Should I Pay Off My Rental Mortgage?

debt-37557_1280-PDIf I pay off my rental mortgage, my cash flow will definitely increase.  It has been a year since I paid off my last mortgage, not literally my last mortgage, but the most recent one I paid off.

My investment account balance has grown back to where I was before I paid the mortgage off, and then some.  So, I am now wondering if I should pay off one additional mortgage.  There are a lot of things to think about before you make a sizable payoff.  What are the other uses of the capital?  How strong will your cash flow be after the payoff?  What are the alternative investments, such as the stock market?

Here is the analysis that I am going through.

The mortgage I paid off last year, almost to the day of this post, was $188,758.33.  It was at 5.5% interest and has now saved me quite a bit in interest, almost $10K.  It added another $1,071 in monthly cash flow.  The second mortgage I paid off, on my personal home, added another $1,403 in monthly cash flow.  While the extra almost $30K in annual cash flow is nice, it is very likely more than I need for retirement when combined with the existing rental income and future retirement draws from my investment account and pensions.

I have three mortgages currently; here are the approximate mortgage amounts as of 07/2015.  August payments will lower each mortgage by ~$300.  The remaining balances are not bad for seven multifamily rental properties grossing over $25K per month.  The property values, based upon tax value or recent sales, should generally be worth approximately $2.5M, of which I paid ~$1.8M over the years.  In early 2012, I had over $917K in mortgages loans, so I have paid off almost $360K in mortgages in the past 42 months or so.

Mortgage Principle Payment (P&I) Interest Rate Payoff Yield
1 $181,301 ($1,071.12) 4.88% 7.09%
2 $218,822 ($1,308.50) 5.00% 7.18%
3 $160,517 ($960.35) 5.38% 7.18%

 

Mortgage Debt Payoff Strategy (or any debt)

In general, when you are paying off debt, you should pay off the debt in some sort of organized fashion.  Generally, it amounts to paying off debt in one of three ways.  Pick the highest interest rate debt, pick the lowest balance account, or pick the one you will generate the most cash flow on.

In my case, the highest interest rate and the lowest balance is the $160K mortgage, or mortgage 3.  It is also the one that will generate the most cash flow yield.  It was taken out in March 2011 and still has ~26 years left, which may be longer than I will live.  It will take me ~160 months to recover the amount I am using to pay it off, based upon the cash flow savings.  160 months to replenish my investment account using the extra cash flow from the mortgage loan payment.  Realistically, it will take about 12 months to recover the amount, if I include my after tax rental savings.

The cash influx will get weaker as time goes on, as this time next year, I will not have a megacorp job.  That might make for a longer account recovery.

Less Leverage

Some investors like lots of leverage.  I like cash flow.  Paying off a mortgage is close to the equivalent of buying another property I terms of top-line cash flow, but not adding any additional work.  I like less work.  If I can get a solid guaranteed return, almost as good as the stock market, it’s a plus.  I can save later, and if my cash flow is greater than my needs, I do not even need the market.

Cash Flow Yield vs. Interest Savings

I am only saving the interest percentage on the loan.  As an example, if I put up $10K on a 5.375% mortgage, I save 5.375%.  It does not help my cash flow.  I still have to make the monthly payments, but for a shorter timeframe.

If I pay off the entire loan, I eliminate the principle and interest payments for the month.  With the principle not having to be paid, it increases my cash flow further.  In my case, I calculate that as payoff yield.

If I put up $160K, and my cash flow increases by $960.35 x 12 per year, it is like a guaranteed 7.18% investment.  It is definitely guaranteed, if I do not pay it every month, the bank will come and take the building away.  It is worth about double the mortgage, so it is likely I would never, ever, ever, want it to go back to the bank.  If I was underwater, it may be a strategy to cut the building lose and pet the bank take it back.  With today’s non-owner occupied down payment amounts of 25% – 30%, there is little incentive to walk away.

Benefits

  • I will increase my cash flow, that is a given.
  • If rents decline, I am in better shape.
  • If I need another mortgage, I have more cash flow to show, and am further away from any four mortgage limit.
  • I do not have to pay 5.375% interest on $160K, which is a tidy sum.
  • If I split the 4-plex into condominiums, and sell them one-by-one, I do not have the bank objections.
  • I do not have to worry about any due-on-sale clause for putting the building into an LLC name.

 

Down Sides

  • My investment account, which is fairly liquid, will be lower. It becomes less liquid Real Estate equity.
  • My interest rate deduction is less. However, it is always better to pay $0.50 in taxes, than $1.00 in interest.
  • I may have a higher taxable income.
  • A lawsuit would bring a larger ‘prize’ to a potential litigant.
  • I have to account for property taxes that I was escrowing for. So, it is a larger tax hit during May and October when I have to make out a $10K check, rather than a smaller amount throughout the year.  It’s the same price, it just pinches more.
  • If inflation goes to 6% or more, a 5.375% mortgage is gold. It is less than inflation.  Inflation is helping you pay off the mortgage.

