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:
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.
Hi Everyone! I have a rental property with the following details:
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.
I would pay it off in a heartbeat and be done with all the risk and hassle of trying to find an investment that pays more. If you are in California, you probably won't find one. The market is too frothy in CA. It is no longer justified by fundamentals (i.e cash flow), only speculation that the value will go higher. That is why so many people are selling CA and buying the Midwest. I wouldn't do that either. Good luck!
After reading a number of posts here, I can't help but wonder how many investors passed basic math classes. I guess they were the ones that said, "why am I learning this...I'm never going to use it",...and they were right.
After reading a number of posts here, I can't help but wonder how many investors passed basic math classes. I guess they were the ones that said, "why am I learning this...I'm never going to use it",...and they were right.
There was actually a post on another thread this week about HELOC's and the guy said math is getting in the way of people understanding the concept.
The great thing about math is that it is always right and it isn't emotional. Sometimes it reveals an inconvenient truth.
My guess is half the people on this website couldn't calculate a cash return or interest without the help of a pre-populated spreadsheet formula.
Lots of good ideas here, pros and cons on all sides. Everyone has different goals, different ideas and different ways to achieve them. A few things to remember, always calculate your Capitalization rate on CURRENT VALUE and not on what you paid for the property. For instance, if I paid $100,000 for a SFR that rents for $1,000 a month, using 50% for all expenses, I have a 6% cap rate, $6,000/$100,000. But if that property goes up to $200,000 in value and the rent has only risen to $1,200 a month, I have a Cap Rate of 3.6%, $7,200/$200,000. One possibility I have not seen is to sell your current rental, use a 1031, add your cash to it, and buy a nice, multi family property, or buy several SFRs. If you have only one rental and are young, wanting to add to your portfolio, I would advise you to buy four more properties, put $50,000 down on each, with a buying range of $150,000 to $200,000, and get a minimum of 1% of purchase price in rent. I did this when I sold a Texas property and bought 2 SFR's in Missouri. With no money out of pocket, I raised my monthly income from $1,500 to $2,200 with no raise in debt service and got a lot LOWER property tax bill and lower insurance costs. With all my costs, all the numbers, bottom line is that I raised my net monthly income about $1,000 without costing me a dime. This took some work on my part, but Real Estate Investing is NOT PASSIVE if you are still buying and selling. It only becomes passive if you are done buying and selling, have all of it under GREAT management, and are resting on a Caribbean Beach!
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.
Is no one going to ask what the 2nd Golden Rule is? :)
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.
Is no one going to ask what the 2nd Golden Rule is? :)
Golden Rule #2: Never, under any circumstances, for any reason or rationalization, ever...forget Golden Rule #1.
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!!
($730 x 12) / $140,000 = 6%. That's your ROI for paying off your mortgage early. I'd go borrow on that property again and look for an investment paying more than 6% but that's just me. :-)
I would not consider putting my personal money into a rental property to pay it off.
I would consider putting my own money into my own home to pay it off
I would consider putting extra money from monthly cash flow (from the renters) towards paying off rental properties.
I'm not saying I actually do those last 2 things, but they are things that would at least be on the table to consider.
I think it is worth pointing out that even if you do pay off a property early, you can always draw on the equity later using a HELOC or even a full cash out refinance. My point is that "paying off a mortgage early" isn't a fatal mistake as some would have you believe.
That being said, I agree with others that leverage will allow you to scale faster.
It also may be helpful if you shared your numbers with us, such as loan amount, loan term remaining, loan interest rate and original cash down payment. When deciding to pay down debt, these are important details to consider. For example, I have a loan on one property that is 3.5% interest rate, which is close to what I can get in an FDIC bank CD. Hard money could be 10% or more, so the math would change greatly. Lots of space in between...
I can tell you looking at the numbers you provided that paying off $210,000 will not return you 10%.
