Should we pay off the 9.5% interest loan? Might not be a great idea but not sure

[Mrs. Healthywealth]

Hi!
It seemed cut and try at first, but after running some numbers I'm not as certain.

Loan Details: $43,000 (seller financing) @ 9.5% for 20years. Payment is $401/mos.

The loan is towards real estate which is being leased out with the intention of the lessee purchasing it from us (lease to own). Their note is at 12.41% for 20 years. 

Details on the investment returns:
Internal Rate of Return w/ this loan: 14.62%
IRR cash purchase: 13.68%
Current COC (after all expenses) 15.8%
COC if loan paid off: 14.7%

Federal tax bracket is 22%
State tax: 8%

For taxes I hold the real estate professional title, which allows me to take more deductions. Also, we can depreciate this property.

When I run the #'s through the mortgage deductions real tax rate calculator based on our fed and state tax bracket, I get a real tax rate of 6.82%, but my guess is that it doesn't include the depreciation, which means it might be a bit lower, not sure how much though.

What can I do with the money instead:
1) invest it in VTSAX brokerage account
2) return $50k borrowed from DW's 401k. This has 9% interest rate BUT it's interest that we are paying ourselves and goes back into DW's 401k; there are no fees or interest that goes to the institution, hence this doesn't feel like a priority since we are paying ourselves the 9% interest. Hope that makes sense.
3) Invest in a stable fund producing 8% ROR through a bank which would be a better return than the real tax rate on the real estate loan.

Your thoughts and suggestions are much appreciated! It might be helpful to know that we are FI. Our current income goes towards our expenses and we invest the rest.
Thank you

[JAYSLOL]

I’m not morally opposed to debt or anything, but if I had $43k burning a hole in my pocket, I don’t think I’d keep debt hanging around over 4-5%, unless I had a more concrete plan with the money.  Just to be clear, you’ve got a $43k real estate loan, and a $50k 401k loan?  And both are over 9%?  Yikes, pay it all off if you’ve got the cash.  I wouldn’t try to make a spread between index funds and those debts, not much meat on those bones to justify the extra risk. 

[Mrs. Healthywealth]

I’m not morally opposed to debt or anything, but if I had $43k burning a hole in my pocket, I don’t think I’d keep debt hanging around over 4-5%, unless I had a more concrete plan with the money.  Just to be clear, you’ve got a $43k real estate loan, and a $50k 401k loan?  And both are over 9%?  Yikes, pay it all off if you’ve got the cash.  I wouldn’t try to make a spread between index funds and those debts, not much meat on those bones to justify the extra risk.

Thanks for the feedback. The real estate loan is the 9.5% that we are paying to the seller. However, we also have a lessee that is paying 12.41% in interest to us since it's a lease to own. The $50k from the 401k is at 9%, but all of that interest is being paid back to DW's account, there is ZERO fee or interest that goes elsewhere, which is why it's not a top priority to pay back since we are essentially paying ourselves either way.

Another option I forgot to add is taking the $43k and investing it into a stable 8% fund through a bank, this is lower on the risk side and might be a better use of the $43k since if we were to pay off the loan there is less to write off in taxes.

[JAYSLOL]

I’m not morally opposed to debt or anything, but if I had $43k burning a hole in my pocket, I don’t think I’d keep debt hanging around over 4-5%, unless I had a more concrete plan with the money.  Just to be clear, you’ve got a $43k real estate loan, and a $50k 401k loan?  And both are over 9%?  Yikes, pay it all off if you’ve got the cash.  I wouldn’t try to make a spread between index funds and those debts, not much meat on those bones to justify the extra risk.

Thanks for the feedback. The real estate loan is the 9.5% that we are paying to the seller. However, we also have a lessee that is paying 12.41% in interest to us since it's a lease to own. The $50k from the 401k is at 9%, but all of that interest is being paid back to DW's account, there is ZERO fee or interest that goes elsewhere, which is why it's not a top priority to pay back since we are essentially paying ourselves either way.

Another option I forgot to add is taking the $43k and investing it into a stable 8% fund through a bank, this is lower on the risk side and might be a better use of the $43k since if we were to pay off the loan there is less to write off in taxes.

But don’t you get that 12% regardless of if you are paying 9% or not?

[Villanelle]

I’m not morally opposed to debt or anything, but if I had $43k burning a hole in my pocket, I don’t think I’d keep debt hanging around over 4-5%, unless I had a more concrete plan with the money.  Just to be clear, you’ve got a $43k real estate loan, and a $50k 401k loan?  And both are over 9%?  Yikes, pay it all off if you’ve got the cash.  I wouldn’t try to make a spread between index funds and those debts, not much meat on those bones to justify the extra risk.

Thanks for the feedback. The real estate loan is the 9.5% that we are paying to the seller. However, we also have a lessee that is paying 12.41% in interest to us since it's a lease to own. The $50k from the 401k is at 9%, but all of that interest is being paid back to DW's account, there is ZERO fee or interest that goes elsewhere, which is why it's not a top priority to pay back since we are essentially paying ourselves either way.

