Would you own rental properties free and clear (No mortgage)

53 Replies

Hello biggerpocket members,

Me and my wife are still relatively inexperienced in the world of Real Estate investing. I considered my self a conservative guy and my strategy is to buy and hold.  I have one rental (rental 1) and our primary home that is under my name along with the mortgages. We recently bought another rental (rental 2) back in June and put under my wife's name and the mortgage is under her name as well. I recently called my bank to see if I can refinance my primary home that has an interest rate of 5.75% 30 year fixed. It turns out that they offered me a rate of 3.25% 30 year fixed rate and I have enough equity to pull money out and pay off the (rental 2) property we recently purchased in June under my wife's name, which the current rate on that rental is 5.25% 30 year fixer. My dilemma here is that in the event that me or my wife were to get sued, that property would have equity that is not protected. Right now the equity is on my primary home which is protected by Florida homestead. With this refinance I will be saving a lot of money on interest rates but on the same token I will be exposing my equity. I will be consulting with my lawyer next Friday but I want to hear the opinion from and investor's perspective. Thank you in advanced and I wish you all a happy new year with a lot of success.  

Best regards,

Pablo 

@Pablo Pozo .  I know at first glance, the numbers (different interest rates) appear to make the scenario you described correct.  However, you have it backwards.  You should be refinancing your rental property...not your own home.

If you refinance your own home, and you touched on this, you are putting it at risk from foreclosure...it is protected by Florida law if it has 100% equity, and it would be considered a bad debt since it doesn't make you any money.

If you refinanced your rental property, even if the interest rate is higher, the cash you would be pulling out would be used to buy your next property.  You can refinance that next property, to buy your third, and so on.

By leveraging your rental, and putting that property at risk (really only the equity is at risk to you), you are protecting your own home and with no (or little) cash still in each rental after refi, you have little or now financial risk as well.  Don't believe me?  Ask any bank why they won't lend 100% or more to someone buying a house...and why they want the buyer to put up a down payment?  As them who has, and where is, the risk?

1) do you have a LARGE umbrella?

2) I LOVE leverage!- while I would refinance for a lower rate I would NEVER pay cash unless there was a specific reason. Rates are SO low right now that you are better off borrowing money and reinvest your own.

As always it depends on your comfort. We are young and LOVE leverage because it makes are dollar go SO much further.

I still can't get it straight in my head...

Let's take two simple, hypothetical scenarios, assuming identical property values, say 200k, and a 100k mortgage.

1. I own my home free and clear, and have a mortgage on my income property.

2. I own my income property free and clear, and have a mortgage on my home.

I'm at more financial risk if sued in #2? I don't understand why, the dollars are the same.

Or is this that LLC business, assuming the income property is held in an LLC?

If the income property is not held in an LLC, the risk is the same given my scenario, right?

If you hold both properties in you or your wife's personal name, a lawsuit/judgement will attach to either or both homes. You are more likely to be sued by a tenant, of course, and the first place they will look is to the owner of the rental. If you do satisfy that mortgage, I would put it into an LLC at least. Like @Joe Villeneuve  points out, I would rather have my home paid off and carry a mortgage on my rental from a risk perspective.  Worst case scenerio, I would rather lose my rental to the bank than my home.   I guess another option would be to refinance both properties to a 15-yr mortgage, getting your rate even lower.  That's what I did a couple years ago.  The 15-yr rate is almost 30% lower than 30-yr rates!

@Arnie Guida  OK Arnie.  Let me put it like this.  Financially, what is at risk, is your equity since that has value to you, and most importantly is mostly (if not all) made up of cash you put in.  If you lose that house, you lose the cash you put in.

If your rental home is leveraged, and has little or none of your cash left in it (you may have bought it with cash, but you refinanced it back out), ...what financial risk do you have?  It's not the lender's cash that is in the house...your's cam out when you refinanced it, and....

When you re-use that same cash again, and repeat the refinancing, you are leveraging your cash multiple times.

...

"Would you own rental properties free and clear?"

That's the plan once we enter the retirement and divestment stage of this adventure.  However, while still in the growth and acquisition phase, the idea is to put OPM to work as much as is practical.

Originally posted by @Roy N. :

"Would you own rental properties free and clear?"

That's the plan once we enter the retirement and divestment stage of this adventure.  However, while still in the growth and acquisition phase, the idea is to put OPM to work as much as is practical.

 I understand your reasons to eliminate debt once you retire, but I'm thinking that at that stage the risk of 100% really doesn't change.  I don't know that I ever want to have any of my rentals paid off.

Now, my personal residence...yes.

Originally posted by @Joe Villeneuve :
Originally posted by @Roy N.:

"Would you own rental properties free and clear?"

That's the plan once we enter the retirement and divestment stage of this adventure.  However, while still in the growth and acquisition phase, the idea is to put OPM to work as much as is practical.

 I understand your reasons to eliminate debt once you retire, but I'm thinking that at that stage the risk of 100% really doesn't change.  I don't know that I ever want to have any of my rentals paid off.

Now, my personal residence...yes.


