Evaluating Paying Off Mortgage of Rental Property

[little stache]

Greetings. I am considering paying off a rental property mortgage. It has 260K left on the mortgage with a 3.8% interest rate. Located in a desirable city with a large university, it has been continuously rented to families for extended periods since it was bought in 2016. I currently generate $1,000 in positive monthly cash flow, and the principal payment is now around 600 per month. After paying off the mortgage, the property will generate around $2,400 in positive cash flow after accounting for the property taxes. My small business is having an outsized year, and I will be able to pay off the rental property. Some have advised that I not pay off the mortgage since I will likely get a higher rate of return than 3.8%. However, I think this assessment undervalues the opportunity cost of not investing the principal payment and the steady positive cash flow from an asset that has appreciated 8% a year on average. I would appreciate thoughts on the pros and cons of paying off the rental house mortgage vs. investing the equivalent funds in the stock market. I currently have no plans to get another rental property.

[Sibley]

There is an entire thread about whether or not to pay off the mortgage. A very long thread. You should read it.

This is also an asset diversification question. Do you want more or less exposure to stocks/bonds or to real estate. Those are very different investment vehicles.

Don't forget the tax impacts. Right now, you're deducting the interest payments on the rental. If you pay off off the mortgage, then you won't be - so your tax bill will go up.

You're also not accounting for the potential gains from the $260k that you could invest if you don't pay off the mortgage.

[little stache]

Thanks for the feedback and the suggestion for considering this decision in the context of the kinds of asset classes we have. It is the only source of income we have in real estate, and it has been a very predictable source of monthly income. I will look for the extensive thread on this topic you mentioned.

[neo von retorch]

This is one of the bigger threads encouraging each other to avoid paying off a low interest mortgage:

DONT Payoff your Mortgage Club

[ducky19]

A few things to consider:

First, look at the rate of return on your $260k investment. If you pay the mortgage off, you'll be cash flow positive $1400/mo, but you also need to factor in the principal paydown of $600/mo which lowers your monthly return to $800/mo or $9600 annually. This results in an annual rate of return of 3.69% on your $260k.

Second, if you're strictly focused on cash flow, look at the length of time it will take to return your investment. You would be cash flow positive $16,800 each year, but that means it will take almost 15.5 years before you get your $260k investment back.

Third, consider risk. By using the bank's money instead of your own, you are minimizing your exposure as well as freeing up capital that can be redeployed to other investments (real estate or otherwise).

[little stache]

Thanks for the thoughtful comments/suggestions. The thread on not paying off the mortgage was about a primary residence. The assessment for a rental property changes the calculus, as you note.  I came to a similar evaluation but looked at the $16.8K in additional annual income slightly differently. I agree that the $260K could be used for a higher-return investment in additional real estate, but we decided that one rental house was all we wanted in the asset mix.

If my $260K in cash is invested rather than paying off the rental mortgage at 3.8%, and we get an average return of 5.8% for 22 years of the remaining loan, we get a net increase of 2% per year more than the mortgage loan. Over the 22 years remaining on the mortgage, we get around $140K in returns above the cost of the mortgage loan. The total cost of the rental property (principal and interest) would be around $560K.

If I pay off the rental mortgage, I get an additional $1,400 monthly or $16,800 yearly, as you noted in positive cash flow. This rental's total positive cash flow is $2,400 per month/$28,800 annually. Over 22 years, assuming the extra $16.8K a year is invested and reinvested with a 5.8% average annual return, we would have around $710K. The total cost of the rental property (principal and interest) would be around $406K.

So, paying off the mortgage now allows me to invest an additional $1.4K a month/$16,800 a year, getting around $570K more compared to maintaining the current mortgage and keeping the $260K invested, and reduces the total cost of the house by $154K, seems attractive.

The initial $260K cash stockpile used to pay off the mortgage is replenished in year 12 if gains from the $16.8K annual investment are reinvested.

Because the fiscal benefits seem strongly in favor of paying off the mortgage, my assumptions must be missing something. I appreciate everyone's thoughts and suggestions.

[ducky19]

$260k earning 5.8% (compounded monthly) over 22 years would be around $924k. Add in the principal paydown of $260k from keeping your mortgage, and you're at $1.18 mil.

$1400/mo adding $1400/mo earning 5.8% (compounded monthly) over 22 years would be around $748K.

I think you're forgetting that by keeping your mortgage, you're also getting the full $260k back in principal paydown over the course of the loan.

Looking at your post above, that actually maths out pretty close - add the $260k to your $140k of 2% net gains, and you'll be $400k ahead of the $710k (remember that the $140k is net 2% over your mortgage rate - you're still earning 5.8% on your $260k, not 2%).

[aasdfadsf]

You can currently get 4.25% in a savings account and you're seriously talking about buying back your 3.8% mortgage? Why would do that? Where is the 11th-demensional math that makes it better to get 3.8 vs. 4.25? I guess I've become inured to the fact that a lot of people don't get that buying your own mortgage is just investing at that percentage rate, but believe me, that's all it is.

Okay, it's not just that: the taxes make it much better to float that 3.8% on a rental because that's deductible from your rental income. The 4.25% you get from a savings account is taxable as regular income.

[little stache]

Your wild-eye response, yelling that it never makes sense to pay off a mortgage early, did not add to the discussion. Also, if you only get 4.2% on your excess cash in the current market, you are giving away an easy 0.8%+ of your money to a bank. Let me know how to connect so I can get a referral bonus for giving you a better FDIC-insured rate of return. You're welcome. :)

There are many factors to consider when evaluating whether to pay off the mortgage of a rental property. Removing the mortgage on the rental property increases the monthly positive cash flow that can be invested/repurposed. In this instance, the positive cash flow increases by $1400 a month, and the property would generate a stable $28K in positive annual cash flow that is likely to grow at an average of 3%+ with low volatility, which may be the benefit desired. As suggested, this decision should be considered within the context of the mix of assets in your portfolio and how a mortgage-free rental fits (or does not) into that mix. You may not want to give a bank with practices you abhor $154K in additional interest. You may wish to transfer the property to a child without the burden of a mortgage and a higher positive cash flow. There are many considerations when evaluating paying off the mortgage of rental property, which is the post's title. I hope that reviewing the factors to consider when assessing the long-term fiscal impacts of the different options/choices and what risks you need to consider can be better understood from the thoughtful posts in this thread.

[Mustache ride]

Your wild-eye response, yelling that it never makes sense to pay off a mortgage early, did not add to the discussion. Also, if you only get 4.2% on your excess cash in the current market, you are giving away an easy 0.8%+ of your money to a bank. Let me know how to connect so I can get a referral bonus for giving you a better FDIC-insured rate of return. You're welcome. :)

There are many factors to consider when evaluating whether to pay off the mortgage of a rental property. Removing the mortgage on the rental property increases the monthly positive cash flow that can be invested/repurposed. In this instance, the positive cash flow increases by $1400 a month, and the property would generate a stable $28K in positive annual cash flow that is likely to grow at an average of 3%+ with low volatility, which may be the benefit desired. As suggested, this decision should be considered within the context of the mix of assets in your portfolio and how a mortgage-free rental fits (or does not) into that mix. You may not want to give a bank with practices you abhor $154K in additional interest. You may wish to transfer the property to a child without the burden of a mortgage and a higher positive cash flow. There are many considerations when evaluating paying off the mortgage of rental property, which is the post's title. I hope that reviewing the factors to consider when assessing the long-term fiscal impacts of the different options/choices and what risks you need to consider can be better understood from the thoughtful posts in this thread.

The great thing about math is it is what it is. You can make snide remarks, but everything in that post is factually correct. Now whether you want to bring in emotional circumstances that influence your decision is your prerogative, but that doesn’t change the mathematically correct answer.

We could certainly go back to a low interest rate environment where CDs or HYSA are yielding basically nothing, but until that point I’m stacking my money there until at the very least I have enough to make a lump sum pay off.

The only major consideration I personally acknowledge as a reasonable counterpoint is staying under income limits for ACA subsidies.

[ducky19]

The great thing about math is it is what it is. You can make snide remarks, but everything in that post is factually correct. Now whether you want to bring in emotional circumstances that influence your decision is your prerogative, but that doesn’t change the mathematically correct answer.

I love this about math.

The only major consideration I personally acknowledge as a reasonable counterpoint is staying under income limits for ACA subsidies.

Wouldn't paying off the mortgage swing the wrong direction for staying under income limits?

[bacchi]

The only major consideration I personally acknowledge as a reasonable counterpoint is staying under income limits for ACA subsidies.

Wouldn't paying off the mortgage swing the wrong direction for staying under income limits?

For a rental property, maybe. Increased Schedule E income vs no HYSA income... Paying off the rental mortgage lowers income so it IS better if you're near an ACA cliff.

If one is that close to an ACA cliff, though, it's seems safer to do some safe harbor upgrades.

[little stache]

You missed that the thread is evaluating a lump sum payoff of a rental property. You say you would consider this option once you saved up enough money. Hopefully, you get there soon.

From your post: "We could certainly go back to a low interest rate environment where CDs or HYSA are yielding basically nothing, but until that point, I’m stacking my money there until, at the very least, I have enough to make a lump sum pay off." 

So, when you have saved enough money to lump sum pay off your rental mortgage, we will be in the same boat. When you arrive, I am confident various factors will be part of your decision-making, including evaluating the mix of assets in your portfolio and deciding how to balance its volatility risk with your financial goals. That is thoughtful financial planning, and the factors you consider will be more complex than saying, "3.8% is less than 4.2%."

When you get to the point that you have saved enough to pay off your rental mortgage in a lump sum payment, I encourage you not to be distracted by those who would tell you, "Why would you ever do that?" or accuse you of employing "11th-dimensional math." -- of course, they will say this to you without a hint of being snide.

I hope the discussion of some of the factors to consider when assessing a lump sum payoff of a rental mortgage, the short-, mid-, and long-term fiscal impacts of the different options/choices, how that decision fits into the budgetary goals of the family, and other common factors to consider can be better understood from the thoughtful posts in this thread.
 

[Mustache ride]

I'm not going to touch that bait... I wish you good luck in your decision and challenge you to keep an open mind when requesting feedback. There is a lot of knowledge people are willing to share if you are willing to listen.

[little stache]

Thanks. I have an open mind and have been listening and learning. As I mentioned: "Because the fiscal benefits seem strongly in favor of paying off the mortgage, my assumptions must be missing something. I appreciate everyone's thoughts and suggestions."

That is the statement of someone willing to listen and learn. We got a clarification on calculating the opportunity cost of paying off the rental early. Then the next post said the OP was practicing 11th-dimensional math, and there was never a rational reason to pay off a mortgage early (despite saying they would consider that themselves if they had the money). When the OP called out the intent to shame/bully and noted that others also said this decision should be considered within the context of fiscal goals, the response by several was to reinforce the effort to shame/bully and reject that there were any other factors to consider with evaluating paying off a rental mortgage beyond the marginal difference between 3.8% and 4.2%. Most people consider these more fiscally complex questions, as noted in the first response to the question. From the thread: "This is also an asset diversification question. Do you want more or less exposure to stocks/bonds or to real estate. Those are very different investment vehicles."

Obviously, there is no reason to continue this post since it devolved from a discussion about evaluating paying off a rental property's mortgage to one focused on shaming/bullying the OP.

[waltworks]

Jeez.

OP, lighten up. If you want to pay off your mortgage, feel free. You came looking for advice and got it - which is that, asset allocation goals aside, the math is stacked in favor of holding the mortgage.

You lower your income/taxes since the interest is deductible, you earn more on the lump sum via boring/low risk (ie MM funds or something at ~2% more than your mortgage rate) or higher return/higher risk (ie VTSAX or something, which you can reasonably expect to beat your mortgage by 5+%, if historical trends hold for the next 20-30 years), and if your rental somehow becomes undesirable/town dries up and blows away, you can walk away/hand keys to the bank with less financial harm.

A ~3% mortgage is quite literally free money. In fact you could make a reasonable argument that over the last few years that's a negative effective rate. You need a damn good reason to pay it off.

-W

[clarkfan1979]

Jeez.

