Amortization: Building Real Estate Wealth Through Equity

Welcome to the second installment of our four-part series on the pillars of real estate wealth creation. After exploring the crucial role of cash flow, we now turn our focus to Amortization, a less discussed but equally significant pillar in real estate investing.

In real estate, Amortization is the process of paying down the mortgage associated with a piece of property over time by making regular (usually monthly) mortgage payments.

Portions of these payments are applied toward the loan principal, which is paid down over time.  Over that period of time, assuming the property value stays constant or increases, this leads to a gradual increase in the investor’s equity in the property (Equity = Property Value – Mortgage Balance).

This makes amortization a fundamental concept in building equity and wealth over the life of an investment.

Understanding Your Mortgage Payment

Mortgage payments (not counting escrowed funds for taxes and insurance) are divided into two parts: interest and principal. The interest portion can generally be considered a business expense as it represents the cost of borrowing money.  This means that interest expenses for an investment property can usually be used to offset income from that property when it comes time to file tax returns.

The principal portion of the monthly payment is essentially a form of savings, as it builds equity in the property. This increase in equity is not a business expense but rather a redistribution of your investment’s value from cash flow to equity. This gradual increase in equity is what we are after here – Amortization.

One quick note:  mortgage payments, while impacting an investment’s cash flow (taking money out of the investor’s pocket), are not categorized as an expense on a pro forma or balance sheet.  Instead, debt service is typically recorded as a separate line item. This distinction is crucial for understanding the financial health of an investment property and in valuing a property using its Net Operating Income (NOI).

When calculating the NOI of a property, which is a key metric in real estate investing, debt service (mortgage payments) is excluded. NOI will be the topic of future posts, but for now just know that NOI is calculated this way in to bring about uniformity between different properties, as everyone’s loan situation is different, depending on down payment, creditworthiness, rate, term, and many other variables.

In summary, while mortgage payments do negatively impact cash flow, they are not a pure and simple expense. They’re part “forced savings” contributing to the property’s equity (Amortization) and part cost for leveraging capital (interest).

The Role of Amortization in Wealth Building

Building real estate equity is a cornerstone strategy for long-term wealth accumulation. Equity is the portion of a property’s value that you own outright, and it increases as you pay down the mortgage principal.

Remember, when you make a mortgage payment, a portion is allocated towards paying interest to the bank, while the rest reduces the principal balance.

The process of gradually reducing the principal balance not only contributes to building your equity but also has a compounding effect on reducing the total interest paid moving forward over time.

Early in the loan term, a larger part of the payment goes towards interest. However, as you continue to pay down the principal, the interest portion decreases due to the reduced outstanding balance, and a larger portion of your payment goes towards the principal.

This means the rate at which equity builds accelerates over time. This compounding effect is a powerful tool in real estate investing, as it reduces the overall interest paid over the life of the loan, ultimately leading to more wealth retention.

Something to consider when evaluating a purchase is the loan amortization.  A loan with a 20-year amortization will generally require larger monthly payments than a loan with a 30-year amortization.  BUT, a greater portion of that 20-year loan payment will be towards the principal, meaning equity builds faster. 

Also, a shorter amortization generally means a lower interest rate (just be sure you are doing a fair apples-to-apples comparison of your loan options – some loans like commercial loans may carry a higher rate but come with increased flexibility compared to conventional loans, for example).

How to Use Amortization to Grow Your Portfolio

As your equity builds, it can be leveraged to expand your investment portfolio. Once you have enough equity in one property, it can be used as collateral to secure additional financing for purchasing other properties.

This strategy of leveraging equity allows investors to grow their real estate holdings without necessarily having to liquidate existing assets or bring additional cash to the closing table. Essentially, you’re using the value you’ve built in one investment to foster growth in others, further compounding the benefits of your initial investment.

Another strategy for leveraging equity involves a cash out refinance in which an investor obtains a new loan for an amount greater than their outstanding loan balance, pocketing the difference in cash.  This can be used to purchase additional investments or simply cashed out to reduce or eliminate the investor’s capital contribution in the investment.

In summary, the importance of building equity through amortization cannot be overstated. It’s a gradual process that pays off in the long term through the compounding effect of reducing interest payments and the ability to leverage accumulated equity to acquire more assets. This allows investors to grow their portfolios and increase their wealth sustainably over time.

Conclusion

Amortization is a vital aspect of real estate investing, representing a long-term means of building wealth. By understanding amortization and equity over time, you can significantly accelerate the growth and performance of your investment portfolio.

In the next part of our series, we will delve into Appreciation, another critical pillar of real estate wealth creation.

Interested in learning more about real estate investing? Contact us at Cornerstone Management Group to learn how our property management services can maximize your property’s potential and ensure long-term returns on your investment.

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