Another option I forgot to add is taking the $43k and investing it into a stable 8% fund through a bank, this is lower on the risk side and might be a better use of the $43k since if we were to pay off the loan there is less to write off in taxes.

You've said this twice, and I don't understand.  You can either pocket 2.91% --the difference between what you are collecting and what you are paying, or you can pocket 12.41%.  One of those is clearly better than the other.  Because you will collect the interest either way, that is irrelevant to the decision to pay off the loan or not. 

I can buy arguments for *maybe* keeping a 6% loan, or maybe even slightly higher, but IMO, anything higher than that makes no sense to keep.  More than 12%?  Pay it off yesterday. 

[Mrs. Healthywealth]

I’m not morally opposed to debt or anything, but if I had $43k burning a hole in my pocket, I don’t think I’d keep debt hanging around over 4-5%, unless I had a more concrete plan with the money.  Just to be clear, you’ve got a $43k real estate loan, and a $50k 401k loan?  And both are over 9%?  Yikes, pay it all off if you’ve got the cash.  I wouldn’t try to make a spread between index funds and those debts, not much meat on those bones to justify the extra risk.

Thanks for the feedback. The real estate loan is the 9.5% that we are paying to the seller. However, we also have a lessee that is paying 12.41% in interest to us since it's a lease to own. The $50k from the 401k is at 9%, but all of that interest is being paid back to DW's account, there is ZERO fee or interest that goes elsewhere, which is why it's not a top priority to pay back since we are essentially paying ourselves either way.

Another option I forgot to add is taking the $43k and investing it into a stable 8% fund through a bank, this is lower on the risk side and might be a better use of the $43k since if we were to pay off the loan there is less to write off in taxes.

You've said this twice, and I don't understand.  You can either pocket 2.91% --the difference between what you are collecting and what you are paying, or you can pocket 12.41%.  One of those is clearly better than the other.  Because you will collect the interest either way, that is irrelevant to the decision to pay off the loan or not. 

I can buy arguments for *maybe* keeping a 6% loan, or maybe even slightly higher, but IMO, anything higher than that makes no sense to keep.  More than 12%?  Pay it off yesterday.

I'm leasing the property out and the lessee has to pay a 12.41% interest rate on the note. Our interest rate is 9.5%, but if we keep the loan, due to tax deductions the real rate of return is closer to 6.82%. I'm also wondering how the time value of money comes into play as well.

[Mrs. Healthywealth]

I’m not morally opposed to debt or anything, but if I had $43k burning a hole in my pocket, I don’t think I’d keep debt hanging around over 4-5%, unless I had a more concrete plan with the money.  Just to be clear, you’ve got a $43k real estate loan, and a $50k 401k loan?  And both are over 9%?  Yikes, pay it all off if you’ve got the cash.  I wouldn’t try to make a spread between index funds and those debts, not much meat on those bones to justify the extra risk.

Thanks for the feedback. The real estate loan is the 9.5% that we are paying to the seller. However, we also have a lessee that is paying 12.41% in interest to us since it's a lease to own. The $50k from the 401k is at 9%, but all of that interest is being paid back to DW's account, there is ZERO fee or interest that goes elsewhere, which is why it's not a top priority to pay back since we are essentially paying ourselves either way.

Another option I forgot to add is taking the $43k and investing it into a stable 8% fund through a bank, this is lower on the risk side and might be a better use of the $43k since if we were to pay off the loan there is less to write off in taxes.

But don’t you get that 12% regardless of if you are paying 9% or not?

Correct, the lessee will pay the mortgage note at 12.41% interest rate regardless of whether I pay off my seller financed loan or not. What I really get from paying off this loan is $401 extra per month, which would mean it takes nearly 9 years for me to get recoup that $43k. $43000/400 = 107.5 months/12 = 8.95 yrs

[Telecaster]

Thanks for the feedback. The real estate loan is the 9.5% that we are paying to the seller. However, we also have a lessee that is paying 12.41% in interest to us since it's a lease to own. The $50k from the 401k is at 9%, but all of that interest is being paid back to DW's account, there is ZERO fee or interest that goes elsewhere, which is why it's not a top priority to pay back since we are essentially paying ourselves either way.

There is still the opportunity cost of not having that money invested in the 401(k), which last year was about 26%.   That's not typical, but you can't ignore it. 

 It is too late now, but although you are technically just paying yourself the interest, the funds you borrowed were contributed to the 401(k) on a pre-tax basis. But you'll be paying yourself back for the loan with after-tax money.  So it is kind of a screw job and the costs of this loan are much higher than you think.

[Villanelle]

I’m not morally opposed to debt or anything, but if I had $43k burning a hole in my pocket, I don’t think I’d keep debt hanging around over 4-5%, unless I had a more concrete plan with the money.  Just to be clear, you’ve got a $43k real estate loan, and a $50k 401k loan?  And both are over 9%?  Yikes, pay it all off if you’ve got the cash.  I wouldn’t try to make a spread between index funds and those debts, not much meat on those bones to justify the extra risk.

