There’s a thoughtful debate going on right now over in the Money Mustache Forum, where people are comparing different strategies for investing in rental houses.

Some people prefer to save up the full purchase price of a house before plunging in and making the move. Others will make the buy using a mortgage but then pay down the principal as aggressively as possible. Still others will borrow 75% or more of the purchase price, then leave the balance outstanding as long as possible, keeping more of their cash free to make additional leveraged investments.

That’s a landlord-specific example, and not all of us are interested in owning rental houses. But exactly the same thought process goes into deciding whether you should pay off your mortgage as quickly as possible, or pump your surplus cash into stocks and other investments on the theory that the long-term return of stocks is better than the 3.5-4.5% rates that US and Canadian mortgages are currently charging.

It’s a complicated question, because to fully answer it you’d need to consider risk, your personality type, how close you are to retirement, asset valuation and cashflow, and even make a stab at predicting the future. But there is still some good news: it’s a win/win question since either of these strategies involve YOU putting away money in a productive place, which will tend to make you wealthier over time. The Mustachian Way is flexible enough that it will make us all rich relatively quickly, so there is no need to lock on to one particular strategy as The Only Way To Do It.

But just for fun, let’s consider a few different scenarios to compare the effects of payoff and leveraging.

Strategy 1: The Consumer who Thinks he is an Investor

Some of my less Mustachian acquaintances like to talk confidently about the benefits of borrowing money.

“3.5% is the cheapest money you’ll see in a lifetime! I am never paying down my mortgage, I’ll just use my money to make more money!”

This statement is correct in general, but the problem is that it is often used to justify higher consumer spending rather than higher investment. Some people who have said this to me have expensive cars (bought on more of that brilliant low-interest credit), powerboats, and lifestyles that burn most of their salary. But their investment accounts are smaller than even the value of the material things they have bought. These people would be much better off paying down the mortgage, rather than buying additional Mercedes and iPads, because they are currently using the leverage afforded by the mortgage to purchase liabilities rather than assets.

To justify not paying off your mortgage, you have to demonstrate a genuine desire to get ahead through investment. That means having low living expenses (let’s say equal to or lower than mine), and a correspondingly high savings rate (50% or higher). At this point, I will grudgingly admit that you will probably do much better investing in Index funds rather than paying off your mortgage – we’ll get to this in the “Stock Investor” category later in this article.

Strategy 2: The Aggressive Landlord

One of the moderators of the MMM forum is a guy named Joe. He’s a fast-thinking, voraciously-reading, fast-typing type of guy who is on the rocket path to financial independence. He correctly calculates that you can make money MUCH faster when you carry a mortgage balance on your rental houses rather than buy them entirely in cash. Here’s an excerpt from his explanation, edited slightly for compactness:

Let’s say houses cost 100k each, and you have 100k to invest. You can put 25% down on 4 houses (25k each x 4 = 100k) or 100% down on one house (100k x 1 = 100k). Houses rent for $1200 per month. Let’s compare the two scenarios. We’ll use the 50% rule, a conservative rule-of-thumb which assumes about 50% of your gross rent will will go towards vacancy, repairs, long term capital maintenance, property management, property taxes, insurance, etc. Mustachian landlords can easily beat this performance, but for now let’s go with it. Scenario 1: 100% down, no mortgage payment. You cashflow is $600/month, or $7,200/yr. Total for scenario 1: $7,200 Scenario 2: 25% down, 30 year mortgage. At current mortgage rates of 5% (current owner occupied is about 3.75%, investor is 5%), your mortgage payment will be $402.62 principal and interest. 1200 rent – 600 to 50% rule – 402.62 to mortgage = 197.38/mo cashflow per house, or $2368.56/yr. Times 4 houses = 9474.24 Already you’re making an extra 2 grand per year. But wait, we are also paying down that mortgage. Year 1, your tenants pay down $1,012.19 per house of mortgage, or an extra $4048.76 that you gain in equity. Total for scenario 2: $13,523 So you make almost double in terms of equity gain + cashflow by having mortgages. That’s assuming no appreciation. If the house appreciates, you gain 4X as much appreciation. If it drops, GREAT, buy more houses! If you aren’t buying places where the rents more than cover the expenses + mortgages, don’t buy them. Who cares what the “value” is if you’re holding long term. Even if you lose your job, you can cover the payments because the renters themselves more than cover the payments! But that’s also counting having someone managing all those properties for you (that’s counted in the 50% rule). If you want a side-gig as a property manager, you can save yourself an extra $120/mo on scenario one, or $1440/yr. But if you landlord in scenario 2, you’ll gain an extra $5,760/year. Yes, you’ll have 4x the work (managing 4 houses vs one), but you have that choice – let them be managed and pay for that, or manage yourself and pick up a few extra bucks than you can in scenario 1. On top of that, you ALSO get mortgage interest write-off. So on top of 2 grand more cashflow, 4 grand principal paydown, 4x appreciation potential, you can write off some of that cashflow. PLUS you’ll have 4X the depreciation, sheltering all that cashflow and perhaps protecting some of your W2 income from your normal job.

