Pros/Cons to paying off rental property early

91 Replies

Originally posted by @Tanya F. :

Most of you are replying are in your property acquisition phase. If you already own all of the properties you plan to buy, and have good cash flow, I would have no problem to pay off the loan.  If you change your mind in the future, you can cash-out refinance then.

I plan to pay off two of my properties in about 10-12 years. Hope to sell the third one. We are already living off the cash flow.

So many of the responses in this thread seem to be "more more more more more more". I'm going to express a different viewpoint and say that if you've reached "enough", you'll know it. If the cash is just sitting around, it's a fine idea to pay off your loan if you'd rather not invest it elsewhere, and it'd make enough for you in this property. Now, it's a totally different story if you plan on buying more properties.

I'll say it again. You can always cash-out refinance in the future if you change your mind.

 So you're saying that if you already owned all of your properties, it's OK to buy equity now (pay down mortgage with your own money), and then pay for it again later with interest (refi)?

It's all ok. That's the cost of changing your mind. 

Interest now versus interest later- that's a wash to me.

Buying equity is like investing anything anywhere. If the return is enough, that's where you put your money.

Numerous comments about investors going broke in 2008. Well, if you currently have an interest only loan on all properties, with a 3 year ARM, and/or have hard money loans sitting out there at 10-15%, then yes, you're more likely to go broke and haven't learned a thing. But, are we really in those times right now? It's not difficult right now to get fixed rate loans, especially if you have 20-25% down. Now, if you have a 4% fixed rate loan, and the rents cover all your expenses, cap ex, management, etc., and cash flows several hundred a month after all that, and the market takes a hit, you still have your exact scenario of cash flowing investment property. A simplified example to be sure, and I certainly have other investments as well, but I would never take $210,000 in cash and pay off a mortgage. If that's the only way for you to have piece of mind, then yes, it's the right move for you. Just not for me.

Originally posted by @Gordon Starr :

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.

 First, the stock market refer was based on "what would you do if your stock values went down"...you'd probably hold on until it recovered.  The same holds true here. You're Net Worth can be recovered...and while you're waiting for it to recover, you are still cash flowing (assuming you didn't buy a cash flow property with negative cash flow...LOL).   Why are you focused on Net Worth when we are talking about a rental?  You're talking "trophy money"...I'm talking real money.

Again, if the value of your property goes down after you've already bought it, and have your financing in place and tenant in place, your cash flow won't change.  The tenant isn't going to demand lower rent because the property value went down.  The interest charges on your existing loan won't change even if interest rates go up, so your mortgage payment isn't going to change if the interest rate goes up (unless you went in with a variable rate...talk about risk, wow!).

What happens to Rental Real Estate Values?  Who cares...I'm not selling (yet)...I'm renting it out.

If the "...rents don't cover expenses...".  How is this going to happen if you were cash flow positive to begin with?

This is the part that I can't follow...because it doesn't apply here:  

"...if aggregate rents don't cover expenses", 

Why would the rents all of a sudden not cover expenses?

"...you won't be able to get a loan in the first place..."

In the first place, you already bought the property...what loan are you talking about here?

"...unless you have some other income to pay for your cash flow negative, money losing investment". 

Again, why are we all of a sudden getting negative cash flow if it was positive before the market values went down?

"...The resale value of rental property in this scenario gets absolutely crushed because the vast majority of buyers exit the market".

Why are we selling a rental property?  I thought we bought them for the cash flow?  If the property was bought correctly in the first place, with positive cash flow, "resale value" is a non-issue.  If you want to sell this property, then just wait until the market values recover (like they did), and sell it then.  While you wait for the market recovery, enjoy the positive cash flow.

Originally posted by @Patrick Olownia :

I just want to say as a newbie I've absolutely loved every single aspect of this entire thread. So many great opinions and view points. LOVE IT.

Same here.. Truly like a religious discussion when someone throws out this kind of red-meat question.   So many differing opinions, some staunch, some relaxed.   That's what I've come to appreciate about this group of fine folks.. 

Gather all the info you can, and make your decisions...  "in the multitude of counselors.. is wisdom"

Cheers-

@Kevin Bass and @Patrick Olownia agreed. But we must all be careful to account for what is opinion and what is fact. 

You may be of the opinion that it is better to pay off your mortgage, for whatever your reason. But it is a fact that your return on investment will be significantly less. As @Joe Villeneuve has painstakingly pointed out.

So you may be of the opinion that you should pay it off, and it may be a fact that it makes you feel better personally. But it is a mathematical fact that it will reduce your return on investment and it is a fact that a cash flowing property will continue to hold the exact same risk in a down as an up market.

