This is part 2 of my short series on “What’s the ROI?”. The series is written in 4 parts, Analyzing Cashflow, Principal Reduction, Appreciation, and finally the ROI Calculation. If you have not already read part 1, I suggest doing so.
Principal Reduction is one of the most commonly overlooked areas of profit, though arguably it is just as important as cashflow or appreciation. Principal Reduction comes from the portion of your mortgage payments that is not eaten up by interest. For the first few years this will only make up a small portion of your payments. As you pay down the mortgage, the principal of the mortgage shrinks. What is left is called Equity. This is something that adds to your overall net worth, and should be used in any calculations of the same (including loan applications and such).
The biggest difference between the equity you gain from Principal Reduction, and Cashflow, is that equity is a lot more difficult to either spend or leverage. Most usually only benefit from their equity when selling a property, and using it to ‘trade up’. You’ve probably done this yourself, when you moved into a bigger house. There are some ways that one can leverage this equity without selling, though we will leave those for another time.