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

55 Replies

So my answer to your question is neither. If you already have so much cash that you just can't stand to have it sitting there losing to inflation...buy more real estate...sounds like you are doing this so if you don't need it for a down payment keep it for reserves. 

Originally posted by @Pat Coogan :

@Chris Mason What if you already have a lot of equity in your primary? Do you still recommend paying it off completely before doing a HELOC? Let's say one has 260K left on the primary but it's worth about 600K.

I'm in the same boat as you, Pat. Primary equity is solid, but still a substantial balance. I'm not doing a HELOC because I have a great fixed rate of 3.375 with only 9 yrs left. What's your rate and term?

Theoretically you could get a HELOC large enough to pay off your house I suppose, but then you'll have a variable rate credit line. Pluses and minuses to that. Access to cash would be nice but I don't like the variable rate or small print risk of the heloc.

In general, I like to have about 78% LTV on homes which keeps me below PMI, or none. With none I can put new debt on it or keep it paid off and put it into an entity. The middle ground 30-50% LTV stuff is tougher and becomes a personal decision how to deal with it, IMO. Cheers!

@Steve Vaughan 3.25, 15 yr fixed, 14 yrs left. Did this before I learned about BP and real estate investing. Like you, I don't want to lose the good rate on it now, but what to do with the equity is something I'm trying to figure out. 

As far as I can tell, you don't sound anywhere close to being over leveraged. With that being said, what do you even care about how long your tenants will have to keep improving your credit, your equity position, and your overall purchasing power. I agree with Chris Mason, although I personally hadn't heard of that particular HELOC strategy before, (to me) it makes a lot of since. If you were to use Chris's primary residence pay-off HELOC strategy accompanied with the mindset that I am suggesting you entertain in this post, I believe that you will be able to embrace and enjoy your OPM with a much needed POM (Peace Of Mind). Hope this helps. Much success!

Originally posted by @Pat Coogan :

@Steve Vaughan 3.25, 15 yr fixed, 14 yrs left. Did this before I learned about BP and real estate investing. Like you, I don't want to lose the good rate on it now, but what to do with the equity is something I'm trying to figure out. 

Let's assume that in addition to your primary @ 3.25% on $260k, you have some rental property at 4.625% at the exact same balance of $260k, and the hypothetical in our super simplified model is writing a $260k check to pay either off, but we only have a single $260k check, not two. Just to keep our numbers straightforward. We're also only going to count interest in this simplified model, not principal, because the principal is a wash since we are considering taking a HELOC right back out for that principal anyways.

In one scenario you pay off the higher interest rate rental mortgage and call it a day. Dave Ramsey and the conservative /r/personalfinance 'gurus' on reddit would be proud.

In the other, you pay off the primary and can get (an additional) $260k on that HELOC. Again, keeping it simple.

The difference in interest on $260k each year between 4.625% and 3.25% is $3,575. [ 4.625% - 3.25% ] * $260k = $3,575.

The question then becomes, if I give you access to $260k of working capital priced at [ HELOC interest rate ], can you put it to work earning greater than $3,575 in an average year (or $7,150 every two years, etc)?

This model is of course complicated by the fact that you might be able to find a 50% or 60% LTV HELOC on a rental property, in which case you take the difference between the two HELOC options and compare that to the $,3575 number.

Originally posted by @Chris Mason :

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.

 Out of all the opinions out there Chris Mason's makes the most sense to me!

Originally posted by @Wade G. :

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. 

In my opinion this is the right answer. Investment properties have no such protection, so your equity is going to be safer in your primary residence. 

Chris Mason has the correct answer. You pay down your personal home and take out a HELOC as large as you can on it to reinvest or use as your cash reserves to operate your business.

Investors that pay down a rental income property have absolutely no understanding of the value of cash or how to best use it. If they did they would know that a rental property with large amounts of equity can never produce true positive cash flow. Equity only buys artificial cash flow at a very high cost  (10%) and will ultimately create negative cash flow turning a investment into a liability.

For maximum positive cash flow a property must be 100% leveraged. Not realistic for most risk adverse individuals but they need to understand that for every 100K in equity you reduce your cash flow by $866/month. $866 is the lost  "opportunity" value (10%) of your precious DEAD equity. 

Equity is where money goes to feed off of your profits.   

@Pat Coogan @Steve Vaughan Are you not considering the option of leaving your primary residence loan in tact and adding a HELOC to tap the excess equity that's trapped? For example, I have a primary mortgage at 3.125% 30 year loan that I obtained 4.5 years ago that I'm not about to give up. Just last month I went to a credit union and opened up a free HELOC (no origination fees and no annual fees) for up to 85% of current LTV. With rising home prices they were generous with the desktop appraisal they did on my home and in reality they issued the HELOC with more like 95% to 100% LTV because of the over generous appraisal. Can't beat the free access to that equity which can come in handy if a deal pops up and I need quick access to capital.

In my opinion, if you are worried about limiting your financial risk with leverage I think you really need to analyze what your return on current equity is in each property. If you are worried about potentially not having enough to cover a mortgage payment in the future for whatever reason, I think you need to rethink whether or not each property is a good investment in the first place(i.e. does reserves account for all expenses such as vacancy, repairs, Capex, PM etc.). It is not uncommon for a property leveraged at 70-80% LTV to provide 15-20% return on your equity in the property just as a free and clear property on the surface may provide "great cash flow" however your return on equity could easily be in the single digits. I'm not saying you should leverage up the wazoo, but your inclination that you should be paying off properties early for whatever reason leads me to believe that you're not 100% comfortable with the leverage you've taken on. If you have the extra cash, and you are willing to manage more(if not look turn key, syndication, notes etc.) I would argue that the extra cash would better be allocated towards additional properly leveraged investments.

Shal.

I have a tool that I use to analyze these types of situations. Personally, I would take all the cash flow that you are currently generating and pay off the rental that you own which has the lowest mortgage on it. This will help generate some more cash flow and then you can use that extra cash flow to pay off your home. Finally you can use that cash flow to pay off the rental of your fathers. 

I have a portfolio out of state and do that with my portfolio to speed up the process. 

Originally posted by @Ryan Anderson :

@Pat Coogan @Steve Vaughan Are you not considering the option of leaving your primary residence loan in tact and adding a HELOC to tap the excess equity that's trapped? For example, I have a primary mortgage at 3.125% 30 year loan that I obtained 4.5 years ago that I'm not about to give up. Just last month I went to a credit union and opened up a free HELOC (no origination fees and no annual fees) for up to 85% of current LTV. With rising home prices they were generous with the desktop appraisal they did on my home and in reality they issued the HELOC with more like 95% to 100% LTV because of the over generous appraisal. Can't beat the free access to that equity which can come in handy if a deal pops up and I need quick access to capital.

Thanks for the heloc add suggestion, Ryan. I didn't know there was a low hassle, low fee option for a primary credit line.

I have enough hay in the barn at the moment, but will definitely keep your idea in mind!

@Ryan Anderson I was going to pursue a HELOC on my primary to free up the equity and have it at the ready. @Chris Mason Thanks for breaking down the numbers. Definitely need to mull it over. If I were to open a HELOC on my primary, would that affect my DTI even if I keep the balance at zero?

@Shal Patel

Are all 3 mortgages fixed rates, or are any of them ARMs? If one is an ARM, I would aim at paying that one off first. If all are fixed and at similar rates, and you really want to pay off one of the properties for peace of mind then pay off your primary residence first

  • This wouldn't increase your cash flow from your investment properties, but it would produce more green on your cash flow statement overall, as your primary residence expenses would no longer a mortgage payment.
    • You can then get a HELOC to use as needed, for whatever you need. A lot of flexibility there with a lot of liquid funds to reinvest or just plain cover your butt in case of emergency.

If you are worried about being over leveraged, then you could focus on paying the one with the highest interest rate until you are satisfied.

Of course, if you are looking to acquire another property in the short/medium term, and not super concerned with your amount of leverage at this time, then just pay them all off on schedule (or even refinance to pull some cash out) and grab another deal. 

Originally posted by @Pat Coogan :

@Ryan Anderson I was going to pursue a HELOC on my primary to free up the equity and have it at the ready. @Chris Mason Thanks for breaking down the numbers. Definitely need to mull it over. If I were to open a HELOC on my primary, would that affect my DTI even if I keep the balance at zero?

 Some, but not many, lenders have overlays to that effect.

@Shal Patel , I am going to offer some counter advice based on the way you asked your question.  First, having a paid off residence where you live is not a target for lawsuits.  I do not practice Texas law, but my recollection is that Texas has the unlimited homestead exemption in bankruptcy.  If it does, and you get a major lawsuit and have a $1 million judgement and lose all your properties, you can declare bankruptcy and preserve every dollar of equity in your primary residence, you cannot do that with a rental.  Next how you own each property matters a great deal.  Are all of the properties you own in your personal name?  Are you married?  Is your spouse on any of the other properties?  Is your main residence in tenants by the entireties?  These things matter a lot.  If you own a property in just your name and get sued by a tenant or one of their guests, they cannot sure your spouse if she is not on the title.  In order to be sued you must have a legal tie the property usually. (not always)  Now if your wife pushed the tenant off the steps, sure she can be sued, if she worked on the furnace and improper venting killed everyone from carbon monoxide poisoning sure she can be sued, but if she just does your books she cannot be sued if she is not an owner.  Now if your wife is on the primary residence with you as a tenant by the entireties and she is not on the rental unit, none of the equity in the primary residence can be used to satisfy a judgement against you alone.  Tenants by the entireties can only be used by a married couple, and does not apply to joint debts like medical necessities for either spouse or your children, but does to most other debts.  So if your reason for paying down debt is strictly security, then paying down your main residence is the most secure choice.

Others have commented about lowest interest rate and smallest debt, and even buying more properties instead of paying down, and all of those things have merit, but you mentioned security, so that is why I explained the legal aspects of capital preservation rather than maximum profit.

I hope this helps and keep in mind this is a VERY brief overview of the legal principals and not an in depth study an attorney would normally do with you in estate planning.

Best of luck bud.