And not for nothing- for those worried about a downturn-why on God’s green earth would you want to sink $350k of your cash into a property that may lose it’s value when you could only sink $70k??? Am I missing something? 

Originally posted by @Joe Villeneuve :
Originally posted by @Michael M.:

I don’t believe the biggest risk going forward is a drop in property values but rather an increase in interest rates.  If you have adjustable rate mortgages you could see your expenses spike in the next few years.

On a $250,000 mortgage your annual payments will be $12,650 if you have a 3% interest rate and 30 year amortization.  If rates rise to 6%, those annual payments will rise to $18,000.  

For this reason I keep a balanced view on leverage.  I tend to run at 40-45% equity in my properties.  This keeps me safe and also gets me cheaper interest rates.  I’ve also locked in as long as I can on my properties (although because they are commercial multis it’s difficult finding loans that lock in for more than 10 years).

For me, these are an investment not a job.  I hire property managers and basically sit back and collect the checks.  If I were more involved with my properties I might be willing to take more risk, but at this point I need to focus on my day job.

"I don’t believe the biggest risk going forward is a drop in property values but rather an increase in interest rates. If you have adjustable rate mortgages you could see your expenses spike in the next few years" 

Why would you have an adjustable rate in the first place.  That's a very definite example of risk.  If you have a fixed rate mortgage, as you should, an increase in interest rate has no impact on anything with a hold property.

"I tend to run at 40-45% equity in my properties..."  

You mean you tend to "buy" 40-45% equity in your properties.

"...This keeps me safe..."

Keeps you safe from what?

"...and also gets me cheaper interest rates."

...and in the end you are "spending a dollar to save a dime".

OK Joe I’ll bite.  I assume you posted this more because you didn’t like my response to your comment saying many investors on this forum don’t have basic math skills (and I assume you put me in this group as I like to have equity).  However, I’ll put that aside and respond to your comments on my more recent post.

Before I start, let me apologize for the length of this response. I have a long journey on my daily commute in and out of Manhattan, I figured I’d try to explain how someone can still be good at math even though they don’t use your method of real estate investment. It might not be a productive use of my time but it will be more entertaining than listening to the same old boring news and/or sports radio. I’d be surprised if anyone actually reads the whole thing.

First let me say this, whatever your approach is to making money in real estate, I’m sure you’re much better at that specific approach than I am. I have an intense day job with a long commute which doesn’t give me a lot of free time to spend on my properties. I leave home before 7 and get home around 8 (I’m actually writing this during my long train commute home).  Any remaining time is valuable family time that I don’t want to spend putting up drywall or painting walls or chasing delinquent rent. For this reason I buy apartment buildings which are in major metro areas, which rent to stable professionals, which need no immediate capital investments, which have low vacancy rates, and which are easily handled by property managers.  I’d assume my “hands off” approach is much different from yours, although correct me if I’m wrong.

Secondly, I’m sure the returns you make on your investments are much better than mine. For me this is an investment and not a job. My goal is to have a safe hands-off investment to balance against my stock market investments. Basically a safe investment which outperforms the bond market. My most recent real estate investments in 2017 & 2018 give me returns of about 13%.  Not phenomenal, but pretty good given I do almost nothing post-purchase except collect profits from the property manager. I’m sure you’re doing better as are many others within the BiggerPockets community.

Having said the above, let me provide responses to your post:

My Comment:  "I don’t believe the biggest risk going forward is a drop in property values but rather an increase in interest rates. If you have adjustable rate mortgages you could see your expenses spike in the next few years"

Your Response:  Why would you have an adjustable rate in the first place. That's a very definite example of risk. If you have a fixed rate mortgage, as you should, an increase in interest rate has no impact on anything with a hold property.

Agreed, I said it because I was trying to warn those who use ARMs.  This is why I understand what you are saying about low-risk because you are insulated using long-term mortgages. I tend to go for mortgages on the longer end of the available spectrum too, but as I mentioned in my prior post getting a 30-year fixed rate on large commercial multi-unit properties is difficult to impossible. Freddie Mac won’t give anything fixed longer then 10-years.  I have mortgages which are fixed from between 7 and 10 years which gives me some insulation, but it is a financial impact I must model in my long-term view. I hope those with 3 or 5 year ARMs are prepared for their upcoming rate adjustments.

My Comment: "I tend to run at 40-45% equity in my properties..."
Your Response:  “You mean you tend to "buy" 40-45% equity in your properties.”

I’m not sure why you felt it important to correct this statement, but I don’t actually “buy” with 40-45% equity.  I tend to buy with 30-35% equity and increase equity as I pay it off.  Commercial mortgages force you to put more down as equity, at least 20-25%.  My properties all vary in % equity but average out to about that 40-45% which is what I call my run-rate.  Certainly not how I buy it.  If I missed your point, please better help me understand.

