Author Topic: Pay off Rental Property Mortgage to maximize cashflow?  (Read 17444 times)

mickmey

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Pay off Rental Property Mortgage to maximize cashflow?
« on: January 14, 2013, 02:16:07 PM »
Since I'm new here, some of this is background from my intro post...

My husband and I are both in our mid 30s.  We have two very small children (2 and 3 months).  He's active duty in the army with 7 1/2 years to go before he hits 20 and can receive a pension.  I did 12 years active duty and then transitioned to the reserves so I could be a SAHM.  I still make a good chunk at my "part-time" reserve gig, but we're essentially a 1-income family. 

We have no consumer debt, no vehicle loans, no school loans.  We do have mortgages.  One that we live in and two rental properties that were previous residences (love the military life!). 

We're kind of leary of the stock market.  Partly because we're very conservative investors and partly because we aren't really saving for the long term.  We'll both draw pensions, so we need money in our mid-40s when hubby retires from the army...not at 60 when we'll both be doing well with our pensions. 

The "goal" is for hubby to do about 24-26 years (He'd be 47-49) and then retire simply from his pension.  It would be about 1/2 to 2/3 of what he makes now.  When I turn 60, I'd draw my reserve pension, so at that point, we'd make over what we make now (and have no kids in the house), so we'd be more than fine.  For that reason (and my general distrust of the stock market), I don't see the need to have a lot in IRAs.  We do have our Roth, but that's it.  The military doesn't have fund-matching for the Thrift Savings Program (TSP). 

What we DO need is liquidity of investments at around age 45-50.  That's when he'll retire from the military.  He works so hard and sacrifices so much, I want him to be able to do WHATEVER he wants.  If he wants to greet at Wal-Mart...so be it.  That being said, having kids in middle school is typically not the time to cut your income in half!

We have no consumer debt, no vehicle loans, no school loans.  We do have mortgages.  I bought a house in 1999 when stationed at Ft. Campbell, KY and it has been consistently rented (with a property manager) since 2003. 

That brings me to my actual question.  The other day we were discussing what would happen if he had to retire earlier from the military than he planned.  Obviously, having small children at home (elementary to middle school age) is not the ideal time to cut your salary in less-than-half.  Especially since we'd like to fund some type of private school (thankfully Central Texas has affordable options, as well as homeschool-private school blends). 

So, I realized the best solution (other than him having to find a very good paying job to replace his military income), is to generate income from our two rental properties, as well as pay off our current mortgage.

The question is...what order and how? Ideally, they'd all be paid off in 10 years.  Definitely in 15.

Property 1: bought in 1999 for $72K.  $49K owed. 1250 sq ft house in Oak Grove, KY (Ft. Campbell).  Good rental history.  Rents for $800; I get $730 after management (I'm in TX. It's in KY...hence the need for a manager).  I've refinanced twice (original was 8%. Then 6.5%. Now 4.78% as of last November).  My mortgage including escrow is $378, but I pay $555, so that I'm paying it as a 15 year as of last Nov.  If I do nothing different, this one will be paid off in 14 years.  But, it's also the easiest to pay off quickly, as I owe $49K. 

Property 2: I regret this one.  We were stationed in Leavenworth KS.  Thought we'd be there 3 years.  We were there 10 months!!!  Love the military.  Bought for 202K. 10% down.  Still paying PMI (but looking to get that reviewed...that would save $95/month).  Owe $174K. Mortgage with escrow is $1477.  House only brings in $1350.  The market is somewhat glutted with rentals and people are desperate to rent. Would love to sell, but now isn't the time. In the mean time, this one does have the highest mortgage APR (5%).  And if I get the principle down another $13K, the PMI automatically drops off. 

Property 3: Our current home.  Most expensive.  Did VA loan.  Bought for $225.  Owe $223K.  4% (best rate of the three).  We don't know if we will stay here or if this will become a rental (depends on the Army), but we fancy ourselves coming back here if we leave.  It's a good home for us.

