Which mortgage should I pay off first? Rental or my own

53 Replies

I own three homes with three different mortgages. Now I feel like I start paying off one property so I won't find myself in any future financial issues. What should I pay off first. Here is the details

1 my home - $200k left to pay
2 rental - $100k left
3 rental own by my dad. - $350k

I need best advice from saving tax and interest perspective. Thanks in advance.

Hey @Shal Patel I would say the lowest mortgage first. $100K would be the quickest route, and you can get that done to create a free and clear cash flowing property. 


As you stack the income coming off that property you can reinvest the capital which will build a lot faster than waiting to pay off your home, then deploying that capital. 

The next option with that capital would be to deploy it towards your current home and pay off your own mortgage ($200K) while taking your normal income to save for that next rental.

Shal,  

I agree with Peter on the pay off plan.  As a realtor and a tax preparer, I recommend you find a good IRS Enrolled Agent tax professional so that you can plan for any increased tax hits....  and just remember, the interest deduction comes off of the income you are paying taxes on, not the taxes them self.  So even if you pay a little more in taxes, it is only a small percentage of what you are paying in interest.  

@Shal Patel ,

The title of your thread/question, and the first two replies by BP friends, all imply that you would want to pay off the residence or rental mortgages early. I am comfortable with more leverage myself (you may not be). Why not let the tenants keep paying off the mortgages over then next 20-30 years (especially if APRs are 4 or 5%) and instead, use your capital to buy another rental and aim for 10% to 20% IRR?

Also, your profile says you want several more rentals and you like to fix/flip.....isn't the buy/hold or fix/hold strategy more tax efficient than flips (wherein your profit is taxable at ordinary income rate immediately, as opposed to rental)?

My rates are between 3.5% my home to 5% rentals.
Right now thank god that I am in good shape in financial and hopefully it will be. I am also in process of buying commercial property in a month so that will add some extra income in my portfolio.
I would like to start releasing that mortgage pressure from one by one from my properties. I am almost 40 and need to clear all properties by 50. I would really appreciate your suggestions.

I would talk to my accountant and let's see what he suggests as well.

There is also the theory to keep your personal home 'highly leveraged' in case of a lawsuits or personal bankruptcy.... that way, there is 'not much equity for them to go after'. 

In my case right now, I am in growth mode so not paying ANYthing down faster than needed. When the time comes to do so, I think it comes down to just 'running the numbers' and seeing which one saves you the most between interest rates and loan term length and how far you are into the amortization schedule. 

Dan Dietz

In terms of getting the greatest return for you money as people have suggested you should invest in another property. If you are keen on paying down obviously the biggest return will be to pay the one with the highest interest rate. There is another theory out there that you should pay down the smallest one so that when it is paid you get a "moral victory" but based on your comments I think that these are all options and it just comes down to personal preference. 

Originally posted by @Daniel Dietz :

There is also the theory to keep your personal home 'highly leveraged' in case of a lawsuits or personal bankruptcy.... that way, there is 'not much equity for them to go after'. 

In my case right now, I am in growth mode so not paying ANYthing down faster than needed. When the time comes to do so, I think it comes down to just 'running the numbers' and seeing which one saves you the most between interest rates and loan term length and how far you are into the amortization schedule. 

Dan Dietz

Maybe I'm missing something to your point, but it seems to me that if you are like most folks and your investment properties are financed under conventional freddie/fannie conforming loans under your personal name, then keeping your primary residence 'highly leveraged' vs your investment properties doesn't really buy you much of anything with additional asset protection. If the investments are all free and clear (or with non-recourse commercial financing) under an LLC, then yes I could see perhaps some benefit.

