I want to begin this episode with a story.
There was this guy named Joe.
He was a fairly savvy guy who was always trying to make the best decisions he could with his money so he could build financial security for himself.
He worked a full-time job as an electrical engineer while investing in rental properties in his spare time to receive passive income from the rent payments.
He had a process he followed where he puts money down on a property while letting the bank carry the remaining debt so he can own the property and collect the rent payments.
He accepted a mindset that if the mortgage payment and expenses of a property were less than his rental income, he could collect the difference for himself.
He realized that if a property appreciates over time while the mortgage is paid down it will create future wealth.
A couple of things about Joe….
His father had been sick for years and passed away leaving him as the beneficiary of the estate.
And Joe is really good with money…his finances are in really good shape.
He had no debt other than a thirty-year mortgage on his home that he was half way through.
After his father passed away, he considered the idea of using some of the money to pay off his home mortgage.
Like most people, the idea of getting out of a mortgage payment was appealing.
So, acting on this idea, he looked into what his payoff amount was, wrote the check to pay off the mortgage and set the check on his desk to send out in the mail the next day.
That night he did what he always did and was researching rental property opportunities and came across a property for sale in a growing area across town that he thought would be a nice property to own.
He had money set aside for opportunities like this and reached out to his realtor to arrange a time to check it out the next day after work.
The next day came and he met with his realtor to look at the property. Everything seemed good so he went ahead and wrote a contract with his usual conditions….put some money down to secure the deal and notified his banker to arrange the financing to complete the purchase.
Meanwhile, that check he wrote to pay off his mortgage remained on his desk while his attention shifted to getting the rental property deal closed.
When the dust settled a couple of weeks later, he got to thinking about the check he wrote to pay off the mortgage.
He began having doubts about using the money to pay off the mortgage after the deal he just closed on.
He had gotten so caught up in just paying the mortgage off in his mind that he didn’t really consider the big picture of his long-term goal of having passive income to support his retirement.
He knew there were other properties that he could purchase with the money that he believed would create more passive income and accelerate his wealth.
So, he took time to crunch numbers and figured out that if he were to pay off the mortgage he wouldn’t have a mortgage payment any longer but he would also not have the money to continue to grow his wealth.
Not having a mortgage payment would be great but he figured that if he uses the money he inherited to buy a few more rental properties…he could use the cash flow to make his mortgage payment which gets him the same result.
But the advantage to buying the rental properties is that he would have multiple properties appreciating…not just his residence…which would create more long-term wealth.
The truth is that a home will appreciate whether or not there is a mortgage so the only real advantage to paying the mortgage off is not having that mortgage payment and that can be taken care of through the passive income from the properties.
The alternative If he simply used the money to pay off the mortgage, would be just having his mortgage paid off but again he would be giving up the passive income for his retirement.
He ran though many scenarios and even considered the idea of investing the money in the market since he has seen his investments grow over the years at a higher rate than what he is paying on his mortgage.
He knew that if he made- at a minimum – as much on his money that he is paying on his mortgage that he would come out even if he just followed his amortization.
The thoughts overwhelmed him a bit because the voices in his head were telling him that he should pay off his mortgage which is what he has always heard is the best thing to do.
He remembered hearing that the sooner you pay off a mortgage, the sooner you can begin saving your mortgage payment.
This has always been the popular opinion but his experience with the rental properties and his calculations weren’t coming to the same outcome.
The math he worked through didn’t support paying the mortgage off if his savings is earning the same or more than the mortgage rate.
He determined that if he paid his mortgage off – now at his 15th year – it will take him 15 additional years of saving his mortgage payment to break even.
But if he uses the money to buy more income producing assets and use the income from those assets to pay the mortgage payments until the mortgage was paid off, that would not only result in having a home paid off but he would still have the money he had originally inherited.
You see, the income from the property makes the payments.
This is a huge point. Don’t miss this.
If he were to take the money and pay off the mortgage; that money is now in his home and is no longer working. It is a dead asset.
It is not earning anything because the home appreciates whether or not there is a mortgage.
Consider this, If there are two homes side by side worth the same amount of money and one is mortgaged and one is paid off, they are both valued the same.
If real-estate appreciates the next year, the homes both appreciate the same.
The brick and mortar of the home is what carries the value and is what appreciates.
The equity in the home grows not by the mortgage being paid off but is the result of the appreciation of the physical property.
People get confused when thinking about this because they think that if their mortgage is reduced or paid off, they have more equity.
That is not true.
You don’t have more equity and the reason you don’t have more equity is because you had to use other money that you had to pay off the mortgage.
The equity doesn’t appear out of thin air.
You transferred cash into the home.
If you have a home worth $200,000 and a mortgage of $100,000. The home is worth $200,000.
