Pros/Cons to paying off rental property early

Redwood City, CA · Member since 2018 · 11 posts · 11 votes

Hi Everyone! I have a rental property with the following details:

210k loan balance
$2500/month rent
$6000/yr in income after PITI and costs today

If I pay off the remaining balance on the loan, I will have over 10% cash on cash return which sounds amazing. It is already cash flow positive today, around ~$600/month. My overall investment goals right now are to create passive income, so this would fit in with that. Is there anything I am missing with my considerations? Of course there is the option to invest the 210k in other real estate opportunities, but I may be hard-pressed to find something above 10% return. Thanks in advance for your thoughts.

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Joe VilleneuvePro Member

Plymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes

Originally posted by @Chris Meunier:

Hi Everyone! I have a rental property with the following details:

210k loan balance
$2500/month rent
$6000/yr in income after PITI and costs today

If you pay off your mortgage, with cash I assume, you are not getting 10% CoCR. If you pay off the mortgage (a - $210k) and only make $6k CF + what ever the original mortgage payment was (I'm guessing a bout $15k/year), that gives you a return of only $21k...and an outgo of $210k. That's a net negative CoCR of 90%.

Right now you have the tenant paying off your mortgage for you, with an extra $6000/year in income. Why in the world would you go backwards $210k? Invest that $210k in something that will also let the tenant pay you money to live there.

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Joe VilleneuvePro Member
Plymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes
8y
Originally posted by @Chris Meunier:
Hi Everyone! I have a rental property with the following details:

210k loan balance
$2500/month rent
$6000/yr in income after PITI and costs today
If I pay off the remaining balance on the loan, I will have over 10% cash on cash return which sounds amazing. It is already cash flow positive today, around ~$600/month. My overall investment goals right now are to create passive income, so this would fit in with that. Is there anything I am missing with my considerations? Of course there is the option to invest the 210k in other real estate opportunities, but I may be hard-pressed to find something above 10% return. Thanks in advance for your thoughts.
If you pay off your mortgage, with cash I assume, you are not getting 10% CoCR. If you pay off the mortgage (a - $210k) and only make $6k CF + what ever the original mortgage payment was (I'm guessing a bout $15k/year), that gives you a return of only $21k...and an outgo of $210k. That's a net negative CoCR of 90%.
Right now you have the tenant paying off your mortgage for you, with an extra $6000/year in income. Why in the world would you go backwards $210k? Invest that $210k in something that will also let the tenant pay you money to live there.
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Samuel Liapis
Rental Property Investor · Chicago, IL · Member since 2017 · 83 posts · 46 votes
8y
I always thought the same thing. I was thinking in terms of generating the profits monthly. I thought paying off the property sooner would create higher monthly profits.
For example a mortgage of 1700$, cash flow of $1000. If I pay it off I should make around $2000 a month in profit.
I talked about this to a few people and some said that you lose a lot of the tax benefits too.
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Chris Meunier
OP
Redwood City, CA · Member since 2018 · 11 posts · 11 votes
8y
Thank you! @Joe Villeneuve, to answer your questions: yes it would be paid off with cash. After paying off with cash, my total income would rise to 30k/year (before any maintenance costs). The current PITI+HOA is about $1950/month. I do get your point about investing it elsewhere that also has a positive cash flow, but part of me was thinking this is an easy way to immediately increase my cash flow and return on the 200k investment. But as @Samuel Liapis has said, there are also tax benefits I would lose out on that are not factored in to my calculations.
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Joe VilleneuvePro Member
Plymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes
8y
Originally posted by @Chris Meunier:

