What’s the Best Strategy for Growing a Rental Portfolio?
The end goal for most rental investors is to generate enough rental income to be able to quit their job. What strategy should you use to grow your rental portfolio to this point?
Let’s explore two different strategies: quickly paying off your mortgage versus consistently refinancing to remove equity for additional purchases. Each has its own pros and cons when it comes to building a rental portfolio, so deciding which is right for you will depend on what your goals and investment style are.
Paying Off Mortgage Quickly
This strategy is pretty self-explanatory, and involves paying off the mortgage on your property earlier than the required time. It requires an initial cash flow sacrifice, since all of your rental income will go towards mortgage payments, and maybe even some of your disposable income. Once the property is paid off, you’ll have a lot of equity in the house itself, plus higher cash flow, since there will be no mortgage to pay, only taxes and insurance. As you rinse and repeat this model to build your portfolio, you end up with little cash on hand, because it’s all going into accelerated mortgage repayments, which also makes it slow going on acquiring additional properties.
However, the more properties you have, the easier and faster it becomes to pay them off. This strategy is also better for someone who wants to be better able to manage changes in the market, like in 2008, when many landlords who were too highly leveraged lost everything. Paying off a mortgage quickly helps you survive real estate market fluctuations like these, and it’s also a better retirement strategy, if you want to live off your rental portfolio when you retire.
Pros:
-You eliminate the monthly mortgage payment sooner.
– You have more equity in your properties.
– You eventually have more cash freedom, which might make all the difference for investment somewhere else.
-You save money on interest just by paying off your principal debt early (therefore lowering the payments, due to reduced amortization).
-You can have added peace of mind, knowing you’re debt-free.
In case of emergencies, you can tap the equity of your property for future loans.
–The more your portfolio grows, the easier it becomes to pay off new properties quickly
Cons:
– You don’t have a lot of cash on hand when putting all of your profits into early mortgage repayments.
– If you don’t have cash reserves, unforeseen circumstances could affect your ability to pay down your mortgage quickly (you may want to set up home equity lines of credit to tap for emergencies).
– You’re no longer eligible for the mortgage interest federal tax deduction.
Refinance to Reinvest Equity
There are two types of refinancing: Rate & Term Refinance and Cash-Out Refinance. With a Rate & Term Refinance, you can refinance to lower your interest rate or lengthen the term of your mortgage – both of which lower your monthly payment and give you more cash flow for additional acquisitions.
With a Cash-Out Refinance, you take some of the equity of your property and convert it into cash to fund additional acquisitions. This will usually increase your mortgage payment and thus lower your cash flow. The cash, though, should allow you to acquire additional properties quicker. If you balance your cash flow correctly, you can build your rental portfolio faster. Miscalculate and not leave yourself enough reserves, however, and you could put yourself into a very tough financial situation.
This could be a good solution for landlords during times of COVID, letting you absorb more possible missed rent payments. Even in a normal economic environment, consistently refinancing to increase your cash flow could free up more funds to invest in other rental properties, making it an interesting alternative to the ‘Paying off your Mortgage Quickly’ model. Many rental investors buy properties, refinance them as soon as it’s possible to do so, and then use the added cash to grow their portfolios.
Pros:
– Mortgage rates are at an all-time low right now—making it a great time to refinance.
– You can lower your monthly payments, thereby increasing the amount of cash you have on-hand.
– Tapping your equity allows you to acquire your next rental sooner.
Cons:
– If you try to refinance next year, lenders will look at your income from 2020, which may have been affected by the pandemic – so it may become more difficult to get approved if you wait.
– You take on more debt as your portfolio grows, so it’s important to ensure you can consistently make payments.
– You have less equity in your properties than you would if you paid off the mortgages sooner.
– You’ll need to always make sure you have enough reserves.
Comparison
Now let’s take a look at these two extremes side-by-side, to show where an investor could be financially after 3, 5, and 10 years using each strategy. For example, if two investors each bought properties for 100k every time they added to their portfolio, which one of them would be better off, faster, in terms of things like cash flow, cashless equity, and equity – the refinancer, or the mortgage-free investor?
These strategies sit at two completely different ends of the spectrum, and which one you choose when growing your portfolio depends on the goals you’re trying to achieve.
Which strategy do you prefer, and why? Let us know in the comments.
Image Courtesy of Karolina Gabrowska