People are greatly 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 mortgage early on a rental property?
…I have a similar question on mortgage prepayment that involves a rental property. A little background on my situation. 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 zero sum right now, breaking even between rent 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 rental property is in effect a retirement savings 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 an answer from another reader, Gene:
I’m in a very similar situation as you. I have a rental property that is zero sum 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.
My Thoughts On This
I think the problem is quite intriguing. Without going into all the fuzzy math and simply compare the two possible 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.
I think the answer is self-evident…I would choose #1 over #2 any day — 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.
Advantages of Early Pay Off
Here are some advantages 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 5% gain on your investment because you don’t have to pay taxes on the money you saved (but you pay taxes on the money you earned).
- 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 (easier, faster, and much cheaper to sell stocks and funds than it is to sell a house).
- You lose out on inflation. Basically, $1000 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 mortgage payment.
If you’re in this situation, what would you do?
Pinyo 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®.