Thank you! @Joe Villeneuve, to answer your questions: yes it would be paid off with cash. After paying off with cash, my total income would rise to 30k/year (before any maintenance costs). The current PITI+HOA is about $1950/month. I do get your point about investing it elsewhere that also has a positive cash flow, but part of me was thinking this is an easy way to immediately increase my cash flow and return on the 200k investment. But as @Samuel Liapis has said, there are also tax benefits I would lose out on that are not factored in to my calculations.
...but thisa isn't increasing your CF positively. It's an illusion. All you are doing is paying all negative cash flow up front. You are paying $210k for only $30k return. That means it will take you 7 years of perfection to just break even.
Invest elsewhere with your cash, and let your tenant do their job. They don't need any help.
The 1st rule of the 2 Golden Rules of REI is to never spend your own cash. Use it many times over, but never spend it. Paying $210k for $30k isn't even spending it...it's losing it. Investing it elsewhere, then getting it back and reinvesting it over and over is using it.
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Chris Meunier
OP
Redwood City, CA · Member since 2018 · 11 posts · 11 votes
8y
@Joe Villeneuve thank you for articulating it that way--I definitely see your point now that i'm putting myself in a hole right away!
1 Reply
Sam Josh
Sunnyvale , CA · Member since 2017 · 373 posts · 362 votes
8y
The only benefits are you will own the property free and clear and your monthly cash flow will be better but that is only symbolic as you are putting all the cash into the property to get there. I would reinvest the 210k elsewhere.
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Samuel Liapis
Rental Property Investor · Chicago, IL · Member since 2017 · 83 posts · 46 votes
8y
Even if all you are looking to do is retire? I mean you cannot retire on $210k.. But you may be able to retire on 2000$ a month.. I mean you wouldn't live a lavish lifestyle, but depending on where you live, you could do ok.
I wanted to invest in properties until I start making around 5-7k$ a month in profit. Then retire. That would allow me to purchase a new home and not have to work. I also thought about maybe purchasing the new home and paying my own home off right away, that way my bills per month would not be that much. This would allow me to live very comfortably and go on 4-5 vacations a year I would think.
7 Reply
Vaughn Smith
Property Manager · NJ · Member since 2017 · 786 posts · 396 votes
8y
@Chris MeunierIt looks like you thought this question out really well and many other people consider doing the same thing. I would caution you to consider the opportunity cost of spending that $210k all on one property, there are so many other ways that you can put that money to work for you. Using leverage is one of the greatest benefits of REI the idea of owning a property free and clear is tempting, but, I would let the tenants pay it off for you over time while using your money to make more money for you.
8 Reply
Michael Lee
Investor · Coppell, TX · Member since 2008 · 2k+ posts · 646 votes
8y
You do whatever makes you feel better. There is nothing really bad about debt if it is giving you positive cash flow. Does it meet your goals? You could use any equity to back up another loan on another investment company. That depends on your personal expenses as well as what is available to you and its profitability. Do you need more balance? What were your goals when you bought it? Did you have an exit strategy? If you find a good deal the funding with a loan should not be difficult.
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Andrew SyriosPro Member
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Residential Real Estate Investor · Kansas City, MO · Member since 2014 · 10k+ posts · 5k+ votes
8y
Leverage is one of the biggest advantages of real estate, because it allows you to buy more and thereby take advantage of more appreciation as well as more principal pay down (and more opportunities to buy properties below market and get built-in equity). But it's also, of course, more risky to use leverage or to keep it. You will make a higher cash flow by paying off the loan, but you could do that by buying another property. The big key is how much risk are you comfortable with. If you would prefer a more conservative strategy, then paying off the loan makes sense.
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Nathan GesnerBusiness Member
Moderator
Real Estate Broker · Cody, WY · Member since 2010 · 28k+ posts · 41k+ votes
8y
In general, the more money financed, the higher your rate of return.
Read this article
Personally, I don't ever want more than 50% equity in a property because it reduces my return AND I could use that equity to purchase more property and leverage an even greater return.
