Introducing the slow, but steady, accessory of the real estate world–equity!
Passive Equity – Taking More Ownership
The third reason why real estate is an ideal investment is equity. Passive equity can be built through a leveraged investment by means of mortgage payments, or, if you paid for your investment property in full, equity can be earned by means of sweat (i.e. property improvements), or as a result of appreciation. If you are borrowing money to own an investment property, then an automatic passive equity increase is in your future. Every time the tenant indirectly pays your mortgage via rent payments, you will be earning passive equity. This equity will gradually increase month to month as you begin to owe less on the property and send less of that money to the pesky bank to cover interest. I mean, it’s not like you have a choice anyway–the bank requires it!
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$80,000 loan (20% down payment)
5% interest, 30 year fixed (360 mo.)
As shown in the graph above, your equity increases in an upward curve as you pay off the mortgage. Conversely, the debt balance decreases in a downward curve. The interest rate % is always the same, but as the property gets paid off, and since you pay the same amount on your mortgage every month, more and more of that payment goes to principal repayment vs. interest. Note: This is just an example and does not take potential appreciation into account, which would increase your equity even higher over 30 years!
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WARNING! An investment property should never be purchased for the sole interest of equity increase from mortgage payments. Be sure that you are going to make some positive cash flow on your investment, or at least will be rehabbing the property to earn a healthy income on the sale due to a higher market value. Think of equity increase as an added bonus to real estate investing and a welcome accomplice.
Equity won’t actually show up on your cash flow statement, so you may often forget that it is working silently in the background as your more obvious earnings, such as cash flow, march to the front of the line. A great way to keep an eye on your equity increase is by watching your retained earnings, which is the percentage of your net income that is retained by the company to be reinvested in its core business. Retained earnings could be your office supplies, furniture, company vehicle value, and of course, your real estate. When you borrow cash for real estate and pay that monthly mortgage payment, you are investing a little bit back into your company on every ripping and mailing of that coupon (just kidding, does anyone actually snail mail mortgage payments anymore? Do you even know where your coupon book is? I sure don’t!)
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Another benefit of your equity increase is how you can eventually pull some equity back out of your property in the form of a home equity loan or a refinance. This extra cash might make sense if you are in a place where you are ready to purchase more investment property and kick your Return on Equity (RoE) into high gear again. This should never be used to buy vacations, speed boats, and other doodads! Taking out a line of credit and borrowing against your investments takes a lot of caution, and you should always plan to have enough cash in reserves to cover 6 months to a year of mortgage payments in the event you have vacancies or extensive repairs. You also need to carefully consider the interest rate of this loan (or the new interest rate of the refinanced loan), along with the new mortgage you’ll take on, to see if you will still get a positive cash flow on that purchase.
So there you go…take some of that rent check and pay your mortgage by snail, electricity, gasoline, or foot and feel good knowing that the tenant is fattening up your slice of Equity Pie every month. That makes your real estate deal just a little bit sweeter.
Sweat Equity – Increasing the Value of Your Home
If you’d like to learn more about increasing the value of your home without spending much money, check out the following books recommended by other readers: