An automatic benefit that many investors overlook is the capital “P” benefit: called Principal Pay Down & Principal Return. It is so powerful and totally automatic that I refer to it as the “the automatic piggy bank.”
One of the most overlooked benefits of investing in cash flow producing real estate is Principal Pay Down. Principal Pay Down refers to the amount of the principal balance of your loan that is paid down or reduced each month when you make your loan payment. Close your eyes for a minute and picture tens or hundreds of renters depositing money into your piggybank each and every month until your loan balance and payment is gone completely. This is precisely what happens each and every month that you own investment real estate.
Each month when your tenants pay you rent, which you use to pay for all of the expenses of the property including the loan payment, they are paying off your loan or mortgage. When you make each loan payment, a portion of every payment is applied against your loan balance to pay off your loan. In essence, the tenants are paying off your loan each and every month with their rent payment.
If you have a fully amortizing loan, you will eventually own the property outright with no debt, eliminating your loan payment completely and exploding your cash flow. And, it would be completely paid for by your residents, not you personally! Pretty cool, isn’t it?
Principal pay down is a very steady benefit. You won’t get rich overnight, but over time it can really add up. It’s one of the few automatic benefits of owning multi-family real estate. Meaning, you don’t have to do anything to gain the benefit as long as you make your loan payments each month.
The amount of Principal Pay Down you receive each month can depend greatly on your loan and its amortization period. Amortization simply refers to the time period over which the loan will be paid off if you have a loan that will be “locked” until you pay off the principal balance fully. Commercial loans normally have amortization periods of 20, 25, or 30 years. This means that your loan payments will be stretched over 20, 25, or 30 years to pay off the loan balance fully. The shorter the amortization period, the higher your loan payment will be, but the faster you will pay down or pay off your loan.
Let’s take a look at how the loan amortization period affects the Principal Pay Down. The following graphics show the same $1,000,000 loan at a 6% interest rate over 20, 25, and 30 year amortization periods.
As you can see, using the same loan balance and same interest rate, over 5 years you only pay off 7.5% of the loan with a 30-year amortization, where as you pay of 15.1% of the loan with the 20-year amortization. Over 10 years it gets even bigger. However, you will notice that the payment amounts are different. The difference is the amount of principal and interest you pay off each month.
The percentage differences don’t look that big in comparison to the loan payment difference in actual dollars, but let’s look at how that loan pay down affects the real numbers:
This graphic demonstrates that the difference between a 30-year amortizing loan and a 20-year loan over just 5 years is $76,000 in loan pay down or equity — and that is on a $1,000,000 loan, which is considered small in commercial properties. If you look at it over 20 years it’s over a $500,000 difference in loan pay down or equity. Can you imagine how much would be paid off each year with a $10,000,000 loan? That’s a big chunk of change and it happens automatically when your tenants make your loan payment each month.
Principal Return
One last benefit to keep in mind is Principal Return. Most of the time when you start a business, a big part of your initial investment is a sunk cost. Meaning, it can be difficult to ever get it back. In real estate, your cost of entry is comprised of your down payment plus a few sunk costs like closing costs, points, and legal fees.
In real estate, the largest start-up cost is the down payment. But, since real estate is not a rapidly diminishing asset or one that loses value over time like a car, equipment, business franchise costs, or oil and gas reserves, your principal is retained in the property. You can actually get your principal back when you sell or refinance the property down the road. That’s pretty cool if you ask me. Compare that with other businesses and investments next time you are presented with an opportunity. It’s often overlooked, but can be a major advantage to investing in real estate.
Loan principal pay down or the “automatic piggy-bank” is an often overlooked benefit of real estate investing. However, it can really add up over time. By choosing the right loan for your investment real estate you can pay off your loan very rapidly while still collecting all of the other benefits of real estate investing. Real estate is also one of the only investments where the majority of your initial investment is not lost as a sunk cost, but is retained and returned to you upon resale, called principal return.
Throughout history, there has never been another asset type that has created more wealth for more people than real estate. ApartmentVestors team will teach you how to invest like the pros and maximize your investment dollars.
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If you have questions or want to learn more about investing in multi-family real estate, call Craig Domann at (719) 310-6441 or Spencer Cullor at (913) 324-5900 at ApartmentVestors to ask your questions directly.
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