Plan A: Take 25K out of savings. Put toward property #1. Pay an extra $500/month.  Pay off in 3 years.  Then, take $730 rental income from #1, plus $500 extra, plus $95 from PMI on #2 (which will be gone by then) and put extra $1330 toward house #2 and so on.  Problems...house #2 actually has the highest interest rate, so paying that one down seems to make better sense.  Pitfalls: Taxes on income from house #1 offsetting gains?

Plan B: Put extra toward highest APR mortgage (#2) and continue to put extra as it shows up.  Once that is paid off, dump into next and so on. Pitfalls: most likely to sell this house if opportunity arises.  Capital gains?

Plan C: Put extra money equally to all three? Or just two?

I have about $50K in cash savings.  I also save about $1K/month toward nothing in particular.  I want to pay cash for vehicles from now on, but we drive a 2010 and 2011, both paid for.

Is there anything I'm overlooking?  I know the most aggressive would be to leverage, but I'm honestly looking for cash flow to allow my husband to do what he wants after sacrificing so much in the army!

Thanks!
Heidi

Ben

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Re: Pay off Rental Property Mortgage to maximize cashflow?
« Reply #1 on: January 14, 2013, 03:21:57 PM »
The Leavenworth property may have the most bang for your buck if you need to put a little extra cash to get out from underneath PMI.

Your plan is a reasonable one, as you are seeking an income stream for a specific period, rather than continuing to accumulate at that point. If you believe you would have enough to live off with the income from your pensions + existing real estate, and if you can pay the places off before he retires, then go for it!

However, it puts you at the mercy of a segment of investments (namely, real estate) when you would probably benefit from investing in multiple income streams (e.g. the stock market). As you mentioned, you have a substantial safety net with good pensions, putting you at an advantage and reducing the risk associated with your plan.

If you haven't found it already, Nord's book and blog at http://the-military-guide.com/ may be helpful for your specific situation.

JJ

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Re: Pay off Rental Property Mortgage to maximize cashflow?
« Reply #2 on: January 14, 2013, 09:27:56 PM »
I'd do the numbers for each scenario.  I don't understand how capital gains tax would come into the equation as paying down mortgages is effectively changing your operating costs (income/expense = income taxable) rather than messing with the cost base and sale price (=capital gain or loss), so on the surface it looks like you should, as a minimum, dump $13K into #2 to improve your cash-flow position by $95 per month.  The return on that is effectively $95 * 12 / $13K = 8.8% risk free - not bad at all.

If you don't want to invest the remaining $12K you should generally direct it towards your highest effective mortgage rate.  I'm not from the US, so you will need to check this, but my understanding is that the mortgage on your place of residence is deductible whereas it gets more grey on a rental property where you are not running a property rental business (i.e. passive investor).  You therefore need to take the tax effects into account to figure out your next highest effective interest rate - it may be property #2 or your residence.  However, it probably doesn't matter either way with such low interest rates - we're probably arguing over an effective rate of 3.5% v. 5%, or $180pa difference over $12K - it may be worth a 10 minute call to an accountant to figure out the best way to go.

The only other consideration is if there are fixed annual fees on your mortgage over and above the interest.  In which case, once you have got below the PMI level on #2, it may pay to clear #1 even if it is a slightly lower interest rate than #2.  Again, do up a spreadsheet and run the scenarios. 

Nords

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Re: Pay off Rental Property Mortgage to maximize cashflow?
« Reply #3 on: January 14, 2013, 11:28:14 PM »
Welcome, Heidi, and a few suggestions:

First, if you and your spouse have all the degrees you want, then you could transfer your GI Bill(s?) to your kids.  That'll get them started on their college degrees, and possibly finished.  Second, wherever you decide to retire, check the state's veteran's benefits for your kid's college tuition (and possibly room/board).  My daughter's in Houston, and she seems pretty impressed with Texas veteran's benefits for college expenses.  You'd be able to get your kids through a state college.  Harvard would be their problem.

Second, if you have a choice between private & homeschool, I'd homeschool.  If you have a choice between public & private, I'd go public.  There is no credible research to prove that private schools do a better job than public ones-- let alone homeschooling.  But you know your neighborhood better than I do.

Third, make sure you're insured for at least "named perils" on those rental properties-- if not comprehensive coverage.  You probably also want flooding insurance-- your nightmare is the upstairs toilet that overflows and doesn't stop running, or the washing machine drain line that blows out while it's trying to fill the tub, so that it spews water all over the ground floor.  (Don't ask me how I know those scenarios.)   At a minimum you'll want "replacement cost", and probably "adjusted rebuilding cost" to cover the higher expenses of building materials and being required to upgrade to new codes.  Armed Forces Insurance is pretty strong in the areas of your rentals, and they have cheaper premiums than USAA.  Of course AFI is probably more heavily exposed to Tornado Alley than USAA, and has less capital.  For what it's worth we've been with AFI for nearly 30 years and USAA is tops in customer service.

Finally, are you sure you want to get rid of the mortgages so quickly?  Do you want liquidity or do you want cash flow?  You're paying those fixed-rate loans with dollars that are being eroded by inflation-- which is a good thing.  Every dollar you put into paying off those mortgages early is a dollar of liquidity that you can't get back.  If you want to build up liquidity then you can do it faster by paying the minimum on the mortgages and starting to build up your cash reserves. 

One option would be to max out your Roth IRAs (contributions can be withdrawn at any time).  Another option would be to start stashing the cash in CDs with 3-5 year terms.  A third option would be to start buying as much as you can in I bonds under both of your Social Security numbers, your kid's SSNs, and even by overpaying your taxes-- the refund could be used to purchase I bonds.

A compromise would be to pay down the Leavenworth mortgage to get rid of the PMI.  But the real issue is feeling comfortable enough to sleep at night.  You can also hedge your bets by putting half of your excess funds toward the mortgages (to help you sleep at night) and the other half toward building up your cash reserves (for liquidity or vacancies or repairs).  I think you can be confident that Leavenworth will do well despite the drawdown, and the rental market will recover.

You can talk to Army officers like Mike at LiveTheNewEconomy.com or Jason at  HullFinancialPlanning.com to confirm what I'm going to say next, but... you and your spouse have skills.  When he retires (or when you're ready to go back to work) you will be hired.  You know how to plan, you know how to communicate, you know how to get stuff done.  The bar is not so high.  My cousin and his spouse are both Army, and they're beating off the job offers every month.  This is in addition to the blogging income of all four of them.  I see this concern all the time, and the reality is much better than the scary stories you read in the media.  Please don't let the "military inferiority complex" drag you down.

If you're not already doing so, track your expenses and forecast a spending plan.  See if you can project that to a 15-year retirement, a 20-year retirement, and a 24-year retirement.  Then try to figure out how you want to handle the mortgages, or part-time employment.  Try to estimate how much liquidity you'd need to have until you reach age 59.5.

Speaking of insurance:  Depending on the sizes of your pensions, you may not both need SBP.  When you decide to retire from the Reserves, you should take out maximum RCSBP on yourself (or rather, your spouse should elect that since it's his choice) to cover you through age 60.  (It's literally cheap insurance.)  When he retires, you should consider whether you want full SBP (your choice) or whether your Reserve pension is big enough to consider skipping SBP in favor of term insurance until Social Security.  When you reach age 60 and start drawing your pension, he has two years to consider canceling the RCSBP.   My active-duty pension is paying the bills now, and my spouse's Reserve pension will be more than enough.  We don't carry SBP on each other because we'd rather have the 6.5% now.

"The Military Guide" is probably in a public library near you.  You can also search the blog for keywords or see all the post titles here:  http://the-military-guide.com/post-titles-by-month/

Please ask more questions here, or on the blog, or send me an e-mail.