Knowing your financial objectives and investing accordingly

Many of the real estate investors I talk to these days are buying for the long term hold. In fact, most don’t have a set time-frame in mind, they just know they want to hold properties as long term investments.  But “a long term investment” for one investor might be very different than for another.  I think many investors these days consider anything over 7 years as a long term hold (especially when you compare this to the type of appreciation and quick-flip investing that was popular during the early 2000’s).

However, I think there are plenty of other investors who are truly interested in owning property long after the mortgage has been paid off.  For these investors, the goal of the investment is less geared towards short term cash flow and more about owning an asset that will produce cash flows farther down the road, especially once the mortgage has been paid off. While I would not necessarily say there is one strategy better than the other, I would say that an investor should be mindful of the true objective of their investment when deciding what kind of financing to obtain.  I would venture to guess that most investors these days are buying with the intention of selling in 5- 10 years with the possibility of capturing some upside from a recovery in housing prices. For these investors, obtaining a mortgage with a longer amortization (ex. 30 years) and the lowest possible monthly payment would be a great way to capture immediate cash flow. While the principle would not be significantly paid down during this 5-10 year hold, the cash flow that was generated and potential equity (from recovering prices) could help them achieve their investing objectives.

For the other group of investors who are truly interested in a “long term investment,” the type of financing they might consider should look different.  If my goal was to own a house outright as quickly as possible so I could generate real income from the property for years to come, I would sacrifice current cashflow in favor of principle paydown (another way to achieve equity buildup).  To do this,  I would take a hard look at the amortization length and weigh my comfort level  as it relates to monthly cashflow (or perhaps even negative cashflow if I’m highly motivated to pay off the mortgage quickly). A quick example:

A $100,000 investment at a rate of 5% interest on a 30 year fixed loan would have a principle and interest payment of $536/mo. This may generate nice cashflow for me, but when I start paying on this loan, only $120/mo is actually going towards principle. Even after 10 years of paying on this mortgage, I’m still only paying $199/mo towards principle.
However this same investment, with the same interest rate on a 15 year loan would look quite different. While my monthly payment is higher at $790/mo … I begin to see equity buildup at a much faster rate. My principle paydown is $373/mo initially but jumps all the way to $616/mo by year 10.
Also interesting to note is the fact that after 10 years, I will have paid $46,100 worth of interest on the 30 year note as opposed to $37,000 in interest on the 15 year note – a difference of over $9,000 worth of interest in just 10 years.

Again, let me stress that I am not advocating one strategy over another. I simply believe in the importance of fleshing out your investment strategy before deciding what kind of financing to put in place. Too many investors obtain mortgages that simply don’t line up with their true investing objectives – especially when it comes to long term investing.  If you are an investor who plans on owning property for a very long time, let me encourage you to crunch the numbers on a shorter amortization schedule and consider sacrificing short term cashflow for future income.