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Should You Pay Off Your Rental Property Mortgage Early?

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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?

Question

…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.

Answer

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:

  1. Own a positive cash flow rental property, no mortgage, and has less in retirement savings, or
  2. 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

  1. Better cash flow.
  2. No more interest payment (so the higher the interest rate on the mortgage, the better it is to pay off early).
  3. 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.
  4. 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

  1. You lose out on mortgage interest deduction, so more of your rental income is taxable at your regular tax rate.
  2. You are less diversified (a big chunk of your money is in real estate instead of diversified investment).
  3. Your investment might grow faster.
  4. You are less liquid. It is much easier, faster, and cheaper to sell stocks and funds than it is to sell a house.
  5. 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?

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Keith
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Keith

Great thread. Glad to see a post dealing with mortgage payoff on income property for a change. I had the same situation as the original poster. I own two houses besides my primary and have just paid off the mortgage on one (the other is already free and clear). I played with the idea of paying down my primary (300k+), but decided on the rental because in the current climate, a job is never guaranteed. I am not tax-averse per se and never let that alone sway the decision. One thing I realized was that NOT increasing income purely because… Read more »

mat
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mat

i will give a dumb country boy prospective.first i would like to say my home is paid off. i bought it from in-laws. We had 2 thirds of the money from sell of our home that was paid off…thanks to in-laws’ intrest free loan on that house. the other third once again i had an offer from in-laws to do an owner finance, we declined and paid off the house with the sell of investments. today by my calculations the investments would be worth far less and i would have ulcers from stress and oh yea i would still be… Read more »

kevin
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kevin

I own five rentals averging in price $40,000 to $150,000. I try to put as much down as I can when I buy them and the take out nothing more than a fifteen year mortgage or home equity loan on them. I realize very minimal cash flow during this time, but I am paying these properties down rather quickly and should be in a good place in about ten years assuming these homes gain in value as they have historically done. I know this may not make sense to some people out there, but I am 42 and feel that… Read more »

Mr. ToughMoneyLove
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For rental property, it’s all about ROI and ROE. If the property is worth $200k and throwing off $10,000 per year in net income (doubtful but possible), your yearly ROE is 5% on a paid off property. That’s not very good considering it may be taxable income, further considering that you have to work at managing the property, and also considering that it’s a highly illiquid investment. There are ways to do better with other asset classes so run the ROE and ROI numbers and do what makes sense, comparing it to alternatives.

Zahid Lilani
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Zahid Lilani

People who are tax savvy invest in real estate for the purposes of taking the depreciation expense on the property. I do several hundred returns a year and I can tell you that right of the bat, I think it would be a big mistake to pay off the rental mortgage early. Mortgage interest on rental property amounts for a big expense and the loses you incur help reduce the tax liability. If you can’t break even and are losing money, get rid of the property. Paying off mortgage and hoping the property will generate positive cash flow is a… Read more »

William
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William

What if you put the *extra* in a REIT? This could be divided both within your taxable and tax-free accounts. Try using VGSIX (Vanguard REIT Index) as an example. By law, REITs pay out 90% of their reported earnings as dividends in exchange for status as tax-free corporations. There is Risk in REITs and Risks in Real Estate. I think that relying on a single property in a single neighborhood is risky. You can use REITs to diversify your Real Estate holdings. You want to find the right Risk/Reward profile for your personality in looking at the Yields of these… Read more »

Kate
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I clicked over to this post with great interest. We, too, own a rental property that we could conceivably pay off within a few years (5 if we put the entire net rent back into the mortgage, faster if we threw in a bit of our personal money.) The taxes are the primary reason that we have refrained from paying this house off early. We are borderline AMT every year, and any additional profit from this property is bad. As our income continues to increase, and we definitely get into the AMT zone, we really don’t want to have lots… Read more »

William
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William

Start a business. Form an LLC (KateRents LLC) This business structure will allow you to approach your rental property in a different light.

It is sometimes hard to start thinking in terms of Expenses/Income/Depreciation but it is well worth it.

Make the effort you put into your rental property pay.

Employees are taxed on wages.
Businesses are taxed on profits (After Expenses!)

Your business losses reduce your income.

-WR

MITBeta
Guest

I’m thinking the opposite on my rental property, mainly because I’m not in a position to pay it off. I’m thinking that I might not EVER pay it off, but simply continue to refinance into new 30 year loans to continually lower the monthly liability and increase cash flow. Whaddya think?

Andrea Coutu
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Andrea Coutu

This is something I’ve been thinking about. I’ve got 15 years left on a smaller (well, in my city, it’s small) mortgage. I wonder whether it makes sense to work on paying that off or if I should increase it to 20 or 25 years and instead take on a cash flow positive rental property. I can write off my business use of home, so that helps with my self employment taxes. And then I would have cash flow from the investment property. I live in Canada and we CANNOT write off interest on our own homes, except for the… Read more »

James
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James

it is hard to argue with positive cash flow knowing that this acts as a income stream for you and your family.

Belmont Thornton
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A philosophical way of thought for mortgage interest. This post is informative and useful. I must say finance in poetry is a great way to simplify it.

