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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I’m a new reader to your blog and I’ve been cruising through the real estate posts.
I notice this one originated back in 2014…. what did you eventually decide to do? Did you pay down debt or did you buy more real estate?
I think my proposal in a similar situation would be…. if your mortgages are 50% or less than the total value of the existing properties you own, buy more real estate.
If not, pay down your mortgages until they are 50% or less than the total value of all your properties. That way you will be better able to take some hits during bad times.
Financial Samurai says
In 2014 I decided to leverage up and buy more property in this place called Golden Gate Heights, San Francisco.
See: Leveraging Up To Increase Passive Income and The Best Place To Buy Property In San Francisco
It turned out to be a good move as prices surged about 30%. See: To Get Rich, Practice Predicting The Future
But now the markets have begun to slow. Time to wait for the ~10% fade until Uber or/and Airbnb go public!
Max Haverfield says
Curious…what are your thoughts on investing in cattle grassland? Is it something you have ever considered? In Kansas, where I live, the rent you can receive from grassland ($15/acre) is about 1/2 the total costs (principle, interest, and taxes). So, the land payments must be supplemented, but the inflation has been pretty dramatic. The land is extremely low maintenance, and easy to rent. It has at least quadrupled in value in the last 15 years or so. $170/acre in 2000, to $350/acre in 2007, to $700-$1000 in 2015. The land I am looking at (638 acres) may also have potential for oil production or at least an oil exploration lease. Oil exploration leases have been renewing every 3 years for about $50-$75/acre in my area.
I come from a long-time ranch family, so the land would also bring me pride and recreation…and probably a place for me to have my own cattle and essentially rent the land to myself.
Reid K. says
I never see any point in CDs. The interest you get it less than the country’s inflation, making you essentially lose money.
The only way to do it in that you make something, is investing abroad. That way, you can possibly get interest higher than your country’s inflation and hopefully gain on the currency exchange rate too.
Financial Samurai says
in 2009-2010, CDs were paying 4-4.5% as banks needed to attract as much liquidity to survive. I put a portion of my risk-free net worth there for safe keeping.
But nowadays, at 2.2%, it’s tough.
Jack @ Enwealthen says
Been discussing this exact issue with the wife for a few months now.
We have the cash to purchase some rental real estate, but it’s going to be interesting to see what the Fed does at the end of the year as QE tapers and the market starts to respond. It could make home values rise and people leave the stock market looking for something “safer”, or it could bring it down as people panic and start going old school and looking at their mattress as the safest “investment”.
All the markets have been so irrational lately, it’s resulting in our analysis paralysis. No clear signals, no clear solutions.
For now, we’re paying down existing mortgage and student loan debt. At least we get to live in our investment and maintain the mortgage interest deduction (for now…)
Late to the game on the comments….
Definitely a very personal decision….
If the goal is real wealth accumulation….then the 3.5% gain on paying down debt only makes sense if you are really long term bearish on property (assuming you are looking at buy and hold investments)….. Holding cash may not be a bad idea in the short term..until you either find the property or feel market valuations are more attractive…..
That leads to the question…how short is short term? If you are looking at a year +, and this is supposed to be the “conservative” part of the investment portfolio, seems to me like a mix if Munis, widows and orphans dividend stocks, may even intermediate term treasuries might give a low beta 4% return……
Adam B says
To be fair, any long term investment that can keep up with current inflation isn’t horrible. The Feds are printing our dollar into oblivion. Get into debt, print money to pay off that debt. Get into more debt. Rinse repeat. Unsustainable plan if you ask me.
That’s why it’s so hard for me to keep paying higher taxes. They can hardly manage their own budget, yet they want more of my money so they can “disperse” it to the “less fortunate.” Riiiight.
What makes you think AirBnB or Dropbox are going public soon? The former just received more private funding and has more cash than it needs really. I’m not liking the current way things are going with private equity firms benefitting from these amazing companies! Leave some for us!
After reading Jim Collin’s post on real estate, I will never be one to buy into real estate and hope for equity appreciation. He posted an interesting chart which I’m sure you’ve seen that proves that real estate after inflation is at about the same levels as it’s ever been. Sure you will have fluctuations, but it’s not like the stock market that ACTUALLY appreciates over time. I would only bank on the tenant income myself. That said, I think you’re right in assuming SF has much more growth potential than many other places in the world. What happened to your Hawaii plans?
