Using loans in real estate investment is a common strategy for accelerating asset accumulation. However, loans come with interest costs that can strain cash flow. As a result, many investors consider making early repayments when surplus funds become available. Early repayment of real estate investment loans refers to making additional payments beyond the monthly scheduled repayments to reduce the principal amount ahead of schedule.
This article provides a detailed explanation of the benefits and drawbacks of prepayment in real estate investment loans from a professional and practical perspective, and discusses the optimal timing for prepayment. We hope this article will serve as a guideline for experienced real estate investors considering prepayment as part of their cash flow improvement, risk management, and asset formation strategies.
What is prepayment?
Early repayment refers to repaying a loan, such as a real estate investment loan, by paying more than the specified monthly repayment amount in advance, thereby accelerating the repayment of the principal. Under normal repayment terms, a fixed amount of principal and interest is paid over the repayment period, but by making early repayments, the loan balance can be reduced earlier than planned.
Since the terms and conditions for handling and fees may vary depending on the financial institution, it is important to confirm the details of the loan contract in advance.
Benefits of prepayment in real estate investment
Prepayment offers various benefits, and when used appropriately, it can enhance the stability and profitability of real estate investment. The main benefits are listed below.
- Reduction in interest burden: The primary benefit of prepayment is the reduction in the total amount of interest paid in the future. By reducing the loan balance through prepayment, the interest incurred thereafter also decreases proportionally. This benefit is particularly significant when the loan amount and interest rate are high. Reducing interest expenses contributes to improving the overall return on real estate investment.
- Reduction in monthly repayments: If you choose the “repayment amount reduction type” as the method of early repayment, you can reduce your monthly repayments going forward. Reducing your monthly loan repayments will increase your cash flow. The increased surplus funds can be reinvested in the next real estate investment or used for property maintenance and management expenses, enhancing the flexibility of investment operations. Having more cash flow also makes it easier to maintain financial stability in the event of unexpected expenses or vacant periods.
- Shortening the repayment period: If you choose the repayment amount reduction type through prepayment, you can accelerate the loan repayment schedule. If you can repay the real estate investment loan earlier than originally planned, you can then allocate the funds previously used for loan repayments to other purposes. For example, you can use the rental income from the property after repayment to purchase new investment properties or simply increase your cash reserves as pure profit, thereby contributing to future asset expansion.
- Reducing interest rate risk: If you have a real estate investment loan with a variable interest rate, there is a risk that future repayment amounts and total interest expenses may increase due to rising market interest rates. By making early repayments to reduce the principal, even if interest rates rise, the remaining balance will be smaller, thereby limiting the increase in interest payments. This is a form of risk management strategy that enhances the portfolio's resilience to fluctuations in borrowing interest rates. Especially for long-term investment plans, interest rate fluctuation risk cannot be ignored, so partial hedging of this risk through prepayment is effective.
As described above, prepayment can contribute to reducing interest expenses, improving cash flow, and mitigating risks for real estate investment loans, making it a powerful tool for supporting investors' asset formation. However, there are also points to consider and potential drawbacks associated with prepayment. Next, we will explain the disadvantages that should be considered when making prepayments.
Disadvantages of prepayments in real estate investment
While prepayments offer attractive advantages, they also come with disadvantages and risks that should be considered before implementation. Without understanding these points, prepayments may actually hinder your investment plan, so careful judgment is necessary. The main disadvantages are listed below.
- Liquidity risk due to a decrease in available funds: When you make an early repayment, the corresponding amount of your own funds will be removed from your available funds. A decrease in available funds (cash deposits) can reduce your ability to respond to unexpected expenses or emergencies. For example, if urgent repairs are needed for an investment property or if rental income is interrupted for a certain period due to a tenant's move-out, insufficient reserve funds may make it difficult to address such situations. Therefore, from a risk management perspective to prepare for unforeseen circumstances, it is essential to maintain a minimum cash cushion even when making early repayments.
