Summary: In this article, we will explain whether it’s best to pay off a rental mortgage or buy another property. We will also cover the advantages and disadvantages of paying off a mortgage and ways to minimize risk with a mortgage.
Introduction
Financial experts, real estate veterans and seasoned investors all seem to share their own opinions and advice on deciding to pay off a rental mortgage or buy another property. I won’t beat around the bush and tell you now that there is no definitive “right” answer to this long-debated question.
What you can expect in this article is to learn and gather a lot of useful information on the subject, which can hopefully help you make the most informed decision possible. Learn about the pros and cons of paying off a mortgage and reasons to leverage your rental property mortgage to buy another property.
Should I Pay Off My Rental Property Mortgage?
Is it better to pay off a mortgage or invest elsewhere? According to Justin Goodbread, a financial planner, there are six variables you should consider before making a decision:
- Your home’s current value
- Your mortgage interest rate
- Home appreciation in your area
- Your income tax
- Expectations for inflation
- An assumed rate of investment return
Let’s assume the following numbers for our example:
- Your home’s current value: $250,000 mortgage
- Your mortgage interest rate: 4 percent
- Home appreciation rate: 4 percent (home appreciation is how much the property will increase in value, usually varies between 3%-5%.)
- Your income tax: 20%
- Expected inflation rate: 3 percent
- Your assumed rate of investment return: 8 percent (market return is how much you expect the return will be if it’s invested elsewhere, like buying another property, for example).
Scenario 1: Paying Off My Mortgage Before Investing
Next, we’ll run the numbers to determine which is the best strategy given our example.
Plugging in our numbers, in 30 years, with or without a mortgage, a $250k property should be worth around $810,000 (according to the average home appreciation rate of 4 percent). Not a bad investment!
A $250k home on a 30-year, fixed-rate mortgage with an interest rate of 4% equals a payment of $1,193.54 per month (excluding taxes and insurance). Times $1,193.54 by 12, and we’ve spent $14,322.48 per year on mortgage payments. Let’s say we got a raise at work and are now bringing in an extra $1000 a month. So we decide to add it to our mortgage payment to get the house paid off in 12 years. We’re now paying $26,321.76 a year and cutting 18 years off our mortgage.
For the remaining 18 years, we’re going to invest that same $26,321.76 elsewhere, say in the real estate market. At the end of 18 years, earning 8% (that’s our constant in this example), we would have $1,027,745 in our investment account. Add that amount to the worth of our property, $810,849 and our assets are valued at $1,838,594 after 30 years.
Scenario 2: Buying Another Rental Property Instead of Paying Off My Mortgage
Now let’s see what our total net worth could be at the end of 30 years by investing the extra money in another investment property. We’re still buying the $250k home at 4%. This time we’re paying just the mortgage payment for 30 years, nothing extra. Instead, we decide to take that extra $1000 from our raise, and investing in another property for 30 years with our 8% return rate. Since we already know the value of our property after 30 years will be $810k, we need to know the value of our additional asset at this point. After doing the math, we end up with $1,417,613. Meaning that our asset is worth around $500k more at the end of 30 years than it would be in the 18 years we invested it after paying off the house. Now instead of $1.8 million, we’re worth $2,217,614. Pretty good considering we didn’t pay our property off early.
Once you have determined your own answers to these six variables, you will be ready to move onto the following considerations. Next, I will break down the advantages and disadvantages of paying off a rental mortgage or buy another property.
6 Advantages of Paying Off Investment Property
In the following sections we will talk about six advantages of paying off a rental mortgage. Add this to your list of reasons to get rid of that rental property mortgage.
1- More Cash Flow
Obviously, if you choose to pay off your rental mortgage you will no longer be making monthly payments. So all the money collected from rent, minus ongoing expenses, will become instant profit.
Imagine that you have a monthly mortgage payment of $750 on your investment property. The rent collected from your tenants each month is $1,250. No, let’s say you choose to pay off your rental property mortgage. Now, instead of earning $500 per month in cash flow, you will be taking home more than double that amount. Sounds pretty appealing, right?
