Last Updated on October 14, 2019 by Mark Ferguson
I bought my first rental property in 2010 and paid it off three years later. I was so proud of myself for executing my plan to use all of the cash flow from my rentals to pay off one house at a time. A lot of people told me paying off my rentals was not the best use of my money, but I was sure that I was doing the right thing. A few months later, I realized something. I had just spent $70,000 to save $300 a month. I had made a 5% return on my money.
My rentals were making me 15% percent on my money, not including any appreciation, tax advantages, principal pay down, or forced appreciation (adding value through repairs). I realized that I would have made much more money had I used that money to buy more rentals instead of paying off a loan.
Not only would I have made more money, but I would have made a lot more money! I admitted to myself that I was wrong about paying off the rental, which was not easy to do. It was much better to admit I was wrong and make more money than to lie to myself and others. I got a line of credit against the property and used that money to flip more houses and buy more rentals!
What is the snowball debt method?
The snowball method is a term used to describe a strategy to pay off debt. Instead of paying all your debts off equally, you focus on paying off one debt at a time. The advantage of the debt snowball is that you can pay off the highest interest rate loans or the lowest balances first, which saves you money over paying everything off equally. When you pay off a debt, you can stop making that payment and then apply the extra money to pay off other debts. It is usually faster to pay off one debt at a time than to pay everything off at once.
The snowball method can be used on rental properties as well as other debts. I decided to use the snowball method on my first rental, which was really dumb. I had a conventional 30-year mortgage on that property with a fixed interest rate in the low 4’s. The only reasoning I used to pay that property off was that it was my first one. I took all the cash flow from that property and used it to pay extra towards the mortgage. When I bought a second and then third property, I took all the cash flow from those properties and used it to pay down the first property’s mortgage as well. After three years, I had it paid off!
You can see a video of the rental and how it has performed below:
Why did I use the snowball method?
Below is an excerpt from an article I wrote back when I was using the snowball method.
“The biggest reason I am paying off a mortgage so quickly is that I bought my properties under market value and they have great cash flow. The second reason is that I use the snowball effect to pay off one mortgage at a time. Once a mortgage is paid off, I will bring in more cash flow because I have one less mortgage payment. That extra cash flow is applied to the next mortgage, and it is paid off even faster. Once I have purchased enough properties, I will be paying off one property a year, then two, and so on.
Many people ask me why I use the snowball method and do not buy more properties with the extra cash flow. There are a few reasons why I am paying off a mortgage early.
- Many banks limit how many loans you can have. Some banks won’t loan on more than four properties, and some won’t loan on more than ten. I am lucky I have a portfolio lender who will loan on as many properties as I want. However, I do not know if my portfolio lender will continue to loan on unlimited properties, so I want as few mortgages in my name as possible.
- Having cash available is a huge advantage in the real estate business. Banks love to give lines of credit on houses that are completely paid off. A line of credit is as good as cash in the real estate world. If I pay off the mortgage early, it gives me a huge advantage when dealing with banks.
- My portfolio lender only offers ARMs or 15-year loans for my rental properties. I choose a 5-year ARM to finance my rentals, so I want to pay those off before the rate adjusts. By using the snowball method to pay off the mortgage early, I can pay off my houses before the interest rate goes up.
If you are short on cash, paying off a mortgage early may not be the best choice.
In a perfect world where I could have as many 30-year, fixed-rate loans as possible on my rental properties, I would not use the snowball method. However, the banking guidelines are constantly changing, and the fewer mortgages I have in my name, the better chance I have of adapting to new policies. Using the snowball method to pay off rental properties early will give me much more flexibility in dealing with banks.”
What would I do differently if I could go back in time?
The snowball method wasn’t a horrible strategy, but looking back, I wish I had not paid off my property. The biggest reason was that it took me a while to save up the money to buy more rentals. Had I not used that $70,000 to pay off the debt, I could have bought two or three more rentals. As we can see now, the market has done very well since 2010. I was able to buy 16 rentals from 2010 to 2015, but I wish I had bought more! Even if the market had not done as well as it has, I would have been much better off buying more rentals than paying off the loan.
How much more would I have made by not paying off the loan?
This is a scary scenario to look at because it makes me realize how much money I left on the table. 2010 to 2013 was an amazing time to be buying real estate. I was making from $400 to $500 per month in cash flow after paying all expenses on each property. I would have been better off buying just one more property and not paying the loan off, but I could have bought at least two more. Here are the numbers
If I had bought two more properties I would have been making $800 to $1,000 more per month from both properties.
Buying below market
I not only made money because the market increased, but also because I got great deals. I buy properties that need a little work or that I can add value to. On my first rental, I had to spend almost nothing to get it ready to rent. On my second and third rentals, I spent about $15,000 repairing them, but they were worth $40,000 to $50,000 more than I bought them for after I was done with the work. If I had bought two more rentals I would have gained $50,000 to $60,000 in forced appreciation.