Hi @Joe Splitrock--here are some more details. There is about 26 years remaining on 30 year fixed mortgage at 3.75%. Initial cash investment was minimal, let's call it $20k. Also for everyone else on this thread, I totally get that cash on cash return as a % would be maximized by allocating this money across multiple REIs. However as I stated originally, my goal at this point is to maximize passive income and grow that as quickly as possible.
@ Here's a math question, what happens to your net worth if you are leveraged at 70% LTV and the value of real estate drops 30%. Here is another one, what happens to rental resale values if the interest rate goes up to the point your rent doesn't cover expenses? Whole other meaning for brrrr. Like brrrr its cold out here. or you are brrrroke. Am I right?
The only things that I would add is that this property is not cash flowing at ~$600/month. You said rent of $2500 and PITIAS of $1950. There are many other factors that you need to add in here to calculate actual cash flow. Feel free to search but here is a plethora of information here and available in free calculators.
In regards to the payoff, what is the 210k doing right now? Money borrowed at 3.75% is pretty low and can you make better use of that 210k somewhere else? Very Likely. However, maybe that money is sitting in a checking account at .05% interest with no plans to invest it or buy other properties. If that is the case there maybe an argument being made to have that money "earn" you a return of 3.75%, as stated you could always get some of that back with a HELOC or cash out refi.
After reading a number of posts here, I can't help but wonder how many investors passed basic math classes. I guess they were the ones that said, "why am I learning this...I'm never going to use it",...and they were right.
What an incredibly condescending comment. While I agree that using leverage is the way to get the most out of your investment, there are different goals for people on this website. I would say from reading some posts on this topic, there are some people with very low social IQs.
For those who forgot, here's the first golden rule:
@ Here's a math question, what happens to your net worth if you are leveraged at 70% LTV and the value of real estate drops 30%. Here is another one, what happens to rental resale values if the interest rate goes up to the point your rent doesn't cover expenses? Whole other meaning for brrrr. Like brrrr its cold out here. or you are brrrroke. Am I right?
Here are math answers:
1 - Rental properties are cash flow focused, so if the LTV goes down, and the cash flow stays the same, which it would, the property has the same value it had before. What hapens when your stock value goes down?
2 - Interest rates on fixed loans don't changethe loan payment, so nothing would hapen to the cash flow since therent wouldn't change...either. What other expenses does the interest rate impact?
Never mentioned the BRRRR strategy, so why bring it up?
Buy and hold means buy and hold.
We all saw a lot of leveraged guys go bust last downturn. The old two edged sword cliche.
I never thought I'd see it happen but last year I had a fully rented paid for free and clear single family rental that lost money! Not thru tax and accounting tricks but lost real money. When everything seems to break and needs repair all at once it hurts!
Having numerous paid off houses and a nice contingency fund made this an interesting anomaly and not a devastating calamity.
What happens to your net worth if you are leveraged at 70% LTV and the value of real estate drops 30%?
Try again Joe, you can mathematically calculate LTV goes to 100% and your net worth, or the portion of it you have in real estate becomes negative. You owe more than you receive when you liquidate. You cannot sell the property unless you bring cash to the table. You have nothing in the way of net worth from your RE portfolio.What happens to rental resale values if the interest rate goes up to the point your rent doesn't cover expenses?
Try again, if aggregate rents don't cover expenses, you won't be able to get a loan in the first place unless you have some other income to pay for your cash flow negative, money losing investment. The resale value of rental property in this scenario gets absolutely crushed because the vast majority of buyers exit the market.
These scenarios are particularly germane to California rental real estate that doesn't cash flow at its current value. Its an interest rate increasing environment and high price environment for RE investors and this is why I wouldn't advocate keeping a huge loan just to own more of it!
In regards the stock market, leverage leads to market froth and subsequent crash and I believe it is now illegal.
