People are divided on the topic of early mortgage pay off — some say it’s a good idea, others disagree. This topic is highly debatable because there are so many factors to consider, and even a slight change in one of these factors could swing the answer in one way or another. In any case, a reader left an interesting comment with a different twist on this topic — should you pay off the mortgage early on a rental property?
…I have a similar question on mortgage prepayment that involves a rental property. I am 35 years old and six years away from my military retirement. I am looking for my rental property to generate some additional income when I retire (it is breaking even right now between rental income and mortgage payment), so I am considering paying it off in the next six years. To do this, I will have to stop my IRA and other retirement contributions.
Is it worth it?
Once it is paid off, I could start with the retirement contributions again, but I am not thrilled with the idea I can’t touch my retirement investments until I am 59 1/2. A paid off the rental property is in effect a retirement saving that I would immediately reap the benefits of once it was paid off. I know my ROI drops with every dollar I pay into the property, but I think I am more concerned with cash flow than ROI. The cash flow from the property couple with my retirement would make a decent living in the area I want to retire in.
Here’s a response from another reader, Gene:
I’m in a very similar situation as you. I have a rental property that is breaking even as well… breaking even between rental income and everything I owe on the house monthly. I’m considering paying off the property so I can pocket the income (minus taxes and homeowner fees).
Taking everything discussed here into account — if one can pay off the mortgage on a property that in turn generates income immediately, the decision is heavily weighted towards paying it off.
For instance, I owe $100,000 left on the rent house — and I have about $110,000 in mutual funds that are liquid — if I pay off the rental house, it not only immediately saves me 5.8% in interest but generates a net profit of $1,000 a month — which is which is a 1% a month gain on the “investment” of paying off the mortgage (the rent is actually $1,400 but $400 is spoken for via taxes, homeowner fee, insurance).
Does anybody have any input for us when it comes to paying off a home that currently has renters? I can’t see any additional drawbacks, but I do see an extra 10% on an “investment” in my mortgage being paid off…(PS: I’m military also and have very secure employment – 10 years away from full retirement if I stay in…). I also have $50,000 in a Roth IRA and max the contributions every year, so that $110,000 in mutual funds isn’t my only retirement fundage.
Early Pay Off vs Retirement Savings
I think the problem is intriguing. Without going into all the math , here is the high-level overview of the two scenarios:
- Own a positive cash flow rental property, no mortgage, and has less in retirement savings, or
- Own a zero cash flow rental property with a mortgage, and has more in retirement savings.
From this perspective, I would choose #1 over #2 — even if it means I have less “wealth” in the end. Why? I think there is a lot of value in the peace of mind that comes with scenario #1. However, you need to decide how much you’re willing to give up in retirement savings for that peace of mind.
Advantages of Early Pay Off
Here are some benefits that I can think of right away
- Better cash flow.
- No more interest payment (so the higher the interest rate on the mortgage, the better it is to pay off early).
- 5% saving on mortgage interest is better than a 5% gain on your investment because you don’t have to pay taxes on the money you saved.
- It reduces your debt-to-income ratio and allows you to purchase more rental properties.
Disadvantages of Early Pay Off
On the flip side, here are some disadvantages
- You lose out on mortgage interest deduction, so more of your rental income is taxable at your regular tax rate.
- You are less diversified (a big chunk of your money is in real estate instead of diversified investment).
- Your investment might grow faster.
- You are less liquid. It is much easier, faster, and cheaper to sell stocks and funds than it is to sell a house.
- You lose out on inflation. $1,000 you pay on your mortgage today is going to be a progressively smaller payment each time after you factor in the effect of inflation on the mortgage payment.
Doing the Math
Let’s use Gene’s scenario as an example.
Should she use $100,000 from her mutual funds to pay off a $100,000 balance on a 5.8% mortgage for that $1,000 extra a month cash flow?
In this case, we are going to assume a 9% annualized return for her mutual fund investments.
If she keeps investing, her $100,000 in mutual funds would grow to $109,000 by the end of the year. She will eventually have to pay 15% long-term capital gains tax plus about 5% state income tax on the $9,000, so her net gain is $7,200.
If she uses the money to pay off the rental, her cash flow would increase by $12,000 a year. However, she would have to pay about 28% on federal plus state income tax, reducing her profit to $8,640. But she also loses out on about $1,624 in tax deduction (i.e., her interest payment of about $5,800 at 28% tax rate). Overall, her net gain is about $7,000.
The difference is $200 in favor of mutual funds investing, but paying off the rental is risk-free therefor it is clearly a better choice.
If you’re in this situation, what would you do?
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.