Incidentally, I have heard the exact opposite approach from some very experienced investors I know. To those guys, they would leverage and take just about any calculated risk on their investment properties, but would NOT for anything risk their personal home ... to them, that is not about investment but personal sacred ground for them and their spouse and where they raise their kids that is not to be tampered with or put at risk, and I guess it gives them a certain peace of mind that if everything in their business goes pear shaped, at least they always have their home that won't be taken away. Not saying that one approach is better than the other, just that I've heard it both ways and this is the personal preference and rationale I've heard. 

wouldn't it be easier to overboard on insurance than leverage the crap out of where you lay your head for the sake of reducing the chance of being sued...

My advice:

If you are set on paying down debt rather than investing in a cash flowing property.

1. Create a spreadsheet and generate your own amortization schedules for each loan.  

2. Add an additional column to allow you to make additional principal payments and analyze the impact to each loan.  If you are going to make a $50,000 payment, your location in your amortization schedule can be more important than the rate or remaining principal. 


 

Hi @Shal Patel ,

I'm going to respond without reading the thread, so my answer isn't colored by the other responses. :)

Conventional 'debt payoff' wisdom falls into two categories.

- Pay off the highest rate first.

- Pay off the lowest balance first.

I can see the pros and cons of each.

Specific to real estate, however, I disagree with them both!

Pay off your primary residence first, all day every day, then open a HELOC for as much as you can get (not pitching HELOCs, I very rarely do them, and mostly refer them out to other lenders in the Bay Area that do them). Keep the balance at zero dollars, pay the $75/year maintenance fee (or whatever the nominal fee is).

Reasons:

- First and foremost, now that you owe $0 on your primary residence, you can paint the door red in accordance with the ancient Scottish tradition (and BP members everywhere will know you as a heretic for not being mortgaged up to your neck).

- You also have liquidity that is the envy of REI everywhere. Examples...

- Great deal comes up, you need $200k? Great, click your mouse button twice, dump it onto your checking account, and use it for a down payment. 

- Fellow real estate investor is in a bind, needs $50k in 7 days? Awesome, dump it into your checking account with two mouse clicks, and charge that fellow 10% interest (secure it by real estate... obviously) for saving the day. Borrowing at 4.5% and lending at 10% is a great example of arbitrage, and basically the same as when you put $50k into a bank CD at 2%, that the bank then turns around and lends to someone else as mortgage money at 4%. Grats, now you're a banker. 

- Ah, crap, one of your rentals has a major emergency that must be fixed now, your operating capital is tied up in escrow on some other deal, and it'll take 4-6 weeks for the insurance payout to arrive? Boom, you get the idea.

- Family emergency? Etc etc.

There are HELOCs on investment properties, but as many a REI HELOC seeker will attest, they are far far more conservative, lower LTVs, higher rates, etc.

There would hypothetically be savings in interest from paying off the higher interest rate rental properties first, granted, but I think for most people in the RE game that high level of liquidity will end up more advantageous. You putting that $200k (or whatever) to work on that great deal or two (and who knows what those deals will be, but you're ready for them!) over the course of five years should earn you more than paying that extra fraction of one percent in additional rental property interest rate difference over that same five years.

Since you live in Texas you should pay off your primary residence.  Reason why is simple asset protection.  Your primary is homesteaded in Texas so it is somewhat protected from lawsuits.  Probably need to consult an attorney to find out to what extent it would be protected from lawsuits.  Even with all the insurance you can buy your rentals are open targets to an attorney especially is they are paid off. 

@Shal Patel  I would absolutely pay off my primary residence first, that is if it's peace of mind that you are after. 

If the market tanks, and I lose my job, my wife loses her job, etc. but our house is paid off...I'm feeling ok! What good is a rental being paid off if your house is going into foreclosure? Are you willing to sell a rental by force if something goes wrong?

I would pay off the least expensive one first.  Increase your cashflow and your ability to pay off the others quicker.

I don't think anyone can accurately answer your question with just the information you give. The answer should be- pay off the property that is costing you the most. Obviously your own home isn't bringing in rental income to cover the mortgage, but are the others? What is the % rental income is bringing in vs the % mortgage interest you are paying for them? Figure out which one is costing you the most in mortgage interest, and pay that one down first.