 

The Plan

I will wait until January 2016 to put the plan in action, just after rent collections.

I do not want to sell investments to pay off a mortgage.  They are earning dividends or have capital gains.  I will likely pay about $80K from my cash position, and then use my Home Equity Line of Credit (HELOC) for the other $80K.  I should be able to pay off the $80K by the time I quit working if I pay ~15K a month.

The existing interest is 5.375%, and my HELOC will be at prime, which is 3.25% today.  It is adjustable, but I save about 2% no matter what.  Plus the loan will only be on half of the original amount.

My house continues to get paid off, and re-mortgaged, and paid off again.  I guess the plus side is that I get the ‘paying off my mortgage feeling’ quite often…

So, that is the plan.

The Alternate Plan

I could immediately pay down the mortgage by quite a bit with some money sitting a cash position in my investment account.  Any amounts paid will be like getting 5.375% on my money.  It is currently getting .01%.  That is a 5.374% increase.

I could then payoff as much as I can, while still maintaining my stock investment schedule as close as possible.  Once the New Year comes through, I could pay off the remaining balance, or keep my schedule.

Of course, any amount I pay down becomes illiquid real estate, instead of cash.  And my cash flow doesn’t change for the near future.  Only when the mortgage payment is gone does the cash flow position increase.

Do you have any mortgages?  Have you paid off any mortgages?  Could you write a check and payoff a $160K mortgage?

What would you do in my situation?  Pay off a mortgage or have liquid investments?

 

 

 

 

 

 

 

 

28 Replies to “Should I Pay Off My Rental Mortgage?”

  1. Interesting question. I think the answer lies in where you are in the tolerance of risk, what investment phase you are in, and where in the market cycle the asset is.

    Tolerance for risk is typical of most real estate investors. But there is something to the idea of a risk weighted return. Yes without debt your return is lower, but so is the risk.

    I think investment phase is important when determining the suitability of debt. If you are in an accumulation phase, debt allows you to control a significantly larger asset base than if you werent using leverage. In a pinch outside income can be used to supplement repairs, or tenants who dont pay etc. Cash flow is nice, but the objective really is total return early on.

    Later in life when you are approaching or in retirement, leverage is less desirable. Having paid off properties gives you more cash flow and lowers risk. Paid off property is going to maximize your cash flow in retirement when income from your job is no longer available.

    The third piece, I think where the market is at is also important. Circa 2010-2011, the real estate market was near an all time low and it was a great time to take on debt to invest in the market. Valuations were incredibly low. Today the real estate market is getting close to a top, in some areas I think it is getting close to a bubble phase. Adding additional properties in over heated markets probably isnt a good good idea, and in that case there isnt much of a reason to increase ones exposure to the market. Better to take the guaranteed return (paying down the mortgage).

    My sense from reading your blog is that your free cash flow is fairly large, so that the change in risk is somewhat marginal. But that you are close to retirement so that cash flow is a lot more important that increasing your assets. I think you are more in a phase of focusing in on early repayment.

    Last of all, and I know you have a lot of free cash flow, but under no circumstances would I exchange a mortgage on a rental property for a HELOC that would put my personal home at risk. You would only be saving a little over $100/month on $80K, even less if you factor in the after tax impact. Much rather pay a little more interest than take on a HELOC.

    I think your best move would be to just pay down the $80K and either get a new note on the existing rental property for $80K to increase your cash flow, or just pay down the first $80 and just focus in on cash flowing the last $80.

    1. I have been thinking about the pay-down strategy a bit. For the rest of this year, I will put some cash on the mortgage that is earning nothing. Probably ~$4K a month. That will bring the balance down by $24K by early January. That will not impact my investment accounts at all.

      I still want to keep with my objective of adding ~$10K to the market every month, and add another $5K to my investment cash balance, or short term funds. Once the first of the year rolls around, maybe put another $40K from those funds on the mortgage. That should allow my monthly payment to go quite a bit more to principle. The balance should be ~$95K at that point.

      After the first of the year, I will have to see where I am at from a cash perspective and investment account balance. The rentals do generate quite a bit of profit, so paying the $95K off can be done within about 6 months or less. If I do it on one fell swoop with the HELOC and eliminate the 5.375% mortgage payment, or incrementally over ~6 months is the question. The HELOC would be ~3.25% until it is paid off.

      While the extra cash flow is nice, I really do not need it to live. And I hate paying interest every month, especially if I have money earning nothing. I do need operating capital, so can’t go too far down.