If it were me, I’d pay down debt and invest some into “O”. 5% dividend and very strong financials and monthly income.
This is a good problem to have and a timely article. In 2015 I also have a 5 year CD coming due at which time I will have enough to pay off my mortgage. On one hand this is a guaranteed ROI vs. the other I feel it could also be a missed opportunity cost. Specifically, there are some reports that by around 2017 baby boomers will start “down sizing” in numbers significant to depress home values.
David Michael says
Sam…Whatever happened to your consideration for investing in P2P loans?
I have been in Prosper for about five months now with over 400 loans, making 11-12%. No defaults yet, partly because I focus on A-B-C loans with a conservative set of filters. Generally, it takes about 30 minutes a day for me to select new loans to keep reinvesting the money turnover. I have been very happy with the results so far, realizing the return may drop to 7-8% after the first year. So much better than any of the CDs, Savings Funds, or even our I-Bonds which deliver a secure 4-5% because I purchased them 14 years ago.
It just seems so much simpler and less stressful to balance out holdlings with P2P.
Financial Samurai says
Thanks for the reminder and following up on P2P lending. I’ve totally been ignoring my Prosper account until recently. I just wrote a comprehensive post called, “Should I Invest In P2P Lending? Prosper Performance Overview“. You’re right. P2P lending is a great way to earn passive income!
You could do neither. Just keep it in cash. You don’t have to do a transaction just because the cd is due. The right time to buy the property is if the numbers are right not just because you have cash. Same with stocks. Sometimes it’s nice to keep an elephant gun loaded for when the opportunity arises. Paying down debt decreases liquidity and if interet rates rise you’ll wish you could invest in 6% CDs or if stocks are at record lows on the future you can invest in stocks.
Financial Samurai says
Sitting on the cash is not a bad idea. The reason why I’m planning/thinking now is so that when the CDs start getting released, I won’t have to sit on it as long given the opp cost.
The right property will take time.
Justin @ Root of Good says
I voted pay down debt and save 3.35% in interest. You’ve won the game, you’re just piling on the wealth at this point. ;)
If it was a 30 year fixed note at 3.35% I’d be tempted to say keep the money in CDs at 2.x percent (or cash at ~1%).
Sam, I constantly have to decide the same question you’re dealing with. I voted to pay off the debt and get your satisfaction with some creative tax advantaged investments for any left over income and/or future income, as real estate is work. My solution: since I’ve done real estate in spades, I’ve kept the houses I want, paid them off, and now my new cash is flowing into what I consider to be safe investments: infrastructure MLPs, natural gas Storage and drilling firms, as MLPs distribute tax- free gains regardless of your income, mREITs, tax deeds for returns of 10-36%. I would probably add some option-income closed end funds, as their distributions are close to tax free regardless of your income – check out Eaton Vance for tax-managed ones (and Douglas Albo on Seeking Alpha is the resident expert). I don’t really trust muni bonds, as I believe Meridith Whitney will eventually be proven correct in her BK predictions for many.
How’s that for options? A bit here, a bit there, get debt free, and if you really want to buy real estate, buy a small house that smells like cat pee and paint it all with oil-based Kilz, rip out everything, and rehab it all yourself to fill your time for a few months. Sell it when you’re done and do it again, or rent it for a year then sell to take advantage of capital gains tax. Hope that helps!
debt debs says
Narrow down to your favourite 2 and then flip and coin and don’t look back.
I predict you’re going to have a nightmare about earthquakes and more bad tenants if you agonize over it too much.
I voted pay down debt. Another option is renew one of the five CDs. Invest the rest in solid dividend growth stocks that would pay dividends of ~3.5 to 4 percent, which are deposited into your brokerage account. I recently bookmarked this article which I thought was a good resource for stocks and DGI blogs. It will take some work to get the portfolio researched and set up, but it should be fairly easy to maintain.
Another option (assuming you find a viable property), would be to take on the additional cash flow and hire a property manager? I bet you could get a favorable rate now that you would have two properties to have managed.
Your cash flows would not increase as much as if you do the “management” yourself, but it takes nearly all the stress out of owning the property.
Plus, you have the opportunity to live in a new place, try out some new places, etc. Of course, the financial aspect is the most important, so the extra rent on your current home would make it even better!
If you can find a a good property at a reasonable price, you should invest. Reasonable is the key! If you do not need the (interest) income, it is still good to build or add to your assets.
Pentagon Federal Credit Union is offering 3% 5 yr CD’s… that’s who I use.
