A good friend of mine – who is also a JWB client – asked me this question the other day. He currently has two JWB properties and wanted to know if he should purchase a third rental property or use that lump of cash to pay down one of his existing loans.
You may be in the same boat so I’ll walk you through the thought process so you can make the best decision for yourself. Here are the questions you should start asking yourself:
- What is my passive monthly income goal?
- What is the interest rate of the debt I’m considering paying off?
- What is the potential return on investment of the rental property I’m considering purchasing?
Passive Monthly Income Goal
Let’s say your passive monthly income goal is $5,000 per month from positive cash flow. You currently own two rental properties that are financed with 5.5% interest rates on each of them. You’re considering buying a third property that will generate 8% returns from the cash flows (and an additional 4% per year in average appreciation) and you’d buy this property with financing.
Your passive monthly income goal is the most important factor to consider here. While it always feels great to pay off a debt, it is a much better feeling to arrive at your monthly passive income goal 5, 10, or 20 years earlier because you used smart, inexpensive debt as a tool to get there.
If you choose to not use debt or to pay things off early, you’re likely just extending the timeline to get you to your ultimate passive monthly income goal… by a long time.
Now, let’s consider the interest rates on the debt you would be paying off. By choosing to pay it off early, you’re accepting a 5.5% return on your investment. You’d also get a major boost in positive cash flow because now your property wouldn’t have debt on it.
Return on Investment
We love more positive cash flow… but what are you giving up?
Let’s see what the opportunity cost is of the decision to pay off the debt.
The third rental property you would purchase, if you didn’t pay off the debt, would generate an 8% return on investment just from the cash flows. That’s a better return than the 5.5% return on investment from paying off the debt. But it doesn’t stop there…
You’re planning on holding onto these properties for a full market cycle (10-20 years) so you can take historical average home price appreciation into account. The third property is in Jacksonville which has a historical average appreciation rate
of 4.3% per year.
You’re planning on buying it with conventional financing which means that you’re only putting down 25%. This matters a lot because by using smart debt, you’ll benefit tremendously from home price appreciation over the long run. When the property appreciates 4% per year, it actually generates a 16% return on investment because you only put down 25%.
That’s the beauty of using smart debt to acquire rental properties. So your total potential return on investment for buying the third property is actually 8% plus 16%… which is a 24% return
on your investment.
Let’s review your options so you can make the
Option 1 – Pay off debt
- Earn 5.5% return on your money
- Generate $600- $1,000 additional positive cash flow today because you no longer have a loan on that property
- Give up the potential opportunity to earn a 24% return with that money
Option 2 – Buy a third rental property
- Earn a 24% return on your money
- Generate $200 additional positive cash flow today from new rental property (including
the debt payment)
- Speed up the timeline to get six rental properties in your portfolio (You’ll need at least six to get to your ultimate passive monthly income goal of $5,000).
If you’re young and have other sources of income, the decision is easy on this one. Buy the third property.
You shouldn’t fear debt. When used appropriately, smart debt is a tool that helps you get to where you want to go more quickly. You just have to know how to harness it and be disciplined enough to stick with your plan even if it involves resisting the urge to just “pay it off.”
The only reason I might suggest paying it off is if you were nearing retirement and needed to maximize your cash flow. Otherwise, I’d make another investment and continue to build up your army of assets!