When people think about real estate investing, compound interest isn’t usually a related topic. Indeed, with interest rates being so low right now, compound interest seems like a thing of the past. However, real estate investors can put the concept to use in their niche even though interest rates are so low.
The Concept of How Compound Interest Works in Real Estate Investing
The idea behind compound interest is merely reinvesting whatever income is earned on a particular asset. This concept can easily be applied to real estate investing, although it doesn’t actually mean reinvesting interest. The concept involves reinvesting rental income or income generated from flipping a property rather than interest earned on money sitting in a bank.
Some real estate investors have mortgages on the properties they rent out, and their rental income is used to repay those mortgages. Thus, they must look for other ways to benefit from the concept of compound interest.
One other way landlords benefit from compounding is through increases in property values. If property prices increase 5% every year for 10 years, landlords receive a nice boost to their net worth. Additionally, higher property prices mean rental prices increase, which also increases their bottom line.
Even landlords who aren’t reinvesting the rental income they receive will benefit from such increases. After all, mortgage payments stay the same if a fixed rate was used. Anything extra received in rent enables them to build additional wealth, either by putting more money in their pocket or by enabling them to pay off the mortgage more quickly.
When Landlords Lose out on Compound Interest
While compound interest is like a dream come true for savvy real estate investors, it can also work against you. When applied to debt, compound interest can make a bad situation even worse for real estate investors who don’t pay close attention to their leverage and enter every agreement with careful consideration.
Credit cards can provide a way to finance almost any kind of debt, but they typically come with high-interest rates close to 20% or more. If sizable credit card balances are allowed to compound, you’ll find yourself paying back thousands of dollars more than what you borrowed originally in the first place. For example, a $10,000 credit card balance balloons up to nearly $30,000 if compound interest is allowed to build up on it while you make minimum payments.
Mortgages on rental properties carry interest rates that are much lower, but they still compound the longer the principal is left unpaid. Thus, the faster you can pay off the mortgages on your property, the wealthier you will become.
The Dangers of Interest-Only Loans in Real Estate Investing
One type of loan real estate investors should be especially wary of is the interest-only loan. Regulators have had interest-only loans in their sights as they called for them to be a smaller percentage of loans offered by banks, which further highlights just how dangerous they can be.
Interest-only loans are adjustable-rate mortgages that enable the property owner to pay only the interest for the first several years of the loan. The rate increases and decreases with the London Interbank Offering Rate, better known as Libor. Libor is the rate one bank charges another on short-term loans.
The interest-only period usually lasts one, three or five years. After the introductory period, the interest-only loan is converted into a conventional mortgage. The interest rate may increase when the loan is converted. The monthly payments will then include some of the principal in addition to the interest, just as with conventional mortgages.
Interest-only loans can be tempting in real estate investing because the initial payments on them are lower than with conventional mortgages. Property owners may think they are a good idea because it will give them some time to fix up the property and get it rented out before they need to start making full payments.
Another benefit of interest-only loans is that they enable property owners to pay off the loan much faster. However, neither of these two benefits are realized if the real estate investor doesn’t pay off the loan faster than initially planned for when the loan is taken out. The key is to avoid as much of the compound interest as possible, and the way to do that is to pay it off quickly, possibly even before the introductory period is up, if possible.
Aside from the compounding interest on interest-only loans, they can also be dangerous in real estate investing if property prices decline instead of increasing. Thus, it is very important to buy properties in up-and-coming neighborhoods rather than areas that are slowly dying out.
Time Is Everything
Perhaps the most important thing to remember about how compound interest works in real estate investing is that it depends on time. The longer some income or asset is compounding, the more it will grow. Compound interest creates a snowball effect that grows exponentially as time goes on.
Thus, the earlier you can get started investing, the more money you will be able to make. It’s OK to start with a small amount of capital. As you reinvest the income you earn from each property you rent or flip, you’re forcing yourself to save money because you don’t take anything out of the properties you own. This presents an excellent way to build wealth because you don’t even realize you are doing it until much later down the line when you reassess all your holdings.
Real estate investors will find that if they utilize the principles of compound interest in their properties, their net worth will increase much more quickly than if they don’t. Most real estate investors are in it for the long haul, so it just makes sense to reinvest any gains they manage, whether that includes rental income or money earned from flipping properties.
In this way, one property can become two or three properties in just a few short years.