Financial Samurai says
Good to know. Will look into it. Can anybody join?
Dan @ The Mad Real World Blog says
Yes, anyone can join. You may have to make a deposit to an organization they work with and you will be eligible. They offer good rates on loans also. From looking at the site, I do not see the 3% CD’s however.
Oh man… looks like I barely snuck in at the higher rates… should have socked away more in the 5 year instead of laddering! They’re back down to 1.5%… nevermind!
Keep your eye on them though.
Financial Samurai says
I’ve successfully got my income down to the 28% marginal tax bracket, and I plan to keep on going lower.
4% tax free munis are enticing. I like them better than 1H2013 as they have sold down.
Mr. Utopia @ Personal Finance Utopia says
*You’re too financially savvy to use a financial advisor in this instance. I just don’t think you’d get your “money’s worth” out of such services. Plus, the fees would cut into your 5% required return (unless you meant 5% return after fees).
*Reinvesting in the CD’s doesn’t even really seem like a legit alternative. It (most likely) would offer the lowest return and it seems you’re in a financial position where you don’t need to be that conservative.
*A mixture seems like a headache and too time involved and would make it more difficult to put a 20% down on a new property (at least from the current CD proceeds).
*Leveraging up and buying a new property seems like the most appropriate choice for you IF you can find the right property. My take is that you are financially secure enough to take the risk and would also be able to successfully navigate the waters if things didn’t quite turn out like you had originally anticipated.
*Since the survey asked what “you” would do, I voted pay down the mortgage debt. That’s just me. KISS – Keep It Simple Silly. Then again, I am in a completely different financial situation than you are. I’m a bit more conservative by nature and I love the idea of having a property fully paid off (or very close to it).
Financial Samurai says
If I can find the right property to live in, then I think I would seek to buy another property and feel the FEAR of having less cash/liquidity to try and save more money again.
The more money you save, the LESS motivated you become to save b/c you already have enough e.g. if you have $100,000 in the bank, who cares so much about another $1,000. But if you have $500 in the bank, $1,000 is a great achievement that makes a big percentage difference.
Then you have answered your own question. Put the money in savings, keeping it liquid, until (and if) you find a place worth buying. You have the luxury of holding out for something that is either exactly what you are looking for or too good a deal to pass up. In the meantime, if the market takes a substantial dip (for whatever reason) you could also decide to throw money in. Savings earn low yields, but there are benefits to having big cash piles.
Of course if everything just goes up and you never find that perfect place or get that good deal, then you will just kick yourself for earning nothing.
The Alchemist says
It sounds as though you’ve already answered your own question, Sam— at this point, you’re looking more for excitement than anything else. And you’re in a position where you can afford that excitement, while enjoying the benefit of it still also being a good long term investment. Win-Win!
That being said, I’m having a hard time believing that the SF housing market will sustain its current rate of insanity/appreciation for much longer in the current cycle. Something will have to give sooner or later. You are of course aware of that. But the long term in SF is always good. Thus, you’re probably safe buying a new pad, assuming you can find just the right place in the current tight market.
If you were *only* looking for a good investment with the cash coming available, I would toss out the suggestion that others have floated: consider buying a rental in another market. And don’t underestimate the value and benefit of a good property manager— it makes being a landlord pretty darned pain-free. Property management is a lot cheaper outside of the Bay Area, making it a feasible option. You could purchase a 3/2 sfr outright for the price of an SF down payment. Near Sacramento, rents are decent enough to make the cashflow worthwhile.
But I still think you’re truly jonesing for a new residence for yourself. You can afford the risk potential, and you’ve worked hard to make doing what you truly want possible. Go for it!
(Disclaimer: Admittedly, I want to vicariously experience the fun of watching someone who’s earned the right to do what he really wants DO it; I hope to get there someday myself!)
Seriously, retiring in your mid-30s with more assets than the majority of retirees at age 65?
Financial Samurai says
You know what’s funny? Several commenters have said exactly this, “It sounds as though you’ve already answered your own question,” yet each commenter concludes something DIFFERENT! With this type of feedback, I feel I’ve done my part in being as unbiased as possible with this post. :)
Every time I think prices can’t go higher, they do. I remember renting out my main rental for $2,100 back in 2005. It’s now at $3,800 and going higher. I never thought it would go over $3,000, but yet here we are knocking on $4,000. Inflation is more powerful than anything!