It will be difficult to get further mortgages in the future. Aside of paying off the least mortgage I suggest you to refin the one with most equity to pay off may be 2.

Originally posted by @Shal Patel :

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.

 1. Having mortgages in place helps with taxes since the interest is deductible.

2. Having mortgages in place increases CCR and IRR.

So, if those are the reasons you are considering paying these off - don't. It makes no sense from either tax, asset-protection, or investment return standpoint.

And now tell us - why do you really want to pay these off :) lol

I am amazed with responses I got for my post. There are lot of suggestions and advises how to payoff and not to pay off existing mortgage.
The reason I want to payoff atleast one mortgage because I want piece of mind from atleast one mortgage. I want to feel like I am achieving something in life and will keep me secure in future if any unexpected event comes like job loss or anything which we can't control.
Mostly I break even in my rentals after all expenses so there is no income from any of them. If I pay smallest amounts it will increase my income and reduce debt. And if I need more money for any future project I can get equity loan anytime.
Also. I am buying another commercial property with my last penny and I think that would be enough in my portfolio right now. It's time to start paying off and enjoy my investment.

@Shal Patel , I totally respect and understand where you are coming from when you want to payoff/pay down a mortgage. But I want you to realize, that based on what you are saying, this is a completely emotional response. So, I want you to become aware that you are coming from a place of emotion on this issue. Now I want to give you the tools to combat the emotion, learn and use logic and math to make your decisions. With investing you need to take as much emotion out of the picture as possible and operate off sound reasoning and calculated and realistic assumptions. 

1) Please read my post above if you haven't already. I am a CPA for crying out loud, I am really conservative and play it overly safe. 

2) Please understand that you are achieving a lot right now. You have to understand and see that before you can move forward. 

3) Understand that if you have a 5% mortgage, you are NOT locking in a 5% return when you pay them down. @Ben Leybovich pointed out that interest is tax deductible so when you lose the tax deduction your return on paying down you mortgage is really about 1% less than the stated interest rate.

4) Cash paid towards your mortgage (above the minimum) is negative cash flow....so you are trying to increase cash flow in the future by reducing your cash flow currently (not a great plan for increasing cash flow). I think it is much more conservative, to hold a very strong cash reserve. So, open a separate account that is your reserve account and whenever you feel tempted to pay down your mortgages, instead put the money in the account. My target is to hold 7% of my total Debt in reserves (which I currently exceed). Some might say this is too high but it helps me to sleep every night and when the next recession comes I will be in a strong buying and borrowing position. If I lose my job, I would not have to wonder how I am going to pay my mortgages or feed and cloth my family. 

5) you cannot get an equity loan any time. If you lose your job, or the economy goes to crap like it did in 2008, you will not be able to access your equity. The only thing you will be able to access is your cash reserves. You do not want to access 401(k) with a loan or securities at that time because they're value could be cut in half by the market and you do not want to sell low (you want to be in a position to buy assets when prices are low).

6) I hear people on BP say that just get an Equity line of credit for "reserves." I completely disagree with having this be your only source of reserves. Lenders can shutoff new borrowing on a HELOC without your consent for a variety of reasons...which is usually when you actually need access to the funds. I would never place too much reliance on a HELOC for reserves (They are better used for new acquisitions than reserves).

Sorry I am so wordy but this is an issue that has a ton of misconceptions. People emotionally feel like they will be more secure paying down debt but the opposite is usually the case. Again, It sounds like you are having a ton of success so keep it up and rely on math not emotion.

I hope that helps!

Jered

@Jered Souder thank you so much for your great advise. I totally agree with you on equality loan. I was missing point that who would give you loan if you don't have a job. Specially for me I don't have any business. Well I will keep in mind that Cash on hand always wins investment game.

Originally posted by @Thomas S. :

Chris Mason has the correct answer. You pay down your personal home and take out a HELOC as large as you can on it to reinvest or use as your cash reserves to operate your business.

Investors that pay down a rental income property have absolutely no understanding of the value of cash or how to best use it. If they did they would know that a rental property with large amounts of equity can never produce true positive cash flow. Equity only buys artificial cash flow at a very high cost  (10%) and will ultimately create negative cash flow turning a investment into a liability.

For maximum positive cash flow a property must be 100% leveraged. Not realistic for most risk adverse individuals but they need to understand that for every 100K in equity you reduce your cash flow by $866/month. $866 is the lost  "opportunity" value (10%) of your precious DEAD equity. 

Equity is where money goes to feed off of your profits.   

Cash flow is by definition what is left over after expenses, so lowering your debt service will increase cash flow. All cash flow is real. There is nothing such as "artificial cash flow" - this is where you have it backwards.  Opportunity cost is artificial, because it is only potential income.

What you are referring to is maximizing return on investment by increasing leverage. 

If I pay cash for a property, it has higher cash flow than if I finance the property; however my return on investment keeps increasing as I approach 100% financing. 

Increasing leverage decreases cash flow, while at the same time increasing return on investment and increasing risk. 

Overleverage can be a huge problem - so much so that it has caused countless investors to lose everything. In the housing crash nobody with a paid-off home lost it to foreclosure. 

Any smart investor should be risk adverse to a point.