Real Estate Investor Tips
5 Reasons NOT to Pay Off Your Mortgage
Approximate Reading Time: 2 Minutes
A few years back Fox Business News asked me to comment on a Wall Street Journal article about affluent seniors who are opting not to pay off their homes. Instead they are choosing to take out jumbo mortgages on their homes and using the cash for investments. Sound risky?
They only gave me a couple minutes to talk about it on air, so here’s what I would have said if I had more time:
The Power of Leverage:
Without understanding the power of leverage, none of this will make sense, so let’s start there.
If I offered you a loan for a million dollars at 6% interest, would you take it? Even better, what about a million dollar loan at 4% interest, amortized over 30 years? If you’re answer is “No, I would never want that much debt!” then you may see all debt as bad debt.
Obviously if you spent the money and had no means to pay it back, that would be bad debt – bad for both the lender and the borrower (but worse for the lender because at least the borrower got to spend the money!)
If you answered, “YES! I’ll take the million and gladly pay you back in 30 years,” perhaps you have a good idea how you might turn that million into two million or more.
If that million dollars was invested in a way that returned 7% interest, the cost to borrow the funds would be $40,000 per year and the investment would yield $70,000. The borrower could potentially earn $30,000 per year for borrowing the million dollars and putting it to work. How much could be earned over 30 years?
Bad debt is borrowing money to buy things that you couldn’t afford otherwise.
Good debt is borrowing money to buy assets that make more money.
Warning – This Strategy is Not For Everyone!
Investments have inherent risk. A senior citizen, or anyone for that matter, who is not an experienced, successful investor, should not borrow money for investment purposes!
But if you have an excellent track record and understand what you are doing, using loans as leverage for wealth building can be quite lucrative. Finally, any financial decision should be well researched and discussed with your CPA, attorney and financial advisors.
So… here are the 5 reasons why it might not make sense to pay off your mortgage:
1 – Diversification
Having all of your equity under one roof is not diversification.
I know a retired couple who owned a million dollar home free & clear in the Berkeley Hills. Surprisingly, they did not have earth quake insurance, yet they lived right on the fault-line – talk about having all your eggs in one flimsy basket…
If they had used some of the equity to buy a couple of high-quality rental homes in good neighborhoods, they could easily achieve a 6%-8% return. If they were borrowing the money at 4% interest, they would have enough money to make the loan payments, plus they’d receive additional passive income to put in their pocket.
If an earthquake destroyed their home, they would still have the other assets in tact (as long as they weren’t in the same neighborhood).
2 – Asset Protection
Attorneys tell me they do a quick title search when considering whether or not to pursue a lawsuit. They want to know how they will get paid before they do the work.
It’s very easy to look up what a home is worth, and whether or not it has a loan against it. A fully paid-off home is much more enticing to go after than an encumbered home.
If an investor takes out a home equity line and buys rental properties, those properties can be put into an LLC which offers even more privacy and asset protection.
3 – Inflation Hedge
The U.S. government is currently trying to create inflation. If they succeed, what does that do to home equity? It eats it up, along with cash and savings. What does inflation do to debt? It eats it up as well. Perhaps that’s one reason why the government wants to create inflation – to eat away its massive debt.
Since we can’t always fight the government’s economic strategies, we might need to learn to work with them. Leveraged real estate can be a hedge against inflation, especially when the debt is used to buy income property that yields a return that is higher than inflation. Rental property that brings in 6% net return helps investors stay ahead of 4% inflation. Meanwhile, the debt value is diminished each year.
4. Passive Income
Right now interest rates on primary residences are so low it’s like getting free money. It gives us the opportunity to act like a bank.
Banks borrow money at one rate and then lend it out for approximately 3% more. We can do the same thing by borrowing money from our home at 4% and investing it for a return of at least 7%.
5 – Your Home is Never Really Paid Off
If you still think it’s a bad idea to have any debt on your property, consider this: you never really own your home “free and clear.” Homeowners will always be subject to taxes, insurance, repairs and sometimes HOA fees. If you haven’t budgeted properly, you could lose your “free & clear” home to tax liens or deferred maintenance issues.
The dream of paying down your home loan so you can eliminate bills and retire someday is just not real. The bills will be there, with or without a mortgage. A more prudent goal is to create multiple streams of income through income-producing assets so your bills will be paid when you hope to retire.