  2. I still like to leverage. I have a student loan of $50k now and I still don’t want to use my cash to pay it off, when I could very well use the money where else to make more money.

    When applying for loan, the officer don’t look at the amount of equity you have,they look at your cashflow and the cash on hand. Hence, Bernanky has problem refinance his home mortgage after he quit his federal job. I have no doubt that he’s a millionaire from his total networth, but the bank math is weird. I wouldn’t pay anything off unless I build a sizable cash position and don’t know where to invest my money.

    1. Great points.

      If I only pay down half of the mortgage, my cash flow is not changed, and my cash position is less. It is only by paying off the mortgage completely that my cash flow gets better. I can get a guaranteed 7.18% on my money of I pay off the loan, or I can put it in the market. If I had a crystal ball, it would be easy.

  3. Great to see you work through the numbers to determine if now is the right time to pay off the rental mortgage. Electing to wait – vice selling current investments to pay off the mortgage – strikes me as a wise choice.

  4. I like this statement: Paying off a mortgage is close to the equivalent of buying another property I terms of top-line cash flow, but not adding any additional work.

    I never thought of it that way. I was always thinking if I had the cash, I’d rather buy more properties, but this makes alot of sense. If I have $150k in cash, I could buy maybe 5 more properties with it and at $200/month cash flow, that would be $1000/month. OR I could pay off one mortgage and gain $1,000 in cash flow. But the one thing I think about is I’d rather have 5 more properties to lessen the vacancy hit than having all my cash flow wrapped up in 1 property. It’s definitely an interesting take though.

    1. Thank you for reading!

      You also lose the capital appreciation of the buildings by paying off a mortgage, rather than buying more properties. IF they appreciate, in some areas they will be worth less. The headaches are certainly less. Some investors get too far leveraged, and they lack the capital to weather the bad times. One or two bad tenants and they cannot recover.

      An investor should have a MINIMUM of six months worth of capital to pay all their living expenses, and all the mortgages and all expenses including maintenance, in order to feel somewhat ‘safe’.

      1. Please explain what you mean by losing the capital appreciation of a building by paying off the mortgage. I don’t see how paying off a mortgage could affect the appreciation of the building.

  5. I think you pay it off with the investment capital. This market could continue to run, but I personally think the cracks are starting to show and you may be getting out to pay of debt at a good time. I could be 100% wrong, but oil is down, China is slowing, interest rates are set to rise soon, and global debt is at extremely unhealthy levels. Not sure if they’ll let it crash before the next Presidential election cycle, politics have played to much of an issue as of late with the FED, but we all know it’s coming sooner rather than later. It’s especially worrisome that margin debt is also at all time highs, this typically is a leading indicator of a market correction too. Good luck with whatever you do, you’ve done a fantastic job for yourself!

    1. Thank you for reading!

      It’s hard to tell where the market is headed, but I am definitely going to start putting my surplus cash to use. I’d rather get 5.375% on it, than 0.00%.

      The Fed will likely raise rates, all their member banks want it. Banks make a TON of money if rates are raised. Inflation is tame, average earnings will continue to drop, especially as the older generations retire. Hopefully the younger folks will make enough to pay taxes to support me…

      I do not like timing the market, as it is a fools game. It’s easy to get out, but hard to get back in. And the market moves the most, with the least people on board. There are still folks on the sidelines from 2000 or 2008.

  6. Our investing strategies are quite different, but given your new found freedom from the job, perhaps you would prefer the higher cash flow with less work option.

    However, you obviously aren’t building a Real Estate empire because you think you need money, so you might just hold the cash until the next property comes along.

    1. Thank you for reading!

      That is exactly it. I would prefer more cash flow, and do not want or need to invest in more properties. As it is, I have a 6-figure net income from them and do not need more. But I would like to squeeze more out of them.

  7. I often debate when I will start paying off my mortgages. I also a tend to think where in the cycle you are at that will dictate this decision though. In my opinion, when you are in your early stages of growth and building, it is wise to use leverage so that you can attain higher returns. Which is what I do now because I am in early growth mode.

    After growth mode, when I get to the point where I no longer need to purchase new real estate, I will definitely start paying off mortgages and living off of the extra cash flow for that sweet early retirement we all want.

    Since you are so close to retirement anyways, I tend to think it would be a better choice for you to pay off the mortgages and reap those 5- 7% returns from not really doing anything.

    1. Thank you for reading!

      I agree. If I wanted to accumulate more, I would keep a healthy cash position. I did put a few dollars in the mortgage last week, and will continue to do so until the first of the year. Hopefully, by this time next year, it will be paid off.