OP, lighten up. If you want to pay off your mortgage, feel free. You came looking for advice and got it - which is that, asset allocation goals aside, the math is stacked in favor of holding the mortgage.

You lower your income/taxes since the interest is deductible, you earn more on the lump sum via boring/low risk (ie MM funds or something at ~2% more than your mortgage rate) or higher return/higher risk (ie VTSAX or something, which you can reasonably expect to beat your mortgage by 5+%, if historical trends hold for the next 20-30 years), and if your rental somehow becomes undesirable/town dries up and blows away, you can walk away/hand keys to the bank with less financial harm.

A ~3% mortgage is quite literally free money. In fact you could make a reasonable argument that over the last few years that's a negative effective rate. You need a damn good reason to pay it off.

-W

Consistent with Walt, the math favors keeping the mortgage. Some could argue that you lower your risk by paying off the mortgage. However, if you can be disciplined enough to have the "extra money" in a brokerage account, I personally think the risk is the same or maybe even lower if you accumulate more money in the brokerage account than the balance of the mortgage.

For example, I would rather have a 260K mortgage with 300K in a brokerage account than a paid off mortgage with zero in a brokerage account.

With that said, I have personally started to make extra payments toward my Hawaii rental two months ago. It's a 4.5% mortgage originated in June 2018, originally scheduled to be paid off in May 2048, when I'm 69 years old. My wife and I talked about it and we decided to create a plan to have it paid off when I'm 60 years old. By paying it off early, I'm essentially hiding money from myself. This mid-term rental is also a vacation rental for ourselves and we stay here 2-3 months/year. It will also serve as a part-time retirement home (6 months/year). 

We created a unique order of operations based on our personal goals. I contribute 17K/year to my 401a at work. We then contribute 13K/year to the Roth. After that, the next goal is paying off the Hawaii mortgage. We are starting off slow with $200/month of extra payments and will increase it as time goes on.   

[Dicey]

OP, the DPOYM Club was started by Boarder42, at my suggestion.

I obviously have an opinion on this topic. I also own rental properties, so my opinion might be based on actual experience, the same as others who have offered you advice that you asked for.

I also have opinions on relative newbies who start threads and then are shockingly impolite when people with way more experience take time out of their days to help and are treated rudely.

Do whatever you want and godspToyota.* you.

That's auto carrot for "godspeed to". I'm leaving it because it tickled me, which I found refreshing, given the tone this thread has taken.

[Forticsec]

I’d think about keeping the mortgage and putting that $260K into something that could earn more than the 3.8% interest on the loan.
Since your property’s in a university town, you’ve probably got no shortage of demand from renters, which is a huge plus. That steady income might make paying off the mortgage feel like the safer, more reliable move, especially if you’re more about consistent cash flow than taking risks for potentially higher returns. If you ever think about renting to students, I’ve seen sites like https://axonproperties.ca/student-rentals-kingston/ that focus on that crowd—it might be worth checking out to see how they approach it.

[clarkfan1979]

I’d think about keeping the mortgage and putting that $260K into something that could earn more than the 3.8% interest on the loan.

Hindsight is 20/20. However, it's crazy to think that the S & P 500 is up 14% + dividends from when this thread was originally posted 6.5 months ago.

If you feel like paying off a 3.8% mortgage is a psychological win, then go for it. However, it's incredibly difficult to make the argument that paying off a 3.8% mortgage is the optimal strategy based on math.

[VanillaGorilla]

The monthly payment on a $260,000 loan at 3.8% over 30 years is around $1211 per month, or $14,500 annually.

To cover this much from a stock/bond portfolio requires roughly $260k, with a failure rate of about 4% historically, and a mean ending portfolio value of $545k.

So if you had $260k and you decided to invest it in a 100% equity portfolio instead of paying the mortgage off, on average you'd be half a million bucks richer after 30 years. Best case scenario you'd be up $2.5M.

Worst case you'd run outta money and be in the hole by a few grand.

If you're trying to build wealth in the long run you shouldn't pay off that cheap a loan. If you're trying to maximize short term cashflow then you might consider it. But that still wouldn't be very compelling given today's bond yields.