"In response to last week’s post about where to invest an additional $20,000 outside of retirement accounts, I received these follow-up questions: What about purchasing a strategically selected rental property? If you put that extra $20k into that property for the next number of years, you'd pay it off in short order. Or what about putting it all toward paying down your current mortgage? How do these options compare?"
Great questions/points! I agree with you that purchasing a rental property is a viable and very good option. This sort of investment entails owning and managing a business. It is much different than owning the type of investments that I focused on in my original response. Because this is a business, be ready to be much more involved with its operation than if you just invested your money. Also, make sure you thoroughly understand all that is involved with owning and managing rental property as well as all the numbers. Judging from the fact that you bring up this option, it sounds like you have a good grasp of all that is involved. I personally agree that this is a good way to diversify your investments and also a good way to have positive cash flow. It is also a tax effective strategy since it is possible to legally not recognize any income because of favorable tax treatment of expenses and depreciation. I thank you for bringing this up.
I am not going to write about all the ins and outs of real estate investing, but there is one item that is most important and that I feel obligated to elaborate on. It may be obvious but this sort of investment begins with finding and purchasing the right rental property. What do I mean by the right rental property? According to the original question, this additional $20,000 is being set aside for retirement purposes. Therefore, I do not recommend any speculative types of real estate investments for this purpose. Speculative real estate investments are those that aren’t profitable from day one. Instead of saving and investing money for retirement, you are losing money (through taxes and other expenses) and hoping for a gain when you retire. With the right rental property, you should be able to have positive cash flow immediately. In order for this to happen, you must do your homework and understand all the variables that impact your cash flow—principal and interest payments, maintenance, taxes, insurance, rental rates, vacancy rates, etc. If you do not want to manage the property yourself, then factor in the costs to find tenants and manage the property. When all is said and done, finding the right rental property is a time consuming process. It is easier to find a property that will have positive cash flow if you manage it yourself. If you intend to outsource that responsibility, then finding the right property is extremely difficult. It can still be done; I just want to set the right expectations.
The next suggestion is to put the additional $20,000 each year towards the loan’s principal. Let’s assume you find the right rental property and you can purchase it with a $20,000 down payment. What do you do with the $20,000 next year. If the right property was purchased and you have adequate positive cash flow, I do not see the benefit of paying down the mortgage with the extra $20,000. This mortgage is now a business expense, fully deductible, and should be at a fairly low interest rate. The way I see it, you now have the same options as before: invest as I recommended in my previous post or buy another rental property per the questioners suggestion.
As is also mentioned, you could also put the $20,000 towards the mortgage on your personal residence. I do not view paying down a mortgage as a way of investing for retirement, but I see your point. It can be very powerful to be debt free and have your home fully paid for. I would never discourage someone from paying down their mortgage if this is their goal. It is admirable and will certainly benefit them in the long run. The question boils down to whether it will benefit them more than investing the $20,000 elsewhere. As I’ve written in previous posts, with interest rates on home mortgages barely above historic inflation rates, I am not sure paying down the mortgage is the best financial decision. It is a good decision, but probably isn’t the best decision. From strictly a financial perspective, the $20,000 can probably be put to better use elsewhere.
Thank you for the points that you made. You make a very good point suggesting the rental property. It is a very good investment for those that are willing to make the commitment to the business. I've had multiple rental properties and currently still own one myself. I also assist client's on their rental properties as well.