I’ve been investing in real estate for over 15 years, but at the beginning, like most people, I immediately began trying to pay off my mortgage, figuring the quicker I got rid of the debt, the better. Then, I finally realized something that has revolutionized the way I thought about my investment strategy. This epiphany has set me on a course to financial freedom that is far more productive and successful than just being free from debt.
* This article was first published in Forbes.
What was my sudden realization?
Mortgage debt can be your best friend.
And the longer you can keep that debt, the greater potential for your possible returns. In fact, what if I told you that just by having an affordable, well-structured mortgage for 30 years instead of 15 years, you could earn three-quarters of a million dollars?
Intrigued? I thought so. Read on.
Debt Is Not A Monolith
When most people think about debt, they automatically think debt is bad – get rid of it ASAP! In many instances, I agree that the concept of being debt-free makes complete sense at first. What I’ve learned is that all debts are not equal.
Thankless debt like credit cards, expensive auto loans and personal loans are all examples of what many call “bad debt.” Why? They often carry large interest rates and other charges. Good debt benefits you, now or in the future, and helps you establish a credit history — like student loans or a reasonable mortgage on a property. Most importantly, it frees up money to go to work for you right now.
Paying down and getting rid of bad debt is important. Nobody needs to be climbing the financial ladder with that kind of baggage in tow. But if you want to really grow your wealth, paying off your mortgage won’t let you go as far or as quickly as prudently leveraged property will. Here are some points to ponder:
A Mortgage Leads To Equity
You need a place to live, so purchasing a property can be a wise investment. Your monthly mortgage payments slowly pay off the debt, which is called building equity. That’s a lot better than giving it to a landlord and helping build their equity instead of yours.
A Mortgage Can Help Produce Passive Income
A rental property can produce passive income — profits you don’t really need to work for — on a monthly basis. Plus, your tenant’s rent pays down the debt and there can be tax benefits, too.
In either case — primary residence or rental property — sometimes people choose a shorter mortgage term, often 15 years instead of 30, but paying the debt off quickly may not help you build wealth faster. While it may make you feel good to pay off your debt quickly, you are missing out on some very important lifestyle and wealth-building opportunities.
Time Is On Your Side
Inflation reduces your dollar’s purchasing power over time. With a mortgage, you are borrowing from the bank using today’s dollars but paying the loan back with future dollars. The value of those dollars becomes less every year, but you don’t have to pay more.
Borrowing money today and paying that same amount back later, when the dollar’s value is less, can be a smart strategy. This will have a more significant impact over 30 years versus 15 years. Put time (and inflation) on your side and stretch out your mortgage payments for as long as you can.
The Magic Of Arbitrage
The biggest argument on the side of those who want to pay off their debt quickly is interest. Interest is the amount of your mortgage payment that goes to the bank as their profit for giving you the loan. The longer the term, the more interest you will pay over the life of the loan.
Let’s take a look:
The total cost of a $500,000 mortgage at a 5% interest rate for 30 years is $966,279 with monthly payments of $2,684.
The same mortgage over 15 years would be $711,714 with monthly payments of $3,954.
This is a difference in cost of $254,565.
On the face of it, nobody wants to pay nearly $255,000 in additional interest over the life of the loan. Yet, while that interest difference is substantial, there are tremendous benefits that come along with it. Your 30-year mortgage has much smaller payments, giving you an additional $1,270 in your pocket each month that could improve your quality of life. Even better, if you really want to grow your wealth, you could put that money toward another investment. As long as that other investment has a higher return than the mortgage, you will make a profit. This concept is called arbitrage.
Arbitrage means taking advantage of a difference in pricing. For example, a difference between the interest you are paying on a loan (5%) versus the profit you receive investing those dollars elsewhere (8%) would result in arbitrage (3%).
Utilizing arbitrage, you would actually be making money off the bank’s money. The amount can be quite substantial over the 30-year life of the loan. A $1,270 investment each month, earning just 3%, compounded monthly, over 30 years, grows to $745,089. Yes, you read that correctly. In this scenario, having a mortgage for 30 years versus 15 years increases your wealth by nearly three-quarters of a million dollars. The key here is to invest your money into an opportunity capable of producing that 3% arbitrage.
Winning With Leverage
To be clear, I’m not saying that people should live outside of their means. No one should pile on debt — definitely a bad idea. Leverage is a massive multiplier — it magnifies both wins and losses without prejudice. But don’t be afraid to maintain debt in order to increase your investment potential.
You don’t need to be debt-free to have the financial freedom that comes from more money in your pocket each month, or growing your wealth through arbitrage. Use leverage to increase your returns, just do so responsibly. This shift in mindset away from shunning all debt toward a more nuanced approach can really accelerate your returns.