- Fee burdens associated with early repayment: Some financial institutions may charge a specified fee when making early repayments. These fees can range from a few thousand yen per instance to a certain percentage of the prepayment amount, depending on the financial institution and loan product. Frequent prepayments can result in accumulated fees that become a significant cost. It is important to calculate the interest savings from prepayments and compare them with the fee costs to determine whether the benefits outweigh the costs before making a decision.
- Limited effectiveness for low-interest loans: Japan is currently experiencing historically low interest rates, and real estate investment loans are also set at relatively low interest rates in many cases. With low-interest loans, the amount of interest that can be reduced through early repayment is relatively small. For example, with a loan at an annual interest rate of 1%, repaying 1 million yen early would only reduce the annual interest by approximately 10,000 yen. On the other hand, prepaying the same amount on a loan with an annual interest rate of 5% would result in an annual interest savings of 50,000 yen. Generally, the interest savings from prepayments are greater in the early stages of loan repayment, so if you have the financial flexibility, it is advantageous to prepay as early as possible from the perspective of reducing the total amount paid.
- Reduction in tax benefits: Interest on real estate investment loans is treated as a necessary expense when calculating real estate income. As a result, many investors enjoy certain tax benefits (reduction in income tax and resident tax) due to loan interest payments. If you make early repayments and reduce interest expenses, the amount of interest that can be claimed as an expense decreases, resulting in an increase in taxable real estate income. In extreme cases, the increase in tax liability may exceed the interest savings from early repayment. However, in most cases, the benefit of reducing interest payments outweighs the drawbacks. Nevertheless, investors with high incomes and high tax rates should be particularly mindful of the potential reduction in tax benefits.
- Decreased leverage effect and impact on additional investments: Reducing the outstanding loan balance through prepayment may weaken the leverage effect and slow down the pace of asset expansion. Additionally, a decrease in available funds may negatively impact future loan reviews with financial institutions, posing risks to new investments. For those prioritizing growth and continuing investments, these drawbacks require particular attention.
As described above, early repayment has disadvantages such as reduced liquidity, opportunity loss, and increased tax burdens. When deciding whether to make early repayments, it is essential to fully consider these negative aspects and make a comprehensive judgment based on your investment strategy and business conditions. Next, let's consider the optimal timing for early repayment.
Optimal timing for early repayment
After understanding the advantages and disadvantages of prepayment, it is necessary to determine whether to actually proceed with prepayment and, if so, when to implement it. The optimal timing varies depending on the circumstances of each investor and the market environment, but the following points should generally be considered.
1. Timing based on interest rate environment and loan terms: Confirm the interest rate type (fixed or variable) and interest rate level of your real estate investment loan. If the borrowing interest rate is high and future interest expenses are likely to be significant, or if the interest rate is variable and there is a high risk of future interest rate increases, it makes sense to make early prepayments to reduce interest expenses. In particular, when there is a possibility that interest rates will rise in the future from the current low levels, prepayment can be an effective risk management measure to mitigate the risk of future cash flow deterioration. On the other hand, if the interest rate is fixed at a very low level, it may be strategically advantageous to maximize the use of low-cost funds rather than rushing into prepayment.
2. When there is sufficient surplus investment funds: When sufficient surplus funds are available, it is a good opportunity to make early repayments. However, “sufficient surplus funds” does not simply mean having temporary cash on hand, but rather having enough reserve funds remaining to maintain operations even after making early repayments. Specifically, it is ideal to have enough contingency funds to handle unexpected expenses and vacancy risks even after making early repayments, while also retaining the flexibility to prepare for future investment opportunities. Even when receiving a lump sum of funds, such as a bonus or proceeds from the sale of real estate, it is prudent to allocate only a portion of the funds to early repayment after carefully assessing the overall balance of your finances.
