Amortization

Amortization is one of the most amazing concepts in real estate investing. It has to do with another amazing concept called OPM, which stands for Other People’s Money. Before we get to amortization, the idea behind OPM is that you don’t have to use your own money to purchase properties (or, at least you don’t need to use all of your money for the purchase). An obvious example for OPM is a mortgage. If there’s a property you want to purchase that’s valued at $100,000, you don’t need to have $100,000 in order to purchase it. With a conventional loan, you only need 20% of that price. In other words, if you only have $20,000 you can still purchase a property that’s worth $100,000.

That’s a simple example of OPM. Now, what is amortization? Amortization is the fact that, over the course of the life of that loan, you’re paying it down and slowly owning more of that property.

For example, the day after you purchase that $100k property with $20k of your own money and finance the other $80k from the bank, you own 20% of that property. Since you’re paying the bank a mortgage payment every month, you’re slowly paying back that loan. So after 10 years, you won’t own only 20% of the property, you’ll own 30% of it. And after 30 years (if this is a 30-year loan), you’ll own 100% of that property. In other words, you initially paid 20% of the price and after 30 years you’ll own the entire thing.

But, David, like you said, we’re making monthly payments to the bank to return the 80% back to them. That’s right, but the question is who is paying them back? If you’ve purchased the right property, your tenants’ rent payment should pay back the mortgage. You can see an example from my first home here. With my first property, the rent paid by my renters covers not only the mortgage but also all expenses! The rent pays for the mortgage, insurance, taxes, property management, and maintenance. In other words, my tenants are paying the bank back for the loan that I borrowed.

So, amortization is that slow increase of how much of the property I own vs. how much of it the bank owns. After 30 years I should own the additional 80% of the house without spending any more than my enitial payment of 20% of the property price.

Another example: Let’s say I’m able to save $20,000 a year for the next ten years, and every year I purchase a property with a conventional 30-year loan. After 40 years, I’ll own the ten houses free and clear (no more mortgages). So, in the first ten years I spent $20,000 per year, and after 40 years I’ll have ten houses for a total value of $1,000,000 (not taking appreciation in to account).

That’s how amortization is an amazing part of real estate.