My recommendation: learn the basic math and then assess your property with 100% equity, 50% equity, and 20% equity to see which works better for you.
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Antoine Martel
Rental Property Investor · Miami, FL · Member since 2017 · 2k+ posts · 911 votes
8y
Chris.
There are plenty of deals out there to get over 10% returns.
If your goal is cash flow then you're going to want to continue buying more and more properties. Do not pay off the mortgage if you're in growth mode and want to grow your cash flow.
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Chris Meunier
OP
Redwood City, CA · Member since 2018 · 11 posts · 11 votes
8y
Thanks everyone! This is all great advice.
0 Reply
Derrick E.
Investor · The Creek, WV · Member since 2014 · 890 posts · 1k+ votes
8y
@Chris Meunier I'm in the other boat. I pay all my properties off ASAP and/or pay with cash whenever possible. Currently have 6 SFHs all paid off and rented out. We do have a HELOC on one of our homes that we use to purchase more properties with. It currently has a balance of $0 though.
Should be buying another in the next month or so by using the HELOC and then will use all rent money to pay it back ASAP.
17 Reply
Chris Meunier
OP
Redwood City, CA · Member since 2018 · 11 posts · 11 votes
8y
Interesting @Derrick E. Would you mind sharing more about your reasoning for doing this, in light of the many other responses saying its better to leverage your money in other ways?
0 Reply
Mike V.
Rental Property Investor · Campbell, CA · Member since 2017 · 419 posts · 499 votes
8y
@Chris Meunier, I don’t know why you say you’d be hard pressed to find better returns over 10%? I can give you a few ideas if you’d like, all well over 10%. Just shoot me a PM if you’re curious. I always enjoy chatting with neighbors.
2 Reply
David Wolber
Property Manager · Groton, CT · Member since 2017 · 130 posts · 81 votes
8y
From a liability proctection stand point, having everything paid off like @Derrick E. makes you a very good target for a lawsuit should you be found at fault. Even if you have several properties, if at the end of the day you are only "worth" 10-20 thousand you may be less mouth watering of a target for a lawyer to go after then someone who has 100s of thousands in equity. However this can be mitigated by a good liability protection business structure, it's just another thing to look at.
Dave
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Ali Boone
Real Estate Coach · Venice Beach, CA · Member since 2012 · 6k+ posts · 3k+ votes
8y
I agree with @Joe Villeneuve on this one. It's an illusion. You aren't increasing your cash-on-cash because of how much cash you are now having to put into it to get to those numbers (so that new number needs to replace the denominator in the cash-on-cash equation).
If you want to maximize your returns, you'd use that money to buy more investments rather than put into this one. It's the same question as whether you should buy a property for all cash or leverage it. Leveraging, all day long, will get you significantly higher returns.
There are tons of properties that can get you 10% CoC, as long as you aren't tied to your own backyard.
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Dan H.Pro Member
Investor · Poway, CA · Member since 2015 · 7k+ posts · 8k+ votes
8y
Leverage the money is the way to build wealth fastest especially in appreciation markets. If I have 10% equity and the property appreciates 10% I have achieved 100% return on the equity prior to calculating any cash flow. However, if I had 100% equity on the same property I have achieved 10 return on equity prior to calculating any cash flow.
I am surprised no one pointed out that rent - (PITI+HOA) is not expected cash flow. Expected cash flow should be your best projection of the cash flow and should have a vacancy estimate, PM costs, Cap expense estimate, maintenance estimate, any utility costs, and misc fees that often are calculated over the sum of RE investments such as LLC, umbrella coverage, office expenses (space/help/equipment), car mileage, etc. The 50% rule states that the cost of a property not including mortgage is 50% of the rent. I think this is accurate in low rent locales but too pessimistic in higher rent locations.
Unfortunately, I suspect an accurate cash flow estimate will show <$200/month projected cash flow.
I want to have an equity not much greater than 20% on each of my properties (no PMI but maximum leverage) but that is difficult to achieve for various reasons including the cost/hassle of refinancing, refinance LTV limits, etc. In reality, I probably have equity ranges from 25% to ~55%.
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Derrick E.
Investor · The Creek, WV · Member since 2014 · 890 posts · 1k+ votes
8y
@Chris Meunier I do it for the peace of mind and extra passiveness of the situation (not being forced to pull all nighters to get house rented because mortgage payment is coming up.) I like knowing that no matter what happens then I'm good. Worst case scenario is I lower my rents or I sit vacant a little longer than normal, who knows, possibly both. Not saying my way is right, but its the right way for us (my wife and I.)