  8. This is a super helpful breakdown. You’re making me see that we’d be lousy real estate investors, since we would always be tempted to pay off the mortgages as fast as possible, since we are just anti-debt! 🙂 We have just the one property right now and surprisingly have no plans to prepay it. It’s such a low rate (under 3.5%) and on a 15-year mortgage, so the benefit to paying it off is pretty small, and because we opted for a 15 instead of a 30, the rent barely covers our expenses on it, meaning that the cash to prepay would have to come from somewhere else. But you have so much cashflow from your rentals that we’d almost certainly make the decision to pay them off if we were in your shoes!

    1. I don’t think your strategy is a bad one at all, though. Remember that the additional equity you’re building can come back to benefit you even if you can’t pay off the whole mortgage in one chunk. If you can scrounge up the extra bucks to throw a little extra at the mortgage each month, and later on you need more cash flow, you can likely do a cash-out refi, get a HELOC, do a regular refi for a longer term, or even sell the property.

      This has essentially been my strategy. I had to do some creative financing with a family loan to get my current house (long story). I made extra loan payments every month on that second loan, and finally paid it off last September. Right afterward, I refi’d my primary mortgage for a 10 year (instead of the 27 years I had remaining on it), dropped my interest rate to 3%, and have plowed a bunch of cash into that mortgage, even paying $600/mo over the required payment amount.

      Now I’m setting my sights on acquiring another rental property (my former condo wasn’t well suited to it). I’m tapering back my principal mortgage payment to just the required amount, and using the $600/mo extra, along with whatever else I can scrounge up, to build up a down payment amount again. If I can’t get the bank to lend to me at my current cash flow, I can always refinance my house for a longer term and have a better cash flow statement to support a loan on the new property. After the loan is made, I can always tighten my belt and pay down the mortgages faster again. But I think the compound interest benefit of paying off mortgages faster is a great idea, and worth doing even if you don’t have the money sitting around to pay off the entire mortgage.

    2. Thank you for reading!

      As long as you have jobs that support the rental, it is OK to leave the mortgage as is. At some point, you may cash flow better, or decide to sell. Cash flow is king, and should be the prime consideration when you buy an investment property.

  9. How much cash do you have on hand now?

    I paid one off this year, and will just chip away at the other in $1,000 increments.

    Great job paying so much off in the past three years! Is the income from a day job too?

    1. I have a fair amount of cash that is not earning interest, so I am paying the mortgage with it. Generally I am going to $4K a month, plus the payment, then use a larger lump sum to get rid of excess cash in my investment account. What is left, I may pay with my HELOC, at a 2% savings. Then, pound out the HELOC balance in a few months with a 100% of all excess income to that balance.

      I do have a day job, that helps a bit too. Most of the income is spent paying extra withholding, so I do not have to pay quarterly taxes.

  10. First off very good post. In my opinion it is very important to constantly analyze your position in terms of risk to be a successful investor of any kind. All the information in your post is very reasonable, and while I am a bit more pro-leverage, I think most of your concepts are correct.

    However, the one concept I would argue is incorrect is that the return would go from 5.38% to 7.18% depending on whether you pay the entire mortgage off or not. It is always 5.38%. The fallacy has its roots in that while you are still paying a mortgage some of the money goes into the principal (I’ll call this “building equity” return). So after you pay everything off it seems like you are getting more cash flow but in reality the extra return (0.80%) is just coming from the cash flow instead of from building equity. But paying off the mortgage or not you are still getting that 0.80%. In other words, the only difference in return (whether paid in full or partially) is 5.38% or the interest you are saving.

    I’d love to hear what you think! I will never claim to never have been wrong and would like to know if I am getting something wrong here. =)

    1. Thank you for reading!

      You are correct. The only savings you actually have is your interest rate. The principal is not a savings on expenses, but it is an increased cash flow. Similar to an annuity. If I pay off all but $10K, I have the same cash flow as if I paid nothing. But my interest expense will be less. So, paying off a mortgage should be an all or nothing thing once you get committed to it, if you are going for increased cash flow.

      I am down to ~$143K now with this mortgage, and should be below $139K in another couple of weeks. I have been paying $4K extra each month for 2015, and will accelerate the payments in 2016. I may even use the HELOC for the last bit to eliminate the mandatory payments, then pound the remaining to the tune of ~$10K a month until it is gone. The end date that I want to be 100% paid off is 12/31/2016.

  11. Hi,

    could you please explain why “A lawsuit would bring a larger ‘prize’ to a potential litigant” after pay off mortgage?

    I think no matter has mortgage or not, if you have enough money, the litigant ( if loss) may get what it wants. Thanks

    Xin

    1. Thank you for reading!

      If someone sues you, and gets your equity in a building, it would be a larger ‘prize’ if there was no mortgage. You are correct, if they hit the personal assets, assuming the equity would be in a bank account instead, the ‘prize’ would be the same.

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