telegraph Hill or The Mission come to mind for their different restaurants, parks, and night life.
I don’t plan to buy a rental property for the main purpose of renting it out. I’m also not just going to buy any property. The property has to be something I really enjoy where rent can immediately cover the mortgage and taxes just in case something happens. The new property is where I plan to live for the next five years.
3) Frees Up A New Cash Flow Stream.
I don’t want to get into too many details, but I can rent out my house for roughly double my mortgage interest + property tax amount a month. Renting out my house would therefore increase my cash flow beyond what I lost in CD interest income as I settle down in a new place.
The trick is to find a place in a market when there’s hardly any inventory. I went to check out this nice three bedroom, three bathroom + bonus room house which I liked, but the asking price was literally 20% higher than what I had initially guessed.
The Biggest Determinant To Paying Down Debt Or Leveraging Up To Buy More Property
So far I’ve simply assumed property prices will continue to go up or stay stable. The issue is, nobody knows for sure. The real estate market did slow down in 2018-2019, but it has since picked back up strongly.
Everybody wants to buy property because we’re all spending so much more time at home. Mortgage rates are at record lows so affordability is up. Rental income is more valuable now as well.
If there is a downturn in the property market, I’ll wish that I had paid down debt instead of leveraged up to buy a declining asset. That said, homeowners went through the worst economic decline in our lifetimes and we’ve turned out OK five years later if you held on.
I don’t think we’ll seen another catastrophic economic crunch in the next 20 years, but who really knows? I do know that being stuck with a bad investment really hurts my mood.
The biggest determinant of whether to pay down debt or leverage up to buy more property is the future of real estate prices. If the future of real estate prices is bright, then leverage up and buy more property.
Dead Many Cash
I absolutely hate holding cash. Although my Personal Capital Dashboard (free financial tool everyone should sign up and use) classifies my CDs as cash instead of as investments, CDs are absolutely investments in my book. They are like bonds with a FDIC guarantee component.
I had to declare my CD investments at my previous employer because they consider my CDs outside investments. The fact of the matter is that I’ve got more expiring CDs that need to be put to use once this first CD comes due – five more actually.
If I don’t pay down debt or buy another property, I’m strongly considering just handing the money over to a financial adviser. I’ll tell the financial adviser that this money is to be invested conservatively with a target return of 5% per annum and to not mess things up! I’m busy writing, traveling, and consulting.
I’m happy to manage my money as I’ve done for the past 15 years. But I’ve come to realize that after a certain threshold, I’m warming up to the idea of an adviser always looking out for my money as I’m doing other things. The key is finding the right financial adviser.
Would You Pay Down Debt Or Buy More Property?
If you were to come into a decent chunk of liquidity, would you pay down debt that doesn’t need to be paid off given the rental income more than covers the interest payments? Or would you leverage the money to buy a new home in a different part of your favorite city and rent out your existing home to unlock income?
I don’t need more cash flow anymore because of my online business, which has finally replicated my day job income after five years of hustle. It would be nice to own another piece of property if there aren’t any headaches involved in renting out my home.
Here’s what I ended up doing since writing this post:
1) I bought a new place with panoramic ocean views in May 2014! Once the CD came due, it just started burning a hole in my pocket. So I went out to the western portion of San Francisco to look for property and was amazed there were all these single family homes with ocean views for 40% less on a p/sqft basis than the home I was living in.
2) Instead of selling my home of 9.5 years, I ended up renting it out for $8,600/month starting June 2014. The place now generates $9,000 a month in rent. It’s a good chunk of change, but it comes with some headaches since my tenants don’t pay on time and are very messy people.
3) I paid down the Pacific Heights condo mortgage in the summer of 2015. The property is now worth between $1 – 1.1M. I found new tenants who are paying $4,200 a month (from $4,000). I don’t regret paying off this mortgage one bit and am very happy with the cash flow.
4) In 2018, the San Francisco real estate market has finally slowed after another30% increase since 2014. As a result, I’ve been aggressively hoarding cash as prices soften. I’ve also begun to surgically invest in higher returning properties in the South, Midwest, and East Coast through Fundrise, my favorite real estate crowdsourcing platform.
Instead of coming up with a $200,000 downpayment and carrying a $1M mortgage, I’d much rather invest $10,000 – $25,000 in individual real estate deals. Fundrise is worth checking out if you don’t want the headache of tenants, want real estate exposure, and want to stay nimble.
5) In 2019, I bought a new Golden Gate Heights house with cash.
6) In 2020, I bought another Golden Gate Heights house with leverage at 2.125% for a 7/1 ARM jumbo! Then I rented out the house I bought in 2019 for $6,555/month.
I’m very pleased to have paid down debt AND leveraged up to buy property in Golden Gate Heights, an area I believe to be the most desirable neighborhood in SF over the next 10 years.
No other major international city where you can get panoramic ocean views for less than $1,000/sqft. With the $9,000 in rental income coming in from my new house, I feel like I’ve unlocked a lot of wasted value and feel more financially secure despite taking on another mortgage.
Wealth Building Recommendations
Invest in real state crowdfunding. If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, or don’t want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.
Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. Sign up and take a look at the various eREITs Fundrise has to offer. It’s free to look.
I’ve personally invested $810,000 in real estate crowdfunding to invest in the heartland of America. This way, I diversify my real estate exposure and earn income 100% passively.
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