@chris mason that was awesome. Red doors and a heloc on the primary. Nice!

I've paid off a couple high rate and high hassle mortgages this year. 8 red doors for me! Not even I would rush out to pay off long term fixed rate resi mortgages that don't bother you and are at or below 5%. 

But if I did, it would be my primary. If all goes to he** and the s**t hits the fa*, I want MY HOUSE paid off.

But that's a big if, and like Chris says, I'm sure I can reinvest $200k for a better return than saving $.32 in interest over the next 5 years.

And what's up with the apt purchase? Can't pay off these low fixed rate loans and buy that, right? 

Ive often thought about this. There are pros and cons of both

1. Pay of rentals first: The reason is that it increases your cash flow but not your taxes by much due to depreciation (depending on your numbers of course). The primary home interest is also tax deductible against your regular income. Rental interest only against rental income and then sometimes you cannot even use the depreciation fully. So from a tax optimization pay the rentals first.

2. Pay Primary home first: This is best for peace of mind and ultimate security against down markets, lost jobs etc. You lose the tax deduction so thats the downside. But also you can more easily pull that money back out in the form of a HELOC much easier from a primary home compared to the rental.

So in the end do you want peace of mind or mathematical optimization (which some would argue is leverage even more!)

I've created the spreadsheet that Hal Davis mentioned above and I've done a few different scenarios.  If you're concern is interest expense, it's better to put extra dollars towards the property with the highest rate.  If you have equal or very similar interest rates with two different properties, then choose the property closest to being paid off.  Attack the rate.

I'm not sure if anybody else has mentioned this, but from an asset protection point of view, paid off properties are a target.  

It is all about what makes you feel comfortable, for most people that is paying off the primary home. 

 If you are asking a financial question, leverage as much as  you can and keep reserves to protect yourself.  It's impossible to plan for the catastrophic events, you can plan for the smaller issues, roof, A/C vacancy, etc.  In the event of the catastropic issue, you will have to hold a paid off property until the crisis has passed.  There is no exit strategy when the market dries up.  In a high leveraged scenario, you can do a strategic default and return the property to the bank and retain the money that would have been tied up in the property as equity.    

I find it interesting that people that are risk adverse always want to pay off their mortgages when in reality, paying off assets that are not liquid is much more risky. I have been working with my fiance on this concept as she is nervous that I want to do a cash out refinance on a house that we have 40% equity in. Here are two different balance sheets. One with the person that pays down their mortgage and one that puts all the extra money in cash reserves (or refinances)

Paydowner

Asset: Cash - 5,000                 

Asset: House - 200,000

Liability: Mortgage 95,000

Equity: 100,000

Reserver

Asset: Cash - 55,000

Asset: House - 200,000

Liability: Mortgage - 145,000

Equity: 100,000

Which "Company" or "Individual" is in a better finance position? Which one would do better during an economic downturn? The only factors to consider are interest rates (after tax advantage which is much lower than the stated APR) and fees (if you were to refinance).

Now with a certain amount of cash you have too much but that could be deployed into other investments (diversify) IRA, 401(k), taxable brokerage account, notes, other real estate. But the idea of paying off real estate (the most ill-liquid investment there is) is silly with today's low rates. You still have access to the cash to invest in paying down debt if you really needed to for some reason. Cash is King. The more cash you have the more conservative (or should I say safe) you are.

Paying down debt on real estate is risky from and investment and financial health perspective. If your debt is amortized, pay the minimum if you have a good rate. Let the standard amortization and the fact the the value of your debt will decrease with inflation work to your advantage. 

Another thing I find Funny are people that want to pay off their debt to increase cash flow. You are getting rid of cash to do this! You are paying cash today for cash later. Look at the Reserver...he doesn't need cash flow any time soon. He could breakeven. At $500 per month cash flow for Paydowner...how long until he has the cash of Reserver? 100 months or 8 years and 4 months. 

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