By Nikki Senopoulos, Author of Run the Numbers: The to-the-point book on analyzing rental properties using basic real estate financial modeling concepts
As I was at the closing table signing off on my mortgage, my attorney strongly encouraged me to make additional payments towards my principal loan balance each month when possible. He briefed me on the benefit of accelerated loan paydown: faster principal paydown equals less interest paid over the course of the loan. It made sense to do as it ultimately preserved the money in my pocket.
Is it a good idea to pay off your loan faster? If your goal is to pay off expensive debt quickly, this strategy could be useful. Such a tactic may not be so practical on a cash flowing asset, however, if your goal is to minimize the cost of your mortgage to thereby maximize ROI. Here’s why.
Before anything else, we need a brief refresher on how interest is calculated. A mortgage payment typically occurs once a month, and a portion of that pays interest to the bank while the other portion pays down the principal balance.
Mortgage Payment = Principal Payment + Interest Payment
We know that the monthly Mortgage Payment is always the same for a fixed-rate mortgage. However, the Principal Payment and Interest Payment amounts change as the loan amortizes. In other words, as the loan principal is paid down each month, the Interest Payment decreases, and the Principal Payment increases going forward.
Here’s the key to why. Interest is calculated off of the current loan balance. For instance, a $100,000 mortgage at 6% interest produces a monthly Interest Payment of $500.
$100,000 x 6%/12 = $500
We divide by 12 because there are 12 months in a year, and interest rates are stated on an annual basis.
With that logic, we can conclude a reduction of that $100,000 will result in a lower Interest Payment. If you decide to pay extra towards your principal balance each month, interest is essentially bypassed. For example, if you paid down the principal loan balance by $500 in the first month, your next Interest Payment would be $497.50.
$99,500 x 6%/12 = $497.50
In month 360 of your 30-year fixed mortgage, interest is only going to be a few dollars because the principal balance is so low.
What do you need to consider before making additional payments toward principal balance?
Ideally, rent revenues cover the monthly cost of a mortgage, among other operating expenses of a multifamily asset, so many times there is no real urgency to rapidly pay down a mortgage. Instead, you might consider reinvesting the cash flow back into your project to improve operations and increase future cash flows. The ROI achieved through reinvesting cash flow might exceed that of the reduced cost of the mortgage.
Direction of Interest Rates
We are currently in a rising interest rate market. If you locked in a fixed-rate mortgage at the especially low interest rates seen in 2020, when the 10-year treasury yield hit nearly a half a percent as opposed to today’s 4.2%, there’s no need to further reduce total interest paid since your monthly mortgage is likely already so low. It’s probably unnecessary to pay off relatively cheap, fixed debt.
What about adjustable rate mortgages? ARM debt may prompt a different strategy. In the commercial world when it comes to adjustable or floating rate loans, pricing typically follows a benchmark rate (such as SOFR, the LIBOR alternative many banks are adopting). If the benchmark rate plus the spread exceeds the floor pricing in your contract, debt can get pretty expensive.
Over the course of 2022, 30 day SOFR increased around 2.5%. That could be a difference of about $2,083 in monthly interest on a million dollar loan (or $25,000 per year), putting a huge dent in cash flow for operators. In the case of rapidly rising interest rates, and without the protection of fixed debt, one could say additional principal paydown is beneficial to reduce its impact.
Would it be worth allocating excess cash flow from operations to accelerate the principal paydown of your floating debt? It’s a matter of how effectively accelerated loan paydown can offset the impact of rising interest rates. In other words, is your money better spent reducing debt service, or reinvesting into your project?
Below we will look at an example to assess the impact of both rising interest rates and accelerated loan pay down on debt service. In this example, we use a $1,000,000 loan starting at 5% interest, increasing to 7.5% interest by year end. The loan will be offset by $15,000 in principal paydown. Let’s break it down:
Beginning of year interest rate = 5%
Principal balance = $1,000,000
Monthly Interest Payment =$4,167 ($1,000,000 x 5%/12)
Impact of new rate:
End of year interest rate = 7.5%
Principal balance = $1,000,000
New monthly Interest Payment = $6,250 ($1,000,000 x 7.5%/12)
Impact of new rate with $15k principal paydown:
End of year interest rate = 7.5%
New Principal balance = $985,000
New monthly Interest Payment = $6,156 ($985,000 x 7.5%/12)
That’s $15,000 locked up for a savings of $94/month or $1,125/year in interest (you could view it as a 7.5% return). Note, this wouldn’t factor in any prepayment penalties potentially woven into the loan agreement with the bank. Now ask yourself, could I reinvest that $15,000 to produce additional cash flow exceeding $1,125/year? If the answer is yes, then you may want to rethink accelerated loan paydown.
So maybe the accelerated paydown strategy is useful when it comes to very expensive credit card or student loan debt. But when it comes to mortgage debt, which is typically less expensive and backed by a cash flowing asset, you may want to reconsider how you use your excess funds. Think about the ROI within each opportunity you have and allocate your excess cash flow into the highest yielding one.
About the Author
Nikki Senopoulos operates a vacation/mid-term rental company in New Jersey where she oversees the acquisition and management of various properties. Prior to starting the vacation rental business, she worked for several companies valuating distressed assets and senior housing through deal screening and operational income analysis. Nikki received a division I scholarship for Beach Volleyball at Georgia State University.