Sal
Guest

it likes some very interesting thoughts. Lets look at this way, pay off your mortgage lowers your monthly expensies but increases taxible passive income. But if the rental increases invalue and you have no debt aginst it then you could possibly buy another one with half of the equity of your rental and have 2 cash flows and two mortgages. but if licened in the Business quadrent then you have two passive income which pay for all expensive and usually increases your passive cash flow by 20-30%. , passive is taxed the least if your savey and know the tax… Read more »

Blair Wendell
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Blair Wendell

Simply put, there is not enough information here to give an accurate answer.

There are 2 scenarios ONLY where you should pay down your mortgage:

1) If the CAP rate of the property is lower than the mortgage interest rate, pay off the mortgage or sell the house.

2) Are my alternative investments earning more than the interest rate of my mortgage? If they are earning LESS than your mortgage, then pay it off.

Those are the only 2 scenarios in which you should pay down your mortgage. Otherwise you are making a bad financial decision, period.

Keith
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Keith

One thing about income property that lots of people miss is that some folks look at income property as their investment vehicle of choice (as opposed to putting money in an IRA or mutual fund). That said, the incremental yield on the lump sum used to pay off my rental mortgage was a little over 12%. It’s hard to beat that in a mutual fund or IRA, especially when the yield generates current income. It’s real and comes in the form of a check every month, vs an IRA yield (theoretical/paper gains and even if achieved, only realizable in the… Read more »

Greg
Guest

I am looking at it a little differently. We have positive cash flow properties and use that for buying more. more.more. Someday they will be paid off and instead of just looking at 1000 per month. It will be like 50k per month. I would use the property to leverage to buy more and create a bigger retirement nest egg from rentals.

sandra
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sandra

Thanks for putting it so simply. I would also go for case 1 for the same reason you have. When I retire I want to be debt-free. I think I can sleep better with the knowledge that the place is already mine. Even if I have less retirement funds I still have a source of income. And I think the proceeds will be enough to get me through my retirement years. And besides I also would want to look for form of work even after I retire so that life won’t be boring. It’s never too late to earn money… Read more »

w
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w

Comments are similar to what I read elsewhere….all over the board so it comes down to personal opinion and comfort. If it’s breaking even I see that as a problem as you should be positive after a couple years and the paper loss for depreciation should offset your income. I don’t know if I’d pay it off at this point but would increase my payment to have it paid off earlier. IF something should happen you do have the ability to pay it off. On the other hand, if you pay it off and don’t need the income right away,… Read more »

JR
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JR

First off, thanks to everyone who took the time to post their comments and thoughts here. Very constructive and informative. My situation is that we have a very financially manageable mortgage on our prinicpal residence, along with two rental properties that we paid cash for. Income from our jobs easily covers our principal residence costs. The decision to pay cash for the rental properties, for us, was easy. I can walk up to the properties any day of the year and touch and feel my investment. Can’t do that with stocks in companies. It’s call piece of mind and affords… Read more »

HUDSON
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HUDSON

I HAVE A QUESTION. I OWN 3 RENTAL PROPERTIES THAT I PAID CASH FOR . BETWEEN THE THREE I BRING IN $1650.00 MONTH I AM SAVING TO PURCHASE ONE MORE BUT I WAS TOLD IM NOT BEING SMART BY PAYING CASH FOR MY HOUSES AND IT IS GOING TO COST ME IN THE LONG RUN . IS THIS TRUE …. THANKS BIL

ufarooq
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ufarooq

Late to the comments… but if you have a zero-sum property you need to get out of the rental businesses… no point in holding something where you can’t even generate any income to pay for the crap you have to deal with. You have no buffer against bad tenants in this situation… my advise increase the rent by upgrading the place a bit… don’t know of the tenant laws where you at but you need to bring the property cash positive by any means possible. If it even means evicting current tenants and getting new tenants at current market rate.… Read more »

bobby
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bobby

I have 3 houses, my primary and 2 others. One is paid off, I owe a mortgage on my primary and a mortgage on a rental. The interest on my rental is slightly higher. I’m trying to figure out whether to pay off my primary first or my rental first, I’m not sure which of the 2 should be first, but I’m thinking I should pay off my rental, then I’d not be throwing money at a bank and I’d be getting more cash flow. Why get so wrapped up in trying not to pay taxes, that you would rather… Read more »

Tia b
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Tia b

Bill, I think you have made a very wise decision by putting more money down on your properties. It shows that you are not an investor who tends to rely on speculation (i.e. putting the least amount of money down in hopes of either flipping or creating an increased risk of losing your property to unaffordable payments on the mortgage due to vancancies) I choose to do the same with mine.

Tia b
Guest
Tia b

Hudson:

I think you have made a very wise decision by putting more money down on your properties. It shows that you are not an investor who tends to rely on speculation (i.e. putting the least amount of money down in hopes of either flipping or creating an increased risk of losing your property to unaffordable payments on the mortgage due to vancancies) I choose to do the same with mine

morgan
Guest
morgan

Great forum. I’m 67, living with a partner in his home, but have a small house, currently rented, for the future if I need it. My main objective is to own a home when/if I have to live alone. Currently I owe $100,000 on the mortgage, but could pay it by using all my investments. The tax benefits I now have would disappear, and my income would probably rise to a higher tax bracket. But I want the peace of mind of having a home should the markets crash again. My only other income comes from Canadian government pensions.

Should You Pay Off Your Rental Property Mortgage Early?

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