3. Turning points in investment strategies and life plans: The optimal timing for prepayment varies depending on an investor's real estate investment strategy and personal life plan. For example, during a phase focused on actively expanding assets while still employed, reducing loan balances may be less prioritized compared to a stage where stability becomes a priority in anticipation of retirement or semi-retirement. If your goal is to stabilize your monthly cash flow and secure your livelihood by generating real estate income without any loans, it may be strategic to plan for early repayment around the time of retirement. Market conditions should also be taken into consideration. When real estate prices are rising and the appeal of investment is waning, it may be more reasonable to allocate funds to early repayment of existing loans rather than acquiring new properties. Conversely, when the market presents favorable opportunities, prioritizing new investments over prepayments may yield greater long-term returns. Thus, it is crucial to identify the optimal timing for prepayments by assessing shifts in your investment strategy and changes in market conditions.
Based on the above, the optimal timing for prepayment is often when interest rates are high or there is a risk of rising interest rates, sufficient cash reserves are available, and the strategy is shifting from expansion to stabilization. On the other hand, prepayment is likely to be a lower priority when cash reserves are limited and there is a desire to actively expand assets under low interest rates. Each investor must make the optimal decision based on their specific circumstances.
Key considerations when considering prepayment
When considering and executing early repayment of real estate investment loans, the following points should be kept in mind.
- Securing necessary funds: When making early repayments, it is essential to ensure that sufficient cash is available after the repayment. In real estate investment, it is necessary to prepare for various risks, such as property maintenance costs, expenses during vacancies, and increased repayments due to interest rate hikes. When determining the amount of the early repayment, it is advisable to limit the amount to what can be retained as cash to withstand such risk events. Generally, it is recommended to retain at least several months' worth of loan repayment amounts or operating expenses as reserve funds and allocate only the remaining surplus funds to the early repayment.
- Verification of Loan Contract Terms: Prior to making any decisions, review the loan contract and the financial institution's terms and conditions to understand the rules regarding early repayment.
- The minimum amount that can be prepayment, whether there are fees, the amount of fees, and the procedure for prepayment (whether it can be done online or requires a visit to the bank) vary depending on the financial institution. In particular, fees can increase costs, so be sure not to overlook them. In addition, for loans with a fixed interest rate period, there may be restrictions or penalties on prepayment during the period. It is important to confirm in advance whether there are any penalties under the contract.
- Comparison with alternative investment options: Compare whether you should use the funds for early repayment or for other purposes (such as acquiring new properties, renovations, or investing in other investment products). If the expected return from additional investment exceeds the interest savings from early repayment, it would be more advantageous for asset formation to use the funds for other investments rather than early repayment. On the other hand, compared to the risks and uncertainties associated with new investments, prepayment offers the certainty of interest savings (reduction in expenses), akin to a “fixed return.” It is important to consider the balance between certainty and growth potential, taking into account the risk tolerance and investment opportunities of your current asset portfolio.
Furthermore, since prepayment reduces interest expenses, which in turn reduces taxable income, it is important to compare the net returns after taxes.
- Consistency with investment strategy: Prepayment is a measure to enhance safety by reducing debt, but it also has the effect of slowing down growth. Please confirm whether, based on your own medium- to long-term investment strategy, this is a phase where stability should be prioritized over expansion, or whether this is a phase where asset scale expansion should be prioritized. Depending on the strategy, the allocation of funds for prepayment and the timing of prepayment will also change. It is also effective to consider the overall balance of the portfolio and decide what percentage of prepayments to make and how to allocate the remainder to other investments. In addition to making large lump-sum repayments, you can also make regular small prepayments. It is important to make prepayments in a planned manner in line with your strategy.
Taking these points into consideration, it is important to carefully weigh the advantages and disadvantages of prepayments and execute them in a planned manner. Do not hesitate to gather information in advance, conduct simulations, and consult with experts before taking action.
Impact on cash flow and asset formation
When deciding whether to make early repayments, it is necessary to comprehensively consider the impact on both short-term cash flow and long-term asset formation. Let's examine how early repayments affect income and expenses in real estate investment and financial balance.