My Comment:"...This keeps me safe..."

Your response:“Keeps you safe from what?”

OK this is the hardest to answer, especially since several others have tried to explain why they are more comfortable with more equity in their properties but their reasons aren’t making sense to you. I’ll do my best to explain my situation.

My investment style is what I call “buy-and-die”.  I call it this for two reasons. First, it’s a way of avoiding capital gains taxes and sales commissions by never selling (although I have 1031’ed in the past).  Secondly, and more important for this response, it’s a way of making sure my family has steady income even if I get hit by a bus tomorrow. It needs to be easy enough that my wife isn’t overwhelmed with maintaining it as she’s trying to raise our young children by herself.  Something VERY easy should the worst happen. With this investment style I need to have decent equity in the property in order to not have all the cash flow go to the mortgages. I’m sure if I operated in riskier markets and had a higher cap rate return I could achieve this while using higher leverage, but that’s not my approach or my goal.

I’m sure in your approach you can make good cash flow even on highly leveraged properties. I’m glad that works for you, it doesn’t work for me.

My Comment:"...and also gets me cheaper interest rates."

Your response:...and in the end you are "spending a dollar to save a dime".

Ahhh here’s a small math dig, albeit in a much nicer tone this time for which I thank you.

Because we like math, here were the choices I had for mortgages on my upcoming June 1st purchase:

$3,635,000 mortgage at 4.50% (annual interest of $163,575)

$3,900,000 mortgage at 5.25% (annual interest of $204,750)

So the cost of taking an extra $265,000 in mortgage is an extra $41,175 in interest.  That’s actually 411,750 dimes per year.  It’s a little more than $10K above the median personal income of an American*.  Most importantly, that’s a 15.5% interest rate on the extra mortgage (41,175/265,000). I opted to put in more equity rather than pay the 15.5% marginal interest rate.

For 28 years I’ve worked in a job where it is my duty to evaluate risk & reward. In other words, I’m ok when it comes to math.  Please trust that I would never “spend a dollar to save a dime”.  The only times I am stupid with money is when I tip.

In fact, the most important thing I’ve learned over 28 years in the working world is not to think you are smarter than the next guy.  There’s more than one way to skin a cat so the approach that works best for you might not work best for the next guy. Hopefully this brings you a little closer to understanding why we all don’t operate using maximum leverage.

The American real estate business is very diverse and we all invest in our own unique ways.  Best of luck to you all in your own Big Pocket aspirations however you aspire to achieve them.  To those who had the stamina to read this whole post you certainly have the energy to succeed in any endeavor!

*https://en.wikipedia.org/wiki/Personal_income_in_the_United_States

@Michael M. I did not read @Joe Villeneuve quip as being insulting. People were commenting on how they would increase the return on their investment by paying off a mortgage. Mathematically speaking this is completely incorrect- and a rather humorous observation was made by Joe. I do manage my properties- so I am trying to account for the very thick skin of a landlord here!

I read your post in its entirety and I completely understand the opinions you expressed, but I can tell you that it doesn’t take away from the hard facts of the original posters question and subsequent responses. I also don’t know how the heck you would interpret Joe as insulting you when you didn’t even contribute until after his comment?

Overall I was really left quite saddened by your post. I too am doing this to provide for my family and my children’s future, but certainly not at the expense of their present. I would be absolutely crushed to spend so much time away from my family, especially with multi-million dollar holdings. 

Originally posted by @Patrick M. :

@Michael M. I did not read @Joe Villeneuve quip as being insulting. People were commenting on how they would increase the return on their investment by paying off a mortgage. Mathematically speaking this is completely incorrect- and a rather humorous observation was made by Joe. I do manage my properties- so I am trying to account for the very thick skin of a landlord here!

I read your post in its entirety and I completely understand the opinions you expressed, but I can tell you that it doesn’t take away from the hard facts of the original posters question and subsequent responses. I also don’t know how the heck you would interpret Joe as insulting you when you didn’t even contribute until after his comment?

Overall I was really left quite saddened by your post. I too am doing this to provide for my family and my children’s future, but certainly not at the expense of their present. I would be absolutely crushed to spend so much time away from my family, especially with multi-million dollar holdings. 

 Patrick I think you misread the tone of my post.  I was trying to explain in a reasoned way how someone would  need higher equity to avoid certain risks.  My risk has nothing to do with losing the properties but rather what is left for my family to survive on should something bad happen. 

 I was also trying to show that sometimes higher equity makes more sense financially from my own personal mortgage choices.  Please tell me if you would have chosen the more expensive loan with a 15% marginal rate or if you find that to be spending a dollar to save a dime?

