On real estate leverage and paying off a mortgage

JLP at AllFinancialMatters has a disagreement with some arguments on the virtues of paying off a mortgage early. I agree with JLP, and it comes down to some (somewhat) basic calculations. Let's take a quick detour here by talking about real estate as an investment. First of all, my opinion is that real estate is a phenomenal investment. The reason can be summed up in one word: leverage. Leverage, in terms of real estate, refers to the relatively small investments you make each month in order to get the returns on a much larger sum of money. This leverage comes in two basic varieties.

1. You own your home. You get phenomenal leverage here because the "investment" turns out to merely be a tradeoff. It's what it costs you to buy a home vs. what it costs you to rent. Housing expenses will always be there, whether you rent or buy. So the real "cost" of homeownership is how much more it costs you to buy than rent. If renting costs you $800 a month and owning a $150,000 home costs you $1100 in mortgage payments, taxes, maintenance, insurance, etc., then your investment cost for the real estate property is $300 per month. Historically, real estate appreciation is in the neighborhood of 5%. But do you earn 5% on your $300 monthly investment? NO! You earn it on the value of the house-- $150k. A quick calculation says that 5% of $150k is $7500. So after one year, you've invested $3600 into the house, and the value has gone up $7500-- not to mention the small gains in equity from paying down the principal. You don't have to be a math whiz to know what a phenomenal return that is.
2. You own rental property. The reasoning here is identical. You pay so much per month in costs, but you get some (or all, or more) back in rental income. So again you pay a small amount (at worst) each month to get appreciation on a much larger amount. Interest rates are higher on rental properties, but rental income usually makes up for much of this difference. Again you get a phenomenal return.

In both cases you are putting in a small amount to obtain growth on a much larger amount. Leverage. In all but the worst housing markets you can get good financial gains using leverage in real estate.

How does all this relate to the argument over paying down a mortgage? The bottom line is that every time you throw extra funds at the mortgage, you are reducing the leverage you have on the property. Think about it this way: if you buy a house outright (no mortgage), you have absolutely no leverage. How long will it take you to see good returns on the investment? Well, unless appreciation is well above average, you never will. You'll merely see a 5% ROI. There is a sliding scale between paying in full and paying only the minimum payment, and the earlier you pay off the mortgage, the closer you are to paying in full. In other words, your returns go down as you try to pile up the equity. It has less to do with the difference in rates between the mortgage and the stock market (though this does matter if you divert additional mortgage payments into the market) and more to do with the reduction in leverage.

Let me give you a quick example. Take the $150,000 house mentioned above, at a rate of 6%. The payment is approximately $900, so assume an extra $200/month for other associated costs. The costs above renting (assume $800) are $300/month. You are paying an extra $300/month over renting to gain this investment. Assuming 5% appreciation per year, at the end of 10 years your equity is almost $118,000 (on $36000 total investment over time). According to Excel's XIRR function, that's an annual return of 22.5% on your money. Not bad!

Suppose instead that you pay an extra $100 toward the principal each month over the same 10 years. Then your equity would be about $134,200. Sounds better, right? But wait-- you paid an extra $100 each month ($48,000 total). What is your annual return now? About 19.6% per year overall. Still phenomenal, of course. How does it compare to investing in the market? When the extra $100 is conservatively invested in the market (assume 8%) instead, your overall rate drops only to 19.8%. With more aggressive investments (12% return) your overall rate climbs back up to 20.3%. If you invest that $100 in another real estate property (say, a rental) your returns are likely to be even greater (again through the power of leverage).

How many investors would shrug off a couple of percentage points? Not many. But that's exactly what you do when you sacrifice leverage for more equity. Paying off a mortgage 5 or 10 years early sounds great for your peace of mind, but it's lousy for your bottom line . . . many higher yield alternatives will make you richer in the end.