I should also say that I buy cheaper homes than what you will find in coastal areas and do the work myself. I no longer work a 9-5 as I work full time on our rental properties.
For me, it takes out a lot of stress. I agree that you need to use some leverage to grow, but I use as little as possible. I'm all about the cash flow and thats what I invest for.
19 Reply
Tyrell Perry
Rental Property Investor · Cleveland, OH · Member since 2016 · 69 posts · 108 votes
8y
I'm in the same boat as @Derrick E. but like he, I too buy lower priced properties and leverage should be scrutinized differently for the lower priced structures.
Opinions will always differ on the subject as the decision is a matter of personal preference. If debt makes you lose sleep at night, pay it off, otherwise invest the money in other real estate ventures or business endeavors.
9 Reply
Anthony Wick
Rental Property Investor · Ankeny, IA · Member since 2017 · 2k+ posts · 3k+ votes
8y
What are everybody’s mortgages at, 4-5%? I’ll take all your cash, give you 5% returns every month for cash flow, and I’ll make 10-20% on your cash. All while your tenants still pays off your mortgages.
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Steve Vaughan
Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
8y
The rate wasn't mentioned and whether it is fixed, conventional residential or not, but I'll assume it's a long term fixed rate below 5% that doesn't bother you for your financials every year.
Not even I rush to pay down sweet residential mortgages at 5% or below and I paid off 19 rentals last year. Which ones did I pay off? Rates over 6% and commercial loans at 5.75%+ with shorter terms, adjustable rates, calls and hassle. And a seller financed house at 6% with an old guy. Didn't want to have legacy/heir risk. The son is in jail again actually.
I understand what you're trying to do more than most, but it's just too easy to beat 4-5% returns about anywhere. I would wait until I had at least 5 before paying off the 'good' loans. I waited until 35 before beginning to knock out the bad. Not all were horrible, the prevailing residential rates 15-11 yrs ago were 6.5% and I still had a few.
If you do decide to pay this off (you have $210k lying around?) make sure you have an opportunity fund still. Even while paying mine off I kept reserves and dry powder. Closing on a cash buy next week that's not bankable so he came to me. IRR will be over 20%. Be a shame if I had stuck it all into a 4% mortgage instead...
Oh- the 'tax befits' of carrying a mortgage. Don't let that be a big factor in your decision. Pay $10k in interest, get $3k back. Negative 70% 'return'.
10 Reply
Zach CumminsPro Member
Real Estate Agent · Carlsbad, CA · Member since 2017 · 53 posts · 68 votes
8y
First of all, be present in the situation you are in. What an awesome dilemma to have! My wife and I were recently in this situation with enough money in savings and individual investment portfolio to pay off our rental mortgage of 140k. We prayed about it and spoke with our financial advisor about it. And then I watched a YouTube video on Dave Ramsey. Look it up, it is called what To do if your investments can pay off your mortgage. He says, pay off the mortgage and if you don’t like the feeling of NOT having mortgage then go ahead and borrow on the property later. We created an extra $730 in passive income monthly doing this. We are now one step closer to bringing my wife home from work to be with our son because this passive income is freed up! Good luck!!
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Luka Milicevic
Real Estate Agent · Nashville, TN · Member since 2015 · 2k+ posts · 2k+ votes
8y
I'll give an example of a property i've owned 3 years.
Over 3 years my collective cash on cash return has been 55%. This is collective, not annualized. My annualized return is therefore 18.34%
Property has $76k of debt left.
If I pay off the $76k it boosts my cashflow $405/month $4860/year.
$4860/76k=6.39% annualized return
Let's say my original number of 18.34% was cut in half to around 9% because I had a bad year or a few bad years. I am STILL better off with the debt.
Honestly buying properties cash is nice in terms of safety. Have tons of equity will propably make you fall asleep easier, but anyway that I have sliced cash purchases it comes out to around a 7% annualized return. (In my market).
I am better off not dealing with property managers, tenants and contractors and investing in mutual funds.
My draw to RE is the leverage it provides and the increased returns you can get if you extend your money. There is of course a trade off between leverage and what Warren Buffet calls the margin of safety.
Either way, there is no right or wrong answer. It all depends on the individual.
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