Joe:

Perhaps, but maybe not. :-)  The idea behind owning free and clear when we begin divestiture is to both maximise cash-flow of those properties we hold and allow us to turn those properties we sell into annuities ... while deferring and mitigating capital gains inclusion.

As for the personal residence, we paid that off, in eleven years, long ago.  In Canada, mortgage interest on your personal residence is not deductible.  Since you are paying that mortgage from after tax dollars , the incentive is to pay it down as quickly as possible ... unless you can get a better after tax return from those funds elsewhere.  Given our mortgage's life started in the era of double-digit interest, expedited pay-down was the best option.

For us, the 2.5% difference would likely not be enough to reason away risking our protected home equity just to pay off a rental, so we'd look into the refi on the investment property, as even if it wouldn't be as good a deal as the primary, it still might be worth it with today's rates. As far as lawsuit issues, make sure you have a decent umbrella or at least up the coverage on each policy (we had to do this for a few years when we lost our umbrella after our teenagers totalled one too many of our vehicles). I'm not a lawyer so no legal advice, but we were disappointed when our lawyer told us to go the LLC route and we followed his advice initially, but frustrated with issues with mortgages and potential pass-through liability, anyway, so we got rid of the LLC and went the umbrella route instead.

What about a HELOC on your primary, using it to pay cash when you find a great deal, then paying it off once you get financing on the new purchase, then repeat? It would give you an advantage in buying when you can pay cash at closing using your home equity, but your primary home would only be compromised until you financed the new unit. I'd discuss that scenario with your lawyer as well. We bought our first 3 properties that way long ago, so I'm not sure if the new rules muck it up, but it worked very well for us back then.

it sounds like you have a good head for numbers. that is good. but here is some more numbers advice. first, equity in a home, be it yours or a rental, is money going unused. sure, you could refinance your home and pay off the other, and on paper, that sounds good, but if your tenants are making the payments on your rental, why are you worried about having it paid off? let the tenant pay the payments for you. as far as your house, if you have enough equity in the house to pay off the other, then you have enough equity to buy another place to increase your net income. with the drop in your intrest rate, you should save money there anyway, plus, with a new rental, you would increase your net monthly income and come out money ahead. then, refinance the rental and do it again. get the snowball effect going using other peoples money. 

One thing many are forgetting...

Not everyone is a one trick pony, their are more asset classes, and more to do in life than real estate. 

For the maximum leverage crowd, you must have short memories. My painter had a helper...nice guy, late 30's..."I had a 5 bedroom house and 15 properties"...then the downturn around 2007-08 came, all that wonderful leverage that guys like Joe Villeneuve take every opportunity to post in every thread they can, left this guy bankrupt, being a painter's helper, working for me.

I have enough properties, most are free and clear, there are other asset classes and more to do in life besides real estate. There are only so many hours in a day, and the clock is ticking.

Be careful with leverage. There's nothing wrong with owning income properties free and clear. I sleep like a baby...

@Arnie Guida  Paying off a refinanced rental is a good thing since your tenant is paying off the lenders money.  Putting $50k of you own money into a property and leaving it there, while only getting $500/month ($6k/year in return), defeats the purpose of investing.  Take out $1000/year for issues, and at a $5k return/year it will take you 10 years to break even.  In other words, you are behind on your balance sheet.

Before you can say, "but I have $50k in equity", I will bring up that same painter's problem. How many of those 15 houses would he have had if he had to come up with $50k for each one?  Let's do some basic math here.  15 x $50k = $750k.  

Let's say he did have $750k to buy these houses.  He would have spent $750k, and based on the above scenario, he would be getting back a whopping $75k/year...this is if he was able to accomplish this at one time.  That too is unlikely.

What is more likely is he would have been restricted to one house at a time.  So how long would it take to put the $50k together for the first (and for the subsequent) house?  Let's say he is a great painter, and runs a great business, so we'll let him save $10k/year...that means it would take him 5 years to put the funds together for each house....times 15 houses = a lifetime.  This is allowing him to use the cash flow to live on.

If he uses the cash flow to buy the next house in addition to the $5k/year savings, then it would take him 20 years....as long as everything stays the same.

I appreciate all of your great point of views. I am most concerned about the liability perspective. Thank you Joe for bringing up a good point, that is better to shelter your equity under your homestead than exposing it to an unprotected asset. I guess once you build enough equity on your rentals you have no choice but to have rentals free and clear. For now though I believe that is not a great idea to take out shelter equity to risk it on an unsheltered asset. Even if I put the property under an LLC that asset remains vulnerable. Some members point out that it doesn't matter the interest rate because the tenant is paying for the mortgage and I completely get that. However, in my opinion, if you can get a lower rate over the long haul you will pay less interest over the life of the loan and also lower you payment, which increases you cash flow. I would think that this would make the same rental income go further. I am really after asset protection because you never know when your are going to run into a bad situation.

@Pablo Pozo   This is a GREAT question, and I can relate, as I am in a very similar equity/rentals scenario.

IMO, there is no right answer to this question.  Some people love leverage, I appreciate that.  Some people love owning owning rentals free and clear, and I appreciate that.