2- Equity
Paying down a rental mortgage increases the equity you have in a property. There’s definitely something to be said for having 100 percent equity in an asset. Owning a rental property outright is considered a huge accomplishment.
3- Rent Flexibility
The cost of vacancies can become less of a stressor because you are not on the hook to pay a mortgage every month. So other than the costs to simply own a property, you won’t be reaching into your own pocket to cover the mortgage. This will give you more time and flexibility to find quality, long-term tenants to fill your rental. Rather than rushing to find just anybody to pay rent to avoid losing money on your investment.
4- Eviction Protection
In addition to the advantages of more rent and vacancy flexibility, paying off a rental mortgage will also protect you through the inevitable and joyous process of evicting a tenant. Without the proper preparation, planning and cash reserves, if a previously reliable tenant stops paying rent and you are forced to evict, you could be put in a tough financial position.
Making a late mortgage payment will affect your credit score and impact your ability to buy in the future. If you don’t have a mortgage to worry about, there’s less at stake when you have to evict someone.
5- No Debt
Many of us know Dave Ramsey’s philosophy in regard to paying off your mortgage versus not paying off your mortgage. Ramsey sticks to his hard and fast rule of “no debt”, which is difficult to argue with. Being debt-free is the ultimate goal for some homeowners and investors. Whether it’s the reprieve from stress caused by debt, peace of mind or simply the best financial decision for you, having no debt is usually advantageous.
6- Guaranteed Return on Investment
One of the more common viewpoints on paying off your mortgage is that is gives you a guaranteed return. Now you may be thinking, “How does not having a mortgage guarantee a return?”
Here’s an example:
Assume that you currently have a mortgage interest rate of 5.8 percent. If you pay off your mortgage, you will guarantee a 5.8 percent return on your remaining balance. Because that’s the money you’ll be saving on interest. Let’s say you don’t feel confident that investing your money elsewhere, like in the stock market or buying another property, will produce a better return than 5.8 percent. If this is your situation, it may be in your best interest to consider paying off your mortgage.
8 Disadvantages of Paying Off a Rental Mortgage
In the following sections we will discuss eight disadvantages of paying off a rental mortgage on a property.
1- Real Estate Investors Should Have Liquid Assets
One of the disadvantages of putting a large amount of money toward paying off a mortgage is that you make yourself less liquid. Less liquid assets means less accessible money in the bank.
What if something happens to your home or property and you don’t have enough money available to take care of it? You will either have to figure out another way to come up with the money or take out equity against your house. The second option will obviously lock you back into a mortgage, which is counterproductive. Make sure you have enough cash reserves set aside before paying off a mortgage.
2- Mortgage Interest is Cheap
The interest you are paying on a mortgage is cheap, relatively speaking. Mortgage interest rates are very low compared to the interest rates on personal loans, car loans and credit cards. Because mortgages are a cheaper way to borrow money, it allows more people the opportunity and affordability to buy real estate.
Additionally, investment property owners can write off up to a certain percentage of their mortgage interest, which makes mortgage loans even cheaper.
3- Dead Money
Too much equity in an investment property basically makes that money useless. That’s because your property is not a liquid asset. If the majority of your money is buried in your home, you can’t use it unless you choose to sell it. It also makes you a target for creditors and anyone that may want to sue you.
4- No Leverage
As I stated in the previous section, money in the form of equity (tied up in property) can’t be used to earn more money. People that refinance a property are taking out equity so they can utilize those liquid assets elsewhere. In essence, it allows you to buy more properties with more leverage.
In her book, Retire Rich with Rentals, Kathy Fettke uses an example to explain leverage and how to take advantage of leveraged appreciation.
“Using leverage can significantly increase your return. Look at it this way: Which scenario makes more sense and puts you in a better position 10 years from now? Tying up your capital with one $100,000 home? Or putting down 20% and owning five homes?