Joe goes on to point out that over-leveraging is bad, but moderate leveraging (which we’ll define as 4-to-1 in real estate) works out well. But you must you have the personality type to deal with getting loans, and running a business. Real estate investment is actually a business that takes some skill, rather than just a free-for-all form of passive investing. This skill also allows you to avoid buying houses during property bubbles (Joe’s analysis would have ruled out the overvalued sunbelt properties that later lost 50-75% of their value in the US housing crash).

But if you develop the skill and understand the numbers, there are few ways to make as much money so quickly.

Strategy 3: The Young Stock Investor

You’re just getting started on saving for early retirement. You have a good career that is providing some surplus cashflow. But you are not interested in landlording or you live in Silicon Valley or Vancouver where house prices are far too high to justify buying them as rentals. So you decide to invest in stocks.

Over the long run, people who understand economics will generally agree that stocks will do better than the 3.5% return (before inflation) you get by paying off your mortgage. We’ll leave the explanation to the stock market books, but most would predict about 7.5% before inflation* even given today’s relatively high stock prices.

Being sure to max out your 401(k) is even more important, especially for those with incomes over $50,000/year due to the benefits of tax deferral and employer matching.

Strategy 4: The Conservative Early Retiree

You may notice that I speak favorably of strategies 2 and 3 above, and I have followed parts of them both over the years and benefited (even while living through the great financial crisis, the US housing crash, and two major recessions). But now I operate on an all-cash basis. I have no mortgage on my primary house, or the rental house, and I avoiding the temptation to borrow to expand my investments further. And many other retirees, both early and late, take the same path. Why is this?

I am a wimp: I learned during my heavily-leveraged “Big Mistake” business phase that I do not sleep well when things go wrong while there are monthly loan bills that are still due. But I get great pleasure from cashing rent checks and keeping the proceeds entirely for my family. My analytical side knows that I could make much more income through leverage, but sometimes you can afford the analytical side be damned. When? See the next point. I already have enough income: Once the groceries and the property taxes and the family trips are paid for, the marginal utility of more money drops significantly. If I had more income, I could spend more, which is definitely not interesting. I could save more, which is slightly interesting. I could give more, which is actually quite interesting, but so far I haven’t gone so far as using debt leverage to achieve it. I’d rather achieve more on the production side of things: working hard on things that force me to simultaneously learn and gain skills, and earn income as a side-effect. Even this blog meets those criteria, although it is heavily tilted towards learning and away from income right now. Paid-off assets can replace some of the “cash/fixed income” portion of a retirement portfolio: What is better for a retired person: keeping a $200,000 mortgage on your house and having $200,000 invested in corporate bonds that yield 3.5%? Or putting that cash into the mortgage and just having a more stock-heavy portfolio? In general, the mortgage is better since its return is 100% guaranteed and there are no income taxes on saved mortgage interest. Nobody wants to lend me money anyway: During the years since early retirement, and before switching to the current “all cash” model, I decided to refinance the main house and a few rental houses at various times. As the US credit system tightened, I found it increasingly difficult to qualify for these refinancings, despite the fact that I could prove invested assets greater than the mortgage amounts on the houses. This is because most banks are only set up to handle the typical borrower: someone with lots of income, and negligible assets. When they see that my income is relatively low compared to the value of my house, they assume that I could never handle paying a mortgage. So I had to do much more paperwork and work with special lenders to do these refinancings. Mustachians tend to blow the minds of the regular world, because our spreadsheets do not work the same way their spreadsheets do.

In the end, I respect the power of leverage, but I also came to appreciate the Peace and Quiet of Cash. But that doesn’t mean you can’t take a totally different strategy!

* for the S&P500 calculated roughly as: 2% current dividend rate+3% inflation+2.5% real GDP growth rate. Don’t go crazy writing comments to me about how optimistic this is, I’m just repeating the orthodox view that economic experts (including Warren Buffett) tend to have of long run stock performance.