Thanks for the feedback. The real estate loan is the 9.5% that we are paying to the seller. However, we also have a lessee that is paying 12.41% in interest to us since it's a lease to own. The $50k from the 401k is at 9%, but all of that interest is being paid back to DW's account, there is ZERO fee or interest that goes elsewhere, which is why it's not a top priority to pay back since we are essentially paying ourselves either way.

Another option I forgot to add is taking the $43k and investing it into a stable 8% fund through a bank, this is lower on the risk side and might be a better use of the $43k since if we were to pay off the loan there is less to write off in taxes.

But don’t you get that 12% regardless of if you are paying 9% or not?

Correct, the lessee will pay the mortgage note at 12.41% interest rate regardless of whether I pay off my seller financed loan or not. What I really get from paying off this loan is $401 extra per month, which would mean it takes nearly 9 years for me to get recoup that $43k. $43000/400 = 107.5 months/12 = 8.95 yrs

If you stick the money under your mattress, yes.  I assume you could do something else with the money that actually allows it to grow though.   Even if it does take some years to get the money back, you are throwing away 9.5%, rather than giving yourself the opportunity to grow that money.   It doesn't make any sense. 

[Catbert]

You seem very invested in keeping 9% loans although I'm still not sure why.

[Mrs. Healthywealth]

Thanks for the feedback. The real estate loan is the 9.5% that we are paying to the seller. However, we also have a lessee that is paying 12.41% in interest to us since it's a lease to own. The $50k from the 401k is at 9%, but all of that interest is being paid back to DW's account, there is ZERO fee or interest that goes elsewhere, which is why it's not a top priority to pay back since we are essentially paying ourselves either way.

There is still the opportunity cost of not having that money invested in the 401(k), which last year was about 26%.   That's not typical, but you can't ignore it. 

 It is too late now, but although you are technically just paying yourself the interest, the funds you borrowed were contributed to the 401(k) on a pre-tax basis. But you'll be paying yourself back for the loan with after-tax money.  So it is kind of a screw job and the costs of this loan are much higher than you think.

Ahhhh, this really helps conceptualize it and what I was trying to understand.  Luckily we took the money out only 1-2 mos ago, so the growth was still there, but this really makes me recognize the importance of paying it back. All in all, it's been out of the market for maybe 6-8 weeks. Super helpful input, thanks!

[Mrs. Healthywealth]

You seem very invested in keeping 9% loans although I'm still not sure why.

Lol, lucky #9.  We did something similar 4 years ago with the 401k loan, though the interest was closer to maybe 5 or 6%.  But we paid it back within a year. It's not so much about the interest rate but what we project our overall ROI to be. For that situation ROI was 28% YOY--super nuts and totally unexpected.

It just happens that 9% is what they were offering currently, but the ROI for this particular investment is projected to be more than that. Maybe we get lucky or maybe we don't...time will tell.

[Mrs. Healthywealth]

I’m not morally opposed to debt or anything, but if I had $43k burning a hole in my pocket, I don’t think I’d keep debt hanging around over 4-5%, unless I had a more concrete plan with the money.  Just to be clear, you’ve got a $43k real estate loan, and a $50k 401k loan?  And both are over 9%?  Yikes, pay it all off if you’ve got the cash.  I wouldn’t try to make a spread between index funds and those debts, not much meat on those bones to justify the extra risk.

Thanks for the feedback. The real estate loan is the 9.5% that we are paying to the seller. However, we also have a lessee that is paying 12.41% in interest to us since it's a lease to own. The $50k from the 401k is at 9%, but all of that interest is being paid back to DW's account, there is ZERO fee or interest that goes elsewhere, which is why it's not a top priority to pay back since we are essentially paying ourselves either way.

Another option I forgot to add is taking the $43k and investing it into a stable 8% fund through a bank, this is lower on the risk side and might be a better use of the $43k since if we were to pay off the loan there is less to write off in taxes.

But don’t you get that 12% regardless of if you are paying 9% or not?

Correct, the lessee will pay the mortgage note at 12.41% interest rate regardless of whether I pay off my seller financed loan or not. What I really get from paying off this loan is $401 extra per month, which would mean it takes nearly 9 years for me to get recoup that $43k. $43000/400 = 107.5 months/12 = 8.95 yrs

If you stick the money under your mattress, yes.  I assume you could do something else with the money that actually allows it to grow though.   Even if it does take some years to get the money back, you are throwing away 9.5%, rather than giving yourself the opportunity to grow that money.   It doesn't make any sense.

Yes!!!! Thank you, totally missed that point. Our plan has been to take the cashflow and reinvest into VTSAX brokerage account...so Yes, it's not going to take 9yrs to recoup the cost.  This is why I appreciate the feedback so much.  Thanks again!