Returns tend to increase with leverage as well. A $100,000 property that rents for $1,000 per month will likely yield a 9-10% annual net return. If financed, that same property might yield an 18% return because the investor used less of his or her own money.”
5- A Rental Mortgage Doesn’t Affect a Property’s Value
Having a mortgage on a property does not affect its value. That may sound like a no-brainer to some, but it is a somewhat common misconception. If you don’t own your property outright, it doesn’t make your asset any less valuable. Simple as that.
6- Asset Protection
Mortgages and liens on a property can offer great asset protection. Paying off your rental mortgage could put your assets at risk in the event a creditor goes after you. Giving up the asset protection that comes with having a mortgage may be considered a great disadvantage to some investors.
7- Inflation Breaks Down Debt
The way inflation works is that it decreases the value of money, in turn making debt worth less. This is the very reason inflation is so important to our economy and country. If inflation breaks down debt, why would you be in a hurry to pay off a mortgage?
Fettke does a great job of explaining how inflation can benefit investors with a fixed-rate mortgage.
“The cost of everything in life will go up, but the size of your loan payments will always stay the same. In other words, your loan will get cheaper as time goes on, while the value of your property will increase along with inflation.”
8- Good Investments Will Outperform the Cost of Mortgage Interest Long-Term
Proponents of paying off a mortgage may argue that doing so secures a guaranteed return on investment, as mentioned under our “advantages” section above. Using the example above, let’s assume that your current mortgage interest rate is 5.8 percent. If you feel confident that investing your money elsewhere will produce greater than a 5.8 percent return, I would recommend not paying off your mortgage.
Ways to Minimize the Risk Involved With Having a Rental Property Mortgage
If you decide against paying off your rental property mortgage and instead put your money toward another property, you’ll want to do everything you can to minimize any risk associated with that decision. There are a few things investment property owners can do to lower the risk of financial distress and better prepare yourself in case you lose your job or your investments take a dip.
Make Sure You Have a Back-Up Plan
There are varying opinions on how much real estate investors should set aside in case of an emergency. Some financial experts will tell you to set aside enough money to cover between 3 to 8 months worth of expenses. That way, if you lose your job, you’ll have some time to figure out your options and decide your next move. Whether that be to sell an investment property to pay down your mortgage, find a new job, income stream or even sell your home. Make sure you have enough cash reserves in the bank to cover personal expenses, plus rental property expenses.
Lots of Insurance Will Help
Of course I’m talking about medical insurance, but you should also make sure you are covered by different forms of insurance. This could include income protection in the event you are unable to work and life insurance to take care of your loved ones.
Make a Plan for How to Get Your Invested Money Back
When you start seeing a return on your investment, you may choose to use it toward your personal mortgage until you want to invest again.
The Hidden Mortgage Tax
All of your paycheck that isn’t going toward paying down your mortgage is being charged interest. That really adds up. This supports the theory that paying off your home mortgage should be your biggest priority.
Thankfully, there is an exception to the mortgage tax rule. Any money that produces a higher return than you are being charged on your mortgage is exempt to this hidden tax.
Should I Pay Off My Rental Mortgage or Buy Another Property?
The best answer I can give is: it depends. Real estate experts offer a few opinions. Financial planner, Goodbread shares a couple of guidelines on the topic:
- Pay off your mortgage early if: (1) you are a conservative investor, (2) in a low tax bracket, (3) with a high mortgage interest rate.
- Invest if: (1) you are an aggressive investor, (2) in a high tax bracket, (3) with a low, 30-year, fixed mortgage interest rate and, (4) you are younger than 50.
Again, depending on which category you fall under and your current financial situation, these guidelines should help in reaching a decision.
Conclusion
Hopefully, this article has provided enough information to help you make the decision to pay off your rental mortgage or buy another property. To use a metaphor, plant as many trees as you can effectively water. This holds true for real estate investors. Build a forest of real estate and create real wealth.
For more information on the advantages and disadvantages to paying off a rental property mortgage, check out one of my recent articles HERE.
Sources:
