Imagine one day you wake up and realized that you own a factory that makes a widget. You have about 200 operators working there with one machine per person, 200 machines total. The factory is full, so you can’t hire more operators or install more machines. You make about $200 per month after all the expenses or $1 per employee.
Your factory is pretty famous for providing a good job, so a few people looking for a job stop by every month. Unfortunately, you have to turn them down and tell them to wait at the cafeteria. I know it's a waste to keep those valuable workers in the cafeteria, so you thought about a few options.
- You can trade-in all 200 machines and replace them with one giant machine to make about $550 per month. The problem is the machine requires 1,000 operators! With only a few people coming in every month, it’ll take you another 30 years to have another 800 people. You can use a recruiter to find 800 people, but that will cost a fortune. While you like the fact that you make more money with the giant machine, you don’t like the profit per person. Right now, you make $1 per person, but with the giant machine, you will only make $0.55 per person.
- You can buy another factory somewhere else. You can take the people in the cafeteria and hire a few more people to run it. With two factories, you have doubled the employees coming looking for a job, so in no time you can buy a third factory.
- You can also sell the factory and buy a better factory or two that gives you more than $200 per month.
- You can mortgage the factory, get some cash, and buy another factory. Even with the mortgage payment, you will make more in total.
In case you have not realized it yet, this can be said for a rental property also. If you own a rental property with a mortgage, that means the following.
- The bigger the mortgage ratio, the bigger the return per $ invested.
- The longer you hold a mortgage, the more “lazy money” or equity you will have. Because of the principal paydown and the appreciation, you have more money sitting in the "cafeteria" doing nothing.
- You have a few options if you have a mortgage on your rental.
a) Do nothing. You don’t have to do anything, and eventually, the mortgage will be paid off, and you’ll make more cash flow, but you will accumulate equity that is not working hard for you, and it'll take a very long time for it to be paid off.
b) Pay off the mortgage. You will have more cash flow, but your money is not working as hard as it can, and obviously, you need a lot of money.
c) Sell the property and buy a property or two with better cash flow. Done right, your cash flow will go up, but eventually, you have to do something with the equity again to prevent you from having too much “lazy money."
d) Do cash-out refinancing. You can buy another property without selling the current property, but the original property's cash flow may go down.
As you can see, once you own a rental for a while, you will start to have some options. The best option will be depending on many factors, so you want to consult with experienced investors or do your own due diligence.