Accelerating Principal Paydown and Increasing Cash Flow
Real estate continues to be the #1 source for an individual or family’s overall net worth than any other asset class. For the average American household, the bulk of their net worth is derived from the equity in their primary owner-occupied residential property.
In recent times, we’ve seen how many paper or digital assets such as the ongoing declining purchasing power of the dollar or various cryptocurrencies that may be backed by mysterious or seemingly anonymous people or offshore companies have fallen significantly in value to as low as zero. With hard assets like real estate, gold, and silver, they’ve proven over time to be exceptional hedges against inflation while being fairly stable and consistent through the various boom and bust economic cycles.
The more money that is created together between the US Treasury and Federal Reserve, the lower the purchasing power. Inflation can severely damage the purchasing power of the dollar while generally benefiting real estate assets as we’ve all seen firsthand in recent years.
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- US M1 Money Supply (February 2020): $4 trillion
- US M1 Money Supply (March 2020 – October 2021): From $4 to $20 trillion
Or, 80% of today’s M1 Money Supply, or an additional $16 trillion dollars in circulation, was created within just 22 months (March 2020 to October 2021). This is perhaps the main reason why inflation has reached 40-year highs as opposed to consumers “spending too much money” on goods and services.
Both the Federal Reserve and US Treasury have shown us that they plan to continue onward with their hyperinflationary strategies which have proven to be incredibly beneficial for boosting real estate asset prices and rental payments collected.
Rising and Falling Rates
The raising of short-term interest rates such as the Fed Funds Rate by the Federal Reserve usually impacts short-term consumer loans like credit cards, automobile loans, student loans, and HELOCs (Home Equity Line of Credit) the most in the short-term rather than 30-year fixed mortgage rates which are tied to the 10-year Treasury yield. In June 2022, US consumer debt hit all-time record highs as did average credit card rates and fees, sadly.
By mid-December, the 10-year reached near 3-month lows in spite of the Fed raising short-term rates. For example, the 10-year Treasury yield on September 15, 2022 closed at 3.45%. On December 16th, 2022, the 10-year Treasury yield reached 3.48% after peaking at 4.25% on October 24th. These fairly consistent 10-year Treasury yields over three months were in spite of the Federal Reserve raising rates three consecutive times at their two-day meeting dates on September 20th and 21st, November 1st and 2nd, and on December 13th and 14th.
Generally, the average 30-year fixed rate hovers about 1.7% over the latest 10-year Treasury yield. However, today’s spreads or margins are much higher than the usual 1.7% spread over the 10-year Treasury yield which has varied between 2% and 4%+.
The average 30-year fixed rate for creditworthy borrowers has been near the low to high 6% rate range in recent months. This is more like a 3% spread (or 1.3%+ higher than the 1.7% average spread) over and above the 10-year Treasury yield as the financial markets continue to disconnect partly due to Quantitative Tapering (or the Fed is selling more of their stocks, bonds, and $2.7 trillion in mortgage bonds).
If and when the Federal Reserve restarts their Quantitative Easing (the Fed buys more stocks, bonds, and mortgages to boost asset prices) program, then we may see the spreads or margins decrease back again to more historical averages closer to 1.7% over the 10-year Treasury yield average. If so, a 3.45% 10-year Treasury yield plus a 1.7% margin or spread might equal a 5.15% 30-year fixed mortgage rate which would boost housing values yet again.
Let’s review the average published 30-year fixed rate for owner-occupants by decade:
Now, let’s compare the average 30-year fixed mortgage rates over the past 10 years as published by Freddie Mac:
Between April 1971 and September 2022, the average 30-year fixed rate mortgage was 7.76% over 51 years as per Freddie Mac. Today’s 30-year fixed rates are still low compared with historical trends.
Doubling Asset Values
If you keep the old Rule of 72 (how long it takes to double an asset value by the annual gain or interest return projections) in mind with rising inflation trends continuing to boost housing prices, you will clearly see the potential to increase your net worth. For example, a home doubles in value based upon the gains such as a 7.2% annual increase that will take 10 years for the home to double in value (72 / 7.2% = 10 years).
Seattle’s real estate prices increased by more than 137% between 2012 and 2022, according to NeighborhoodScout.com. This annual growth rate of 13.7% over the past 10 years is much higher than the 7.2% annual growth rate example used above. As per the Rule of 72 formula, many home prices were possibly doubling in value every 5.25 years (72/13.7). While the Rule of 72 is not meant to be an exact science, it’s been proven to be fairly accurate with investment return and time estimate calculations.
Principal Paydowns at Faster Paces
Mortgage amortization is the process of paying off a mortgage loan over time. An amortization schedule is a reference to how a borrower’s mortgage payment is applied towards principal and interest. It’s also described as a “fully amortized loan” where the fixed equal monthly payments will pay off the loan in full by the end of a designated loan term such as over 15 or 30 years.
A 30-year mortgage loan doesn’t usually begin to pay down any significant amount of loan principal until after the 7th year. Effectively, the first seven years’ worth of mortgage payments are just paying interest on the loan. The average mortgage borrower stays with their loan for close to 7 years, so a more affordable interest-only loan product fixed for 7 or 10 years can be a much more solid choice today for many homebuyers and investors.
The lower your existing mortgage rate, the faster the principal amount will decrease if you pay one, two, or three plus extra mortgage payments per year. Many of our clients over the past 10 years have been fortunate enough to lock into mortgage rates at or near all-time record lows. Rent prices have also skyrocketed in the Puget Sound region and across the state and nation during the same time period. As a result, there may be plenty of extra monthly rental income that can be applied towards paying down the mortgage balance and converting a 30-year term into a 15, 17, or 20-year payoff schedule.
Approximately 36% of all Americans are paid biweekly or every two weeks, which aligns with the biweekly mortgage payment or early mortgage payoff strategy. Biweekly mortgage payments can be structured with automatic online mortgage payments that send out half the required monthly mortgage payment every two weeks. For example, a $1,000 monthly mortgage payment would be paid with two separate $500 mortgage payments every two weeks. In this example, you’re paying 26 half payments or 13 full monthly payments and not paying $1 extra in additional payments each year.
To accelerate the principal payoff, a mortgage borrower can add extra principal over and above the $500 biweekly payment to accelerate the mortgage payoff at a faster pace for owner-occupants and non-owner-occupied landlords. With enough positive monthly cash flow from rising rent payments, the investor could pay $600, $700, or $800 payments every two weeks and pay off the 30-year mortgage in 10, 12, or 15+ years. Please write down on your paper checks or on online transfers to banks that you want any excess money applied towards your mortgage principal so that your mortgage balance is reduced.
Once your real estate assets are free and clear with no mortgage debt, your monthly net cash flow will be much higher and possibly allow you to retire sooner rather than later if you’re not a full-time real estate investor already.
The Sterling Johnston Investor Group is here to partner with you on your real estate investing journey. We look forward to our continued partnership for another year!