Imagine that you have the chance to own something that might be worth a lot of money down the road.
To buy this thing, you will need to pay 25% of the purchase price. The other 75% of the price will be paid by someone else.
Your job is to take care of that thing and keep it for a long time. It won’t be easy, but if you can handle it, you’ll wake up years from now owning something outright that is very valuable.
So far, this sounds pretty good, right?
Of course, there’s a catch. That person paying for 75% of the item will want to be paid back. He’ll want to earn interest, too.
You might be thinking that this opportunity doesn’t sound so promising anymore. Having to pay off that debt might be enough to convince you not to move forward with buying this thing.
You’re smart to be thinking about the debt. I could understand if the prospect of paying back a debt like this didn’t appeal to you. Who really wants to use their own hard-earned money to pay off debt anyways?
Fair enough.
But, what if I told you that other people are going to pay back that 75% (plus interest) on your behalf?
Even more, while those other people are paying back the debt, you still get to benefit from owning the item.
Does that change how you’re viewing this opportunity?
Maybe now you’re thinking that this is too good to be true?
Nope.
This is exactly how real estate investors generate long-term wealth. They buy a property using a loan and then pay back that loan using other people’s money.
This example leads us to the next main reason I invest in real estate:
Other people pay off my debt.
When you acquire the right rental properties, your tenants will pay monthly rent and that rent can be used to pay off your loan.
That means you can pay off that loan without using any of your own money.
As your loan balance shrinks, your net worth increases. As your net worth increases, you are creating wealth for you and your family.
Along the way, you can reap the benefits of monthly cash flow and appreciation. That means your net worth increases even more.
That’s a powerful combination to generate long-term wealth.
If this concept sounds like something you may be interested in, read on.
Before we talk more about debt pay-down, let’s review two of the other main reasons I invest in real estate.
1. Rental property cash flow is king.
With cash flow, you can cover your immediate life expenses. For anybody hoping to reach financial freedom, it is essential to have income to pay for your present day life expenses.
For my money, cash flow from rental properties is the best way to pay for those immediate expenses.
If your present day expenses are already covered, you can use your cash flow to fund additional investments.
That might mean buying another rental property or investing in another asset class, like stocks.
2. Long-term wealth through appreciation.
Appreciation simply refers to the gradual increase in a property’s value over time.
While cash flow can provide for my immediate expenses, appreciation is all about the long-term benefits.
Like investing in stocks over the long run, real estate tends to go up in value. The key is to hold a property long enough to benefit from that appreciation.
To benefit from appreciation, all I really need to do is make my monthly mortgage payments, keep my property in decent condition, and let the market do the rest.
Now that we’ve reviewed how cash flow and appreciation work together to generate long-term wealth, we can look at the additional benefits of debt pay-down.
With rental properties, other people pay off my debt.
When I buy a rental property, I take out a mortgage and agree to pay the bank each month until that mortgage is paid off. At all times, I remain responsible for paying back that debt.
However, I do not pay that debt back with my own money.
Instead, I rent out the property to tenants. I do my best to provide my tenants with a nice place to live in exchange for monthly rent payments.
I then use those rent payments to pay back the loan.
Each time I make a mortgage payment, part of the payment goes to interest on the loan and part of the payment goes toward the principal. This concept is known as amortization.
By the way, this is how real estate investors use Good Debt, also know as leverage, to generate wealth.
You may be totally against debt of all kind. That’s OK. Debt certainly carries risk. I’m not here to convince you that debt is a good thing or a bad thing. I’m just showing you how it works.
For more on the difference between good debt and bad debt, check out my post here.
What is loan amortization?
Amortization is the process of paying back a loan over time in predetermined installments. While your payment amount remains the same, the composition of that payment changes over time.
In the early years of paying off a mortgage, the vast majority of your payment goes to the interest. With each additional payment, more of the money goes towards the principal.
When you take out a mortgage, your lender will give you an amortization table that shows you exactly how much of your monthly payment goes towards interest and principal for the duration of the loan.
For example, if you take out a 30-year mortgage, you’ll receive a chart that shows 360 payments (12 monthly payments for 30 years). You can then look at any month in that 30-year period to see how much of your payment goes to interest vs. principal in that month.
If you’re so inclined, you can also use an online calculator, like this one at calculator.net, to create an amortization chart for any loan you have.
I’ll admit, looking at the amortization chart is the least fun part of any real estate closing.
Seeing debt payments as far out as 30 years is a bit scary. It’s hard not to think of all the things that can go wrong during such a long time period. That’s why I prefer to think of amortization in general terms instead of specifics.
Generally speaking, I know that some of my monthly payment goes to interest and some goes to principal. The longer I pay back the loan, the more of my payment goes to principal. That’s good enough for me.
With a fixed-rate loan, your monthly payment remains the same.
When you have a fixed-rate mortgage, your payment remains the same for the duration of the loan.
At the same time, because of inflation, rents tend to go up over the long run. Rents may also go up if market conditions improve or if you have forced appreciation through enhancements to your property.
When your rental income goes up, and your debt obligation remains constant, that means more cash flow for you.
For example, say your monthly mortgage payment is $2,500 each month for the next 30 years. And, let’s say you currently earn $3,000 in monthly rent payments.
Over time, your rental income should gradually increase. Some years in the future, you may be earning $4,000 or $5,000 per month in rental income. All the while, your monthly mortgage payment remains $2,500.
You can use that extra income, after covering all other expenses, to pay for your immediate life expenses, pay off your loan faster, or invest in other assets.
It’s for these reasons that having a fixed debt payment over a long time horizon is one of the biggest advantages to investing in real estate.
Think of it this way. Just like with your personal Budget After Thinking, you can make significant strides towards financial freedom when your income increases and your expenses remain fixed.
What do you think of investing in real estate so other people can pay off your debt?
Now, you know three of my main reasons for investing in real estate: cash flow, appreciation, and debt pay-down.
Regarding debt pay-down, each month my tenants pay rent, I can use that income to shrink my loan balance.
As my loan balance shrinks, my equity in the property increases. Equity is just another way of saying ownership interest.
When my equity in a property increases, my net worth increases.
So, on top of monthly cash flow and appreciation, debt pay-down is another way to generate wealth through real estate over the long run.
That’s three ways to make money off of a single investment.
Not bad, huh?
If you’re a real estate investor, let us know how you’ve used debt to increase your net worth.
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