Invest Cash Flow or Paydown your mortgage faster?

[kablett]

A friend and I have been debating this topic back and forth.
For years, I`ve believed that it`s better to leverage to the hilt, and use cash flow to re-invest and leverage to the hilt some more.
We would scoff at people who burn their mortgages because their ROI is so much lower, dollar for dollar.

However, we`re beginning to re-address this old question with new eyes and I would love to get the opinions of other REIN members.

If you have extra cash flow, let`s say $500, is it better to:

A: invest that $500 into another property, recognizing of course you may have to let it accrue for a year or more before you have enough money to actually do something with it?
B: Invest that $500 into a high yielding investment like a 2nd mortgage or something, again with the same short term critical mass challenge.
C: Invest that $500 into paying down your mortgage that much faster.
D: Invest that $500 into paying down a `re-advanceable mortgage` that credits the principal reduction back to you in the form of a home equity line of credit, and then investing THAT money into something.

I am torn on this issue for a few reasons:
1. the time value of money is important here.
2. the interest rate you would pay on a heloc is greater than on a mortgage, so does it really make sense to paydown something of lower interest only to replace with something with higher interest.
3. I know taxes are an important factor, but am not sure of their respective impacts in each of these scenarios.

I welcome the thoughts and experiences of other REIN members on this issue.

Thanks,

Kevin.

 

[gwasser]

QUOTE (kablett @ Oct 23 2007, 03:27 PM) A friend and I have been debating this topic back and forth.
For years, I`ve believed that it`s better to leverage to the hilt, and use cash flow to re-invest and leverage to the hilt some more.
We would scoff at people who burn their mortgages because their ROI is so much lower, dollar for dollar.

However, we`re beginning to re-address this old question with new eyes and I would love to get the opinions of other REIN members.

If you have extra cash flow, let`s say $500, is it better to:

A: invest that $500 into another property, recognizing of course you may have to let it accrue for a year or more before you have enough money to actually do something with it?
B: Invest that $500 into a high yielding investment like a 2nd mortgage or something, again with the same short term critical mass challenge.
C: Invest that $500 into paying down your mortgage that much faster.
D: Invest that $500 into paying down a `re-advanceable mortgage` that credits the principal reduction back to you in the form of a home equity line of credit, and then investing THAT money into something.

I am torn on this issue for a few reasons:
1. the time value of money is important here.
2. the interest rate you would pay on a heloc is greater than on a mortgage, so does it really make sense to paydown something of lower interest only to replace with something with higher interest.
3. I know taxes are an important factor, but am not sure of their respective impacts in each of these scenarios.

I welcome the thoughts and experiences of other REIN members on this issue.

Thanks,

Kevin.

Hi Kevin,

Paying off your mortgage with extra cashflow provides you a security cushion against falling property values. In the last 15 years this was not so much needed, because real estate values have not fallen dramatically in Canada during periods of economic turbulence. However, around 1990, famous real estate companies such as Olympia & York got themselves into deep trouble by being overleveraged during the `Savings & Loans` crisis. During that crisis, many properties lost a lot of their value (just read Robert Kiyosake`s Cashflow Quadrant). As a result property values dropped below mortgage principal and banks started to refuse mortgage renewal or even foreclose.

In 1982, as a result of the NEP and super high interest rates, the real estate market in Calgary collapsed nearly overnight (well... 3 to 6 months). A condo I owned lost nearly 40% of its value in a matter of months and many units in the complex went into foreclosure. If you build equity in your property, you can survive such tough times.

Also, instead of gaining capital appreciation, paying off your mortgage results in improved cashflow. Suppose, you paid off $25000 of your mortgage of 6% interest. This results in extra cashflow equal to 6% of $25000. If this cashflow is pure net income, then this money becomes taxable similar to interest income. However, with real estate, you can use the annual depreciation of the building to reduce your paper profit to zero, i.e. you get 6% on $25000 tax free.

If you invested in a 2nd mortgage, assuming a 50% tax bracket, you would need to yield 12% for the same after tax result.

If you get older and closer to retirement, cashflow is important for you to live off. So by paying off your mortgage you can decrease your capital gains and convert your investment into a cash machine. What is better, appreciation or cashflow, depends all on your personal circumstances, age and risk tolerance.

Hope this helps

 

[LongWayFromHome]

Hi Kevin,Whenever I have a choice of A or B, I like to see if I can choose both.
I faced the same question (pay off mortgage or invest) a few years ago. I decided to both. I committed to buying X properties per year which were long term holds and Y properties per year which were flips or sell-for-profit-within-a-year-or-so. The hold properties enabled me to build long term wealth. The profit properties enabled me to spend money on lifestyle and also reduce my home mortgage. (Obviously there are risks with short term property strategies, so do your research carefully and get good advice). A good starting point is understand the ripple effect and then go look at lots of properties especially in smaller cities and towns. I like listening to Raymond Aaron and Dolf de Roos - I`ve learned a lot from them.
LWFH