There is good and bed debt.
In general, good debt:
a) has lower interest rates
b) is tax deductible, and
c) is used to purchase assets/investments that appreciate over time and has cashflow
Bad debt consumes your life. It has:
a) high rates (think credit cards ~20%)
b) is not tax deductible, and
c) the purchase depreciates over time and/or takes money out of your pocket (cars, vacations)
So for a rental property, should you accelerate your mortgage payments and pay them down as fast as you can? After all, once your rental property is paid off, you get a monthly annuity stream (mortgage payment + cashflow) that you can supplement or fund your lifestyle.
For the savvy investor, this may not be the best option for the following reasons:
1. Maximize mortgage interest deduction
Mortgage interest is a deduction that the tax man allows you to deduct from your income to minimize the taxes you pay. Remember, taxes are your biggest expense. In a corporation, passive income is taxed at 50.67% and personally, your marginal rate can be as high as 53.53%. If you refinance and pull more equity out as your properties are paid down/appreciate, you can deduct even more mortgage interest and use that money to do your next deal.
2. Inflation and the present value of money
The central bank targets an inflation rate of 2%. This is a healthy rate to stimulate the economy. Inflation is like a thief that robs the purchasing power of your currency. We live in a debt-based economy, more and more money is printed and circulated into the economy everyday which devalues your money. To put that into perspective, you could purchase a single detached home in Barrie in 2008 for $200,000. Today, the same property is worth $500,000.
The bank is lending you $400,000 of today’s money which you will pay back over time in 30 years. $400,000 in the future will be worth much less than $400,000 today.
To give a simpler example, if I lend you $1 today and ask you to pay me back in 30 years, the purchasing power of that $1 will have significantly eroded. Assuming a 2% inflation/year, my $1 that I lent you will be worth only $0.55. You’re getting the value of $1 for just $0.55. By stretching out the amortization, you’re paying a lower amount in today’s dollar. Your mortgage payments get “cheaper” over time.
3. Leverage (not overleverage)
The game of real estate is leverage, using other people’s money (ie. the bank’s) to purchase a property. You just have to front $100,000 and you own a $500,000 asset. Sure you can purchase a $500,000 rental property in cash and get a monthly annuity stream but the returns are much higher when you instead purchase 5 rental properties with $100,000 down for each property.
As mentioned in our third point, by leveraging, you can scale and purchase more doors. Also, lenders don’t care how much equity you’ve built into your rental properties. They care about your monthly debt obligations. With higher monthly mortgage payments, your debt service coverage ratio (DSCR) is higher which means you can qualify for fewer and smaller loans.
5. Rate of return
There are mortgage rates as low as 2.5% as of writing this article. Inflation is 2%. That is almost like free money. Can you generate a return higher than 2.5% with other investments? There are many passive investment vehicles out there that far outpace this return. Paying down your mortgage is not an efficient use of your capital.
6. Cash Flow
With a lower monthly mortgage payment, you have higher cash flow every month. Again, the present value of this cash flow is worth more than in the future. Cash flow is a buffer during good and bad times and is why we feel so confident in our investments, even if there is a recession.
7. Dead Equity
If you’re going to refinance your properties to pull out dead equity, it’s inefficient and defeats the purpose of putting more equity into the property just so you can pull it out in the future. There are legal fees and possibly prepayment penalties to refinance your properties. Plus, the lending environment in Canada has gotten more and more strict in recent years. Who knows, if we can still utilize this strategy in the future.
If you’re still not convinced after the seven points above and still want to pay down your mortgage faster, a 30 year amortization offers flexibility. You can still pay down your mortgage faster. If you choose accelerated weekly payments, you pay one extra mortgage payment every year which reduces your loan term from 30 years to 26 years. If you want to speed it up even more, you can take advantage of certain terms your lender offers you. Scotiabank for instance offers a 15/15 prepayment privilege which allows you to increase each payment by 15% and another lumpsum of 15% every year. Just by increasing your accelerated weekly payments by 15% further reduces it to 19 years.
In summary, the wealthy use good debt to their advantage and get further and further ahead. Do you want to join us in the investor class where we take advantage of good debt, low interest rates, sound economic fundamentals, and a systematic approach to real estate investing to fuel your financial success?