As far as my long  day, please don’t be saddened.  it was meant to show why I can’t actively participate in my properties.  Millions of others do a long commute every day and still more work hard on their properties for long hours each day.  Each in their own pursuit of the American dream. 

I find there are too many hardened battles on this website where people take their approach as the only approach.  I try to see things from both sides.

I understood your post. 

I think you read to much into Joe’s analysis and interpret to much of it as slights.

Originally posted by @Tanya F. :

It's all ok. That's the cost of changing your mind. 

Interest now versus interest later- that's a wash to me.

Buying equity is like investing anything anywhere. If the return is enough, that's where you put your money.

 Buying equity isn't like investing anything anywhere.  It's just a transfer of cash from a bank (liquid) to a property (solid).  It has the same value in both places.

Originally posted by @Chris Meunier :

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. 

 So based on $6000 income today from your $20,000 investment, that is a return of 30%. Pretty darn good where you are today. If you put another $210,000 into paying off the property, you say that your return will be over 10%. That is not great when you think about it. You have to analyze the return on the $210,000 by itself to know if this is really the best way to deploy this capital. You could invest your $210,000 into an index fund and get over 10% annual return. The reason the numbers don't work is that 3.75% is really cheap money. You can't get a rate like that today, so paying it off just doesn't make sense financially when you can deploy your money for greater return other places.

46k invested.

Once this property is paid off I will use the extra income to quickly pay off the second.

56k invested.

I have attached graphs of a scenario where I use the cash flow I am making to pay off two properties in less than 15 years. This may seem like a great idea at first but if you look below at what the original 46k and taking the extra income would be like in the same amount of time. This is assuming a conservative 10% growth in the NASDAQ where 15.08% is the mean growth of the last 30 years.

It all depends on what you reason for getting into REI is and what you want to gain from it. It also depends on your timing in your life what other foreseeable circumstances.

I am in the same dilemma (good dilemma to have). What's interesting to me is nobody seems to discuss their financial earnings per year...which has a HUGE impact on this decision. 

I get it - you can argue til the cows come home..."let other people pay off your mortgage". Here's the reality, for most people, you won't benefit from this for 25-30 years. If you're 30 and just starting to invest you're 60. 

And in most cases you can over-leverage and it will probably work out if you do your due diligence.  

BUT

Here's my scenario. I can payoff the outstanding debt of 370k and make 3600 a month for life (outside of the typical taxes and what not). It's 3600 for life. This is what I will do. 

Here is where the monthly earnings come in. I can stash cash, while assuming a good life, and buy another 300k property with stone cold cash in 3 years. And by then, I am mortgage free, living in a 1 Million dollar home that others "pay for". 

Some of you will say it's stupid to have a 1 Million Place. But, life is short and I invest where i spend my time. 

Here's where it gets cool...

Because we are mortgage free, all our cash is cake. So we can buy more places with cash more frequently. It's piece of mind and if I do the math...I am 34 and will retire at 44 with 2 Million in RE and make 170,000.00 just to wake up. And save a fortune on interest. 

If you can't stash cash, I have to agree do not payoff the mortgage bc it takes too long to recoup earnings. However, if you make 250-300+ then I would absolutely pay it off. 

Having paid off properties is a win and insurance policy. Am I leaving money on the table? Sure. But if **** goes wide ways I don't care and I don't lose sleep, money, or quality of life. 

The choice is yours!

Originally posted by @Samuel Liapis :

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.

 Cash Flow is only part of the overall cash return analysis.

Look at it this way.  Approach this like you're back in Algebra Class (see, you ARE going to use it)...remember Vectors?

<----------This is negative                                  |                                            This is positive------------>

                                                                         -  0 +

When the Negative is greater than the positive, you are losing money.  Profit doesn't start until you recover ALL of the cash you put in.  The more cash you put in, whether from the start or as you go along, the more you have to recover before any profits are made...and the longer it takes to get there.

This means that when you pay down your mortgage from your own pocket, you are going backwards...not forwards.  When your tenant pays your mortgage (As in rent payments) you are moving forwards since that isn't money you have to recover first.

Oh, and risk?  You are more at risk without that mortgage, than with it.  Just ask any lender.

To me, the situation depends on your age/retirement goals.  It's almost the same thing as allocating your 401k in stocks when your young and shifting to debt instruments as you get older.  Using leverage on real estate is a great growth strategy that will yield greater returns and expand your portfolio,. albeit it with some risk.  When you're older, and thinking about retiring, then having paid off properties generating consistent income is the way to go.  So, there are no wrong answers here.  It just depends on what you're trying to accomplish.