If you use $100,000 that you had in a bank account to pay off the mortgage, the home is still worth $200,000.
No equity was created, you just transferred cash from one pocket to another.
In fact, you took assets valued at $300,000 and by consolidating them reduced them to $200,000.
Yes, you have a mortgage paid off but now you have no cash to grow your wealth.
The mortgage is often viewed as a problem when actually it is a means to create wealth.
By using the cash to create income, you can use the income to pay the mortgage while keeping the original $100,000 out of the home.
The end result is a home that is paid off and your cash on hand.
If you use the cash to pay off the home, the result is a paid off home with no cash.
Now the argument becomes about interest charges on the mortgage and paying off the mortgage to free up cash flow to save the payments.
These are valid points to be made, but they are not the only things to be considered.
This thought process over simplifies and ignores the opportunity cost associated with the decision.
It boils down to looking at all the resources you have in play (the home, your cash flow, your savings) and determine what will provide the best outcome over time.
If you take a thirty-year mortgage compared to a fifteen-year mortgage, you are paying more each month to accelerate the payoff of the fifteen-year loan.
You have to consider that fact, a fifteen-year mortgage takes more of your monthly resources than does a thirty-year mortgage.
It is the same thing as what we discussed before when you used money in the bank to transfer that money to the home.
You didn’t create any more equity, you just transferred equity and it is the same thing with a fifteen-year mortgage.
Yes, you pay the mortgage off in half the time but this is not about the mortgage.
This is about wealth creation and control of capital.
But lets walk through this….
After 15 years of making a higher mortgage payment, you havea mortgage that is paid off but you have no money saved or money available to use for anything else. Remember, you transferred the cash on hand to accelerate the mortgage.
In other words, you forfeited the use of those resources over to the bank.
Now, consider the difference between the thirty year and the fifteen-year mortgage payment look at saving that difference over fifteen years while carrying a thirty-year mortgage.
What you will discover is that the amount of money you have saved is equal to the mortgage balance at the sixteenth year.
So, at the 15 year mark, the result is the same whether you do a fifteen-year mortgage or thirty-year mortgage.
So again, this is not about the mortgage, it is about building and controlling wealth.
It’s as simple as that.
Now, let’s not stop at fifteen years, let’s take this comparison all the way through to the thirtieth year to include saving the fifteen year mortgage payment since the mortgage is paid off already.
That is the popular argument, right?
Pay the mortgage off so you can save the payment.
The results are the same either way and the reason is because it is simple math.
You see, It doesn’t matter what your amortization schedule is or how you structure the payments.
Any combination of the same resources and the same rates will have the same outcome.
So if that is the case, why focus so much on accelerating a mortgage when we can tweak the scenario to have a more favorable outcome.
If you keep your mortgage and focus on creating the best outcome, you will have more wealth and more cash flow for your retirement.
The basis for this again is the fact that your home will appreciate the same whether or not you have a mortgage and the mortgage will get paid off over time by simply making the payment.
You won’t do anything to create more value for your home by paying off the mortgage.
By follow the amortization of the mortgage and using your resources to purchase income producing assets such as with the rental properties, the income from those properties can be used to pay the mortgage payment.
If you can use the rental income to make the payment you now have the money freed up in your budget to save which was the whole argument for accelerating the mortgage.
And the income being received from the rental property is offsetting the interest charged on the mortgage since you are using the rental income to make the mortgage payment, not your money.
The end result is the same but the tweak mentioned before is that you now have two assets growing for your future, not just one.
You have the rental property and the residence which wouldn’t be possible if the money was used to pay off the mortgage.
If you were to pay off the mortgage, you would not been able to purchase the income producing assets and the money would be sitting in a dead asset (which is your home) resulting in no wealth being created and no income being received
So my feedback to Joe and to anyone listening to this podcast is to consider the outcome not just popular opinion.
By maintaining the mortgage and using the money to buy income producing assets you will have multiple assets appreciating as opposed to just having one.
And will have the added benefit of a passive income source that will continue beyond the mortgage being paid off that can be used for retirement purposes.
This always reminds me of the tale I have told many times before about the farming couple who had a golden goose.
The couple saw the golden egg production from the bird but wanted more golden eggs faster so they killed the goose to take more eggs from inside the bird.
But of course, that is not how egg production works so by killing the goose, they didn’t get any more eggs.
And much like how there is a certain way a bird creates eggs; wealth is also created a certain way.
So, if you are quick to kill the goose to pay off the mortgage, you will have no more eggs.
Every financial decision you make – big or small -is like the first domino, each decision has a domino effect and it is best to see how those dominos fall before acting on that decision.
That concludes today podcast.
I am Brian Skrobonja and thank you for listening to the common sense financial podcast.
