A question Real Estate Investors often ask is “I have surplus funds available. Should I use them to pay off my mortgage?”
Paying off the mortgage sounds like a very sensible thing to do. In fact, many banks and mortgage originators go into calculations as to the vast amounts of money, homeowners can save in interest, by paying off their mortgages. They are correct. Paying off a mortgage sooner than required can save a bondholder thousands in interest.
My advice? Investors do not need to pay off their mortgage. In fact, it would be unwise to do so.
Let`s take a case scenario to prove the point.
Imagine two fictitious investors back in 2000, Conservative Clive and Rudolph, the risk-taker. Both had R1m in cash. Conservative Clive used his R1m to buy one property for a purchase price of R1m. Rudolph, the risk-taker used his R1m to buy four properties worth R1m each, using four deposits of R250 000 each and four mortgages of R750 000 each.
According to FNB, since the start of their property price index back in July 2000, almost ten years ago, the cumulative increase in average prices till March 2010 has been 197.9%. This means a property bought for R1m in 2000 would be worth approximately R3m today.
Today, in 2010, Conservative Clive`s property is worth R3m and he has no debt. He has done well but he still only owns one property with a “portfolio” value of R3m.
Today, each property of Rudolph`s is also worth R3m, giving a total value of R12m.
If he never paid off the mortgages, he would still have a debt of R3m (4 x 750 000). The debt of R3m and the interest, however, is so small when compared with the total asset value of R12m. Rudolph`s use of gearing has landed him in a much better financial position.
But acquiring debt is wrong, right?
A lot of people will be thinking here that this kind of thinking led to the real estate bubble that bought the financial markets to its knees in 2008. And they may be right. But the point here is that we are talking about long-term investment buying, not speculative buying. The market may have faltered over a year or two but over a longer-term period, such as a decade or more, prices in South Africa have never EVER gone down. If we use data from two decades, or three or four, the returns are even better.
The fundamental here is the psychology around debt. Most people are petrified of debt. They think debt is bad. Yes, debt on depreciating assets, such as cars, holidays and clothing is bad. This debt should be paid off as soon as possible. Equally, the mortgage on one’s own primary residence should be paid off quickly. In South Africa, this interest is not tax-deductible. But a mortgage on an investment property is not a problem at all. When you owe the bank R5 000, you have a problem. But, when you owe the bank R5m, the bank has the problem!
Imagine you get hold of a lump sum of R100 000 tomorrow in cash. It could be a work bonus or an inheritance or anything. Why would you apply that R100 000 to reducing the mortgage when you could use the R100 000 as a deposit on a R1m property? By using the R100 000 to reduce the mortgage, you are reducing your interest payments and tax deductibility. You could rather earn a better rate of return by purchasing another property.
The biggest advantage of property
To put it into perspective: Experienced investors do not buy property to own the homes and buildings as these deteriorate and require maintenance. Experienced investors do not buy property to own land as land is generally speaking non-productive. Experienced investors do not buy property to acquire tenants as tenants require maintenance. The main reason many experienced investors buy property is to acquire debt because the debt stays the same but the asset against which the debt is secured and the income derived from the asset both increase in value.
*Lance Levitas is an experienced property investor. He graduated with a degree in Finance and Marketing and completed post graduate Real Estate Portfolio Management. He conducts property investment seminars as well as lectures Business Management, Maths and Financial Management to University students. He lives in Johannesburg. You may email him at [email protected]