Buy Another Property Or Pay Of The Mortgage
Lance Levitas*
What we should do with any spare cash.
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.
Case scenario
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 lancelevitas@mweb.co.za
Article: RealEstateWeb
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