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What Is Principle Pay Down?
For those who are new to real estate investing... When you purchase a property using a lot of the bank's money, you sign an agreement that you will not only pay back all of the money borrowed, but will also do so with an agreed upon interest rate tacked on which is mostly paid up front. The longer the amount of time that has passed since the beginning of the mortgage, the less your monthly payment of interest and more your monthly payment in principle. I'll give an example to make this clear.
There are two parts of what you owe the bank. Principle and interest. If the bank lends you $200,000 at an interest rate of 4% and you agree to pay it off over a period of 25 years, by the end of 25 years you will have paid the bank a total of $316,702.10. The principle of this was the original $200,000 and the interest was $116,702.10. That sounds bad initially, but I'll explain why it is actually good very soon. Every month of having this mortgage you will have a payment of $1,055.67. Part of this payment is principle and part is interest, but in the first month of the 25 year period you pay more interest than in the last month. The reason why this takes place is beyond the scope of today's blog. I'm simply focusing on what happens in general terms. In the first month of holding this mortgage $666.67 of the total is paid against interest and $389.01 is paid against the principle. In the last month of the mortgage $3.51 of the $1,055.67 is paid against interest and $1,052.17 is paid against principle.
The bank does this in order to make more money up front, which takes away some of the bank's risk. If you own a home for a short period of time, most of your payments have gone toward interest payments and when you move into a new home the bank can begin a new mortgage with high interest payments in the first few years in order to make a lot of money again. This is a great reason to hold properties long term rather than short term. The longer you own a home, the less money the bank is making from you in interest payments.
To summarize in an interesting way... in the first year of your mortgage payments to the bank/lender you will have paid off almost $5,000 of principle. This will basically remain the same for the first few years, but in the 10th year of holding this mortgage you will pay off over $7,000, in the 20th year it will be around $10,500 and in the final year it will be over $12,000.
How Can $116,702.10 In Interest Payments Be Good?
In the paragraph you just read I made a huge error. Did you pick it up?
I said 'you' paid off principle. While this is technically true, a more accurate statement is that your tenant has paid off the principle as well as the interest of each mortgage payment if it is good investment. Isn't that crazy? You have an investment that is not only paying you a chunk of money each and every year (often the cash flow on a good investment is already paying you more than the percentage you receive for you RRSPs or mutual funds), but you also have an investment that is increasing in value at an alarming rate and someone else is paying off your debt! That's crazy! That's magic! That's real estate if done properly.
I love certain types of debt. Debt that is paying me every month with extremely low risk is the kind I like. Realize I am very careful about what the definition of good debt is. Bad debt is when you pay every month. Good debt is when you are paid every month, and I mean every month. If you are paid some months or most months, this is still bad debt.
But what if a property is vacant for a month or two every once in a while, you ask? That's why you need to go back and read my blog on cash flow. If you only consider being paid after vacancy rates are taken into consideration, it means even when the place is vacant for a short period of time you will be paying yourself out of the money you have saved for this very purpose.
Back to my question.... How is $116k in interest a good thing? Because others are paying it for me. What are they getting in return (this is important)? They are getting a basic human need; shelter. They are also having this basic human need met not by being given the basics... they are actually given a safe, comfortable home that is well maintained. This is important. Next door to me there is a property owned by a slumlord. The property isn't taken care of even when the tenants ask for help. If the tenants leave, the landlord simply finds new people to make empty promises to. This isn't good investing. Rather, it is short term thinking for many reasons (but I again am getting carried away with topics outside of today's scope).
How Does Principle Pay Down Make Real Estate Different?
I have told you before I am biased. It's true. I honestly believe other investments cannot touch real estate when it comes to how diverse this particular strategy is in how you take away risk while building wealth. Principle pay down is a major component of how we build wealth through real estate. I have mentioned, and will mention in more detail again, that real estate can't be compared with gold. I consider gold a solid way to save money as a hedge against inflation, but it is not an investment, simply a savings account with zero percent interest. How is real estate better than gold as an investment?
First, when if I buy gold I can't ask for a mortgage on it. Which means I must pay 100% up front every time I purchase gold. Secondly, if I borrow money to purchase the gold I can't download this debt to anyone else. If I offered to rent my gold out to other people for a substantial monthly payment I wouldn't have a lot of replies, and for good reason. Why would anyone rent my gold? With real estate I can both borrow money to purchase the investment as well as charge enough money for others to live in the property to pay down every penny of my original debt plus the interest charged on that debt AND cash flow on top of these advantages (Just wait until after I've blogged every major dimension I can think of... It'll take me months).
While I've picked on gold a bit here, there are other investments that have the same problems as does gold. Stocks are an example. It isn't typically highly leveraged (when it is leveraged, it doesn't touch the kind of leverage real estate easily obtains) and it definitely cannot be rented out for any more than a low sum (with inherent risk). The reason a lender/bank won't take on high debt with stocks is due to the high risk factors. Not so with real estate. Banks have decided it is a low enough risk that they can give anyone with a half decent credit score a ton of money even if the borrower has no experience with managing this type of investment.
What Difference Does Principle Pay Down Actually Make?
Let's use the example I gave earlier on. If you have properly invested your money and have a cash flowing property, you should already be receiving a decent percentage on your investment simply from rental income. Secondly, over a long period of time you will most likely receive money due to property appreciation. Lastly, and the focus of today's article, you will be receiving another $5k each year on top of rental income in the form of principle pay down. You owe $5k less to the bank in year one, which is similar to putting $5k in a safe, long term savings account. Not only are you making decent money this year and able to spend it, you are also putting a good chunk of change into a savings account that is growing over the long term.
Ok, last question... Why aren't you investing in real estate yet? In just these first three dimensions it should be easy to see that real estate is a fantastic way to build wealth. Not convinced yet? No problem:) I have many more blogs to write that I am sure will argue strongly for real estate over other common investments. Have a fantastic week. I wish you the best in your investing education.
If you would like to learn more about investing in real estate please contact me at the email address listed at the beginning of this article or go to my website at: www.akerahomes.com/investing-in-real-estate.html
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