Impact on cash flow: Making early repayments results in a temporary outflow of a significant amount of cash, causing cash flow to decrease in the month or year in question. However, it may have a positive effect on subsequent regular cash flow. As mentioned earlier, with repayment reduction type prepayments, monthly expenses decrease, improving monthly cash flow. With term reduction type prepayments, although monthly repayments remain the same, the loan is paid off earlier, significantly improving future cash flow. For example, if you reduce the remaining repayment period by five years through prepayment, the five years of loan repayments become unnecessary, and the rental income during that period becomes entirely positive cash flow. In other words, prepayment is a choice that sacrifices part of current cash flow in exchange for the potential to stabilize and expand future cash flow. The key point is whether you can accept this trade-off given your current business situation.
Impact on asset formation: Reducing the loan balance through prepayment reduces liabilities on the balance sheet and increases net assets. However, whether this is more advantageous than the returns from investing the funds used for prepayment in other investments depends on the performance of those investments. While reducing interest expenses through prepayment is a sure way to save money, if there is potential to earn a higher return through other investments, the latter option is preferable from an asset accumulation perspective. Conversely, in situations where the goal is to steadily accumulate net assets while minimizing risk, prepayment is an effective strategy for reducing liabilities. As such, the impact of prepayments on asset accumulation varies depending on the investor's strategy and alternative options, so a comprehensive assessment is required.
In summary, it is necessary to weigh the impact on cash flow and asset accumulation and determine whether the benefits of prepayments outweigh the drawbacks.
Examples of prepayments
Finally, we will briefly introduce a specific simulation example of prepayments on real estate investment loans. The following case study shows how much interest burden is reduced and how much the repayment period is shortened by making prepayments.
Case: For a real estate investment loan with a loan amount of 50 million yen, a term of 30 years, and an interest rate of 3% (equal principal and interest repayment), assume that a prepayment of 10 million yen (term shortening type) is made after 5 years.
In this case, the total interest paid without prepayment would be approximately 258 million yen, whereas with prepayment, it would be approximately 207 million yen, resulting in a reduction of approximately 51 million yen (approximately 20%) in interest. Additionally, the remaining repayment period until full repayment is shortened from the original 30 years to approximately 25 years.
From the above calculation, even with a loan at an interest rate of approximately 3%, making an early repayment of 20% of the principal (10 million yen) after five years can reduce interest expenses by approximately 5 million yen and shorten the repayment period by five years. Note that the higher the interest rate, the greater the effect of early repayment, while the effect is limited under low-interest rate conditions. Furthermore, the earlier the prepayment is made, the greater the interest savings, and the later it is made, the smaller the savings. For example, under the same conditions, prepayment made after 10 years would reduce interest by approximately 4 million yen, while prepayment made after 15 years would reduce interest by approximately 3 million yen. Therefore, to maximize the benefits of prepayment, it is important to make the prepayment as early as possible and in as large an amount as possible. However, as mentioned earlier, this decision should be made after confirming that you have the financial flexibility to allocate the necessary funds and after comparing the benefits and drawbacks with other investment opportunities.
Summary
We have explained the benefits, drawbacks, and optimal timing of prepayment for real estate investment loans. Prepayment is a powerful tool for reducing interest burdens and improving cash flow, contributing to long-term risk management and stable asset accumulation. On the other hand, there are also disadvantages, such as liquidity risk due to a decrease in available funds and loss of growth opportunities due to reduced leverage. Therefore, when deciding whether to make early repayments in real estate investment, it is essential to weigh these factors and make a comprehensive assessment.
There is no one-size-fits-all answer to the question of the optimal timing. It should be determined based on the investor's individual circumstances, including loan interest rates, outstanding loan balances, available cash reserves, future investment plans, life stage, and market conditions. In general, prepayment offers significant benefits when interest rates are high or rising and there is ample excess cash, while there is little need to force prepayment in a low-interest-rate environment where asset expansion is a priority.
Experienced real estate investors will likely view prepayment as one tool in their portfolio strategy and use it flexibly according to the situation. The important thing is to understand the effects of prepayment not only in terms of short-term cash flow improvement but also from the perspective of long-term asset formation and risk management. If you make prepayments at the right time and in a planned manner, it will help you maintain the financial health of your real estate investment and build a stable foundation for future income. We hope this article will serve as a reference for you to make the best decisions aligned with your investment strategy.