When you buy rentals, you depreciate them over time. In theory, the structure of a rental is worth nothing after 27.5 years. Each year, you can deduct 1/27.5th of the structure of the rental from your taxes. If the structure is worth $90,000, you can deduct $3,272 from your taxes. If your tax rate is 30%, you save $991 a year. I would have saved about $2,000 a year on my taxes from having two extra rentals.
Principal pay down
When you buy a rental with a loan, you pay off part of that loan every month. On the properties I was buying, I would pay down the loan about $120 a month at the beginning of the loan, but that number increases over time. To start off with, I would have saved about $240 for having two more properties.
Appreciation is something I do not like to count on, but it happens, and I consider it a bonus. I live in Colorado, and our market has gone crazy over the last few years. The properties I was buying for $100,000 are worth about $300,000 now. Part of that was I got really good deals, and part of that was the market has increased in value greatly. If I would have bought two more properties, they would have each gained about $150,000 in value over what I gained in forced appreciation.
Total amount of money gained each year
- Cash flow: $9,600
- Taxes: $2,000
- Principal Pay Down: $2,880
Total saved paying off the loan
- Payment: $3,600
This does not even consider the appreciation and buying below market value. It also does not consider that rents go up over time as the principal pay down increases either. Over time, the savings decreases when you pay off the loan.
This also does not take into account it takes years to pay off the loan, and you will not see those savings until the loan is paid off. I could have bought more properties much sooner than when I had paid off the loan meaning those advantages start sooner.
To see the total savings, let’s look at a ten-year plan. It took me three years and a few months to pay off the loan. We will assume if I had not paid off the loan, I could have bought a property in year 2 and 3.
Paying off the loan
- Saves 81 months of payments: $24,300
Buying more properties
- Cash flow from property 1: $38,400
- Cash flow from property 2: $33,600
- Tax savings from property 1: $8,000
- Tax savings from property 2: $7,000
- Principal paydown from property 1: $13,000
- Principal paydown from property 2: $11,000
- Forced appreciation from property 1: $30,000
- Forced appreciation from property 2: $30,000
- Appreciation from property 1: $40,630
- Appreciation from property 2: $35,000
Total savings: $219,630
This is crazy when you put the actual numbers to it. I did not even use the appreciation from my rentals: I used 3% appreciation per year. This shows how much more valuable it is to buy more properties than it is to pay off a loan.
What is the debt avalanche method?
Another method is the debt avalanche method, which is very similar to the snowball method, but you always pay off the highest interest rate first.
Is this method better than the snowball method and worth doing? For me, no. I would rather not pay my loans off early. Now, If you have really high-interest rates, it might be worth doing. But for long-term low-interest-rate debt, I don’t see the advantage.
I also think the snowball method is better because the highest interest rate loan is not always the first loan to pay off. Usually, it is best to pay off the smallest balance loan so you can stop making payments on that debt as fast as possible and apply them to other debt.
What is velocity banking?
Another strategy used to pay down mortgages and debt is velocity banking. A lot of people try to make velocity banking out to be a miracle way to pay your house off fast.
The method says you should get a HELOC on your house and use your paycheck to pay that HELOC down every month. Then pay bills and expenses out of the HELOC. What is the advantage? The advocates claim you pay a HELOC down faster because you are only charged interest on money borrowed, so if you use your paycheck to pay down the HELOC right away, you save interest.
Some examples I have seen claim people are paying off their house in a few years. They are paying off their house because they are using every extra dime they have to pay the loan down, not because using a HELOC is a magic trick.
In fact, a HELOC may have higher rates, be variable (meaning the rate can increase), and have more costs than keeping your current loan.
What about avoiding all the front-loaded interest on mortgages?
There is a huge misconception that loans are front-loaded with interest. The idea is that most of the interest is charged at the beginning of the loan. If you can pay more towards the loan at the start, it saves a bunch of money.
The interest rate charged at the beginning of the loan is the same as the interest charged at the end when you have a fixed-rate mortgage. The reason you pay more money towards the interest is that you have a higher loan amount.
If you have a $100,000 loan and a 5% rate, you pay $416.67 towards interest the first month. $100,000 x .05 / 12= $416.67. The amount you pay in interest does not change whether you have a 5-year loan, a 15-year loan, or a 30-year loan. It is always $416.67. The mortgage payment changes because you pay different amounts of principal with different loan terms. The more you pay down the principal, the less interest you pay the next month.
What paying more towards a loan early does, is reduce the principal that you are paying interest on. The interest is not front loaded.
Is it ever wise to use the debt snowball method?
If you have nothing better to invest in or super-high interest rates, it might make sense to pay down loans faster with the debt snowball. The math shows you get higher returns not paying off loans, but not everyone is motivated by getting the highest returns. Some people feel “safer” paying off loans, and there is no problem with that as long as you realize you may not be making as much money with that strategy. I personally think it is safer to have more properties that produce more income than to have fewer properties with less debt.