Another way of looking at this is to do CoC ROI for the first year only. After the first year start calculating cash-on-equity ROI. As the property value increases, and the renters pay off the mortgage, the CoE ROI will decline with time. When the CoE ROI becomes less than the CoC ROI you will make on a new investment, it's time to get the equity out of your original property and reinvest it.
@Chris Meunier - to clarify my math below, I'm assuming you're making $600 per month right now which comes out to $7200 / year. I wasn't sure whether to use that or $500 per month which would come out to your originally-stated $6000 per year, so I just picked one.
I'm also assuming that you're taking into account percentage expenses such as CapEx, maintenance savings, vacancy savings (I did see him mention "before any maintenance costs", @Dan H.)
The last thing that I will assume is that you're sitting at exactly 20% equity on a loan of $262,500 - the reason for this is that it'll take out any extra equity that you could possibly pull out of the current property. It also gives me the assumption that you have $52,500 currently invested.
Following these assumptions:
$52,500 - total invested currently
$7200 - total annual income
$210,000 - total available cash
Option 1: put all $210,000 into your first property
$262,500 - total invested currently
$30,000 - total annual income
$0 - total available cash
In another 7 years, you could double your income to $60,000 if you save all of your rental income to reinvest. I'm going to assume that you won't leverage this property by refinancing or taking out a HELOC since you went through all of the trouble to pay off the debt in the first place.
Option 2: put all $210,000 into 4 more properties with similar cash flow as your first property (this comes out to exactly $52,500 * 4 = $210,000)
$262,500 - total invested currently
$36,000 - total annual income ($7200 * 5 properties)
$0 - total available cash
In another 5.8 years, you could double your income to $72,000 if you save all of your rental income to reinvest. If you leverage your 5 properties and refinance or HELOC, you could do this sooner.
The numbers above are snapshots of what you will have immediately. Cash flow is higher in option #2, at the cost of increased debt. Assuming fixed interest rates, this shouldn't bother you unless if you want to do speculative investing (will your properties appreciate or depreciate?)
I want both of my points to stand out, so I was liberal with my use of bold.
When investing in real estate, debt shouldn't bother you as long as it increases your cash flow. If you believe this, then Option 2 should be the logical conclusion. Smart investments, and allowing for proper vacancy savings etc will protect you from any "all-nighters trying to get a tenant because the mortgage is coming due". If you need to pull an all-nighter, and if you don't have one month of mortgage saved up in vacancy savings, you've been failing in your investments.
If your goal is to increase passive income in order to retire, then Option 2 will get you there fastest. Option 1 will still get you there, but it will be slower. You have to look at your own goals and decide how quickly you want to get there.
A long read - sorry for that. I wanted to at least give some maths to back my answer.
Clearly a lot of left brained investors at BP, which is to be expected. But often the original posters question has to be answered with an emotional component. In my case for example I love debt, why use my money when I can use the banks. Even in Memphis with limited appreciation as long as I can get $200 a month surplus cashflow per property I am having a party every time I get another loan. My wife, who went through my destruction in the GFC in New Zealand, hates debt with a passion and never wants any bank to be in control of our life. So we have debt on some properties but a lot less than I would. That way we can both sleep at night.
So as the OP has 2 positive options and zero negative outcomes, do what feels best in your gut.
You could also put that 210K in a REIT of your choice or VGSLX and be 100% passive, since you did mention passive income.
Ask any investor who went broke in the 2008 crash. What went wrong? Oh, and there was a LOT of them, most of which will never recover. Debt = liability. I personally hate liability and want to pay my self the 5% mortgage interest over the years, rather than the bank. I can come up with deductions other than mortgage interest. Once the properties are paid off I can owner finance to keep the income stream in my golden years or continue to collect rent without paying the bank first. If I wanted to be a BIG investor my strategy would be different. I just want about 5 paid for properties, that's all I need, the Roths will do the rest. Besides, about 5 paid for rentals is so much less work and stress than say 40 or 50. I guess im a dumb a$$ at math.