Here's my $0.02 - I am a working professional in healthcare, and as such do real estate on the side to prepare for retirement / college savings for kids.  My end game is to own rentals free and clear.  THAT SAID, as mentioned already, rates are UNBELIEVABLY low.  While this is the case, I intend to finance all I can......once rates start to creep up, I'll shift my focus from leverage toward the snowball method of paying down each property at a time.

Don't know if that helps, but as a conservative investor, this is my approach.  Not right by everyone's standards, but it's right for me.  Good luck!

Would you own rental properties free and clear?

Yes, I would, and do. We currently own 7, next week 8 SFHs, our business property, and our home completely debt-free. If we need to, we will consider mortgaging a rental or two to make future purchases, but as long as we have the cash we will remain debt-free.

Pablo, you are worried about liability, so be sure you have a good insurance policy. Remember that there are other risks to consider as well. Each of us makes choices partly determined by the risks we find acceptable. Once you have identified the risks you find least acceptable you can take steps to protect yourself.

i agree with @Sylvia B.  

While the liability and equity position are inter-related, this is the first time I have heard an investor make a financing decision based on liability concerns.  I would instead leverage to your risk and comfort level and purchase good insurance and/or put your properties into LLCs

Best of luck

Isn't this all about ROE?  My thought is the only way I'll have my rentals fully paid off is when I am retired and do not look to make any future purchases.

Originally posted by @Kyle M. :

Isn't this all about ROE?  My thought is the only way I'll have my rentals fully paid off is when I am retired and do not look to make any future purchases.

 Correct.  I believe the "risk" string was a side comment that took flight.  It is important, but it still comes down to this.  Equity is where your cash goes to die.  Simple math.

Would anyone pay an employee $50,000 upfront, and after that employee did their work, you (the employer) only made $5,000 in that first year...and in the following years.  Oh wait, 2 years in, the cost of that employee went up (a new roof = $5,000), so the employer (landlord) made no money that year...and it goes on and on.  

If everything was perfect, and every year my employee (rental) made me $5,000, it would take me 10 years before I broke even and my employee actually made me a profit.  Now, I had a brilliant idea.  What if I hire a number of other employees (properties), at $50k startup, that made me only $5k (cash flow) a year?  I'd be rich....right?

As many have already said, make sure you have enough insurance on your rentals or better yet, an umbrella policy, to cover the amount of your net worth that you're concerned about. That will most likely be your first line of defense for liability issues. This should still be the case even if you use an LLC. Crafty lawyers will try to penetrate the veil of your LLC's protection if they sense that there's money available. Why even worry about that? Just carry enough insurance.

On a personal note, my mother didn't carry enough liability insurance on her automobile coverage. She was at fault in an accident and broke the other driver's leg. A quick search revealed that she had good equity in her primary home. The lawyer went after my mom and the insurance company and my mom had to come up with $25k out of her pocket as part of the settlement. If she would have had enough liability coverage, it would have been 100% the insurance company's problem. She learned her lesson the hard way and I know now how to avoid the same mistake. If you've got assets to protect, start with having enough insurance.

What all the pro leverage crowd is ignoring completely is risk of leverage. Leverage is okay, I use it also. But your payments on debt always represent a liability on your balance sheet. Now as long as your income exceeds that , you are fine. But what if it doesn't? Do you have enough reserves to survive  the worst case scenarios? If you do, you are probably okay. But the extreme leverage crowd would have you invest every penny you have and multiply it 5X by leverage. Thats a huge risk. Far greater than the risk of getting sued, which everyone worries about but is really very rare and easy to cover with insurance. I have asked my PM who has years of experience with hundreds of doors under management if any of his owners have been seriously sued. The answer is NEVER. The worst is tenant suing for return of security deposit or something but never the million dollar lawsuits you fear so much. So ignoring a much more real risk for a very unlikely one seems unwise  to me. 

@Anish Tolia  Let's stick to the facts as stated.  Where did you read "But the extreme leverage crowd would have you invest every penny you have and multiply it 5X by leverage."

Also, before you state where the biggest risk is, you need to look at what is at risk.  Now ask yourself this question, "Who knows more about financial risk, than the banks"?.  The answer is nobody.  So, what do they define as "risk"? 

another thing to consider... Create a trust. You can title the properties in the trust and eliminate the risk is of a lawsuit as this money is protected. Good overall plan w a one time small investment. No need for an umbrella policy.  

@Pablo Pozo 

If you plan on acquiring more than 2 rental properties, then now is probably now the time to pay off that mortgage.  At the beginning of your investing career, imho, "you want to borrow as much as possible for as long as possible."

If you're independently wealth, just won the lottery, or are in retirement or pre-retirement mode, then the answer would be different.

Free eBook from BiggerPockets!

Ultimate Beginner's Guide Book Cover

Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks and techniques delivered straight to your inbox twice weekly!

  • Actionable advice for getting started,
  • Discover the 10 Most Lucrative Real Estate Niches,
  • Learn how to get started with or without money,
  • Explore Real-Life Strategies for Building Wealth,
  • And a LOT more.

Lock We hate spam just as much as you

Join the Largest Real Estate Investing Community

Basic membership is free, forever.