Should you pay off a high interest rental mortgage or keep it

Question

There exists a common misconception regarding the financial implications of mortgage interest particularly among real estate investors. It is frequently asserted that these expenses are tax-deductible, and that property owners should not be worried about them, as rental income will offset such costs. Some advisors even recommend against fully paying off a property, regardless of prevailing high interest rates. However, after considerable personal research as a newbie, I have come to understand an important difference: the fact that mortgage interest is tax-deductible does not equate to 100% of the paid interest being returned to the borrower. That was my understanding and I wonder who else thinks like me. Here is the truth, the benefit is limited to a reduction in taxable income, which results in savings equivalent to the taxpayer’s marginal tax rate.

To illustrate, consider a loan amount of $150,000 at an interest rate of 7.125%. Over a thirty-year period, the total interest paid would amount to $214,183. The corresponding tax savings, derived from interest deduction would be approximately $47,121. Consequently, the actual cost incurred by the borrower remains $167,062, even after accounting for tax benefits.

In summary, while the deductibility of mortgage interest provides some financial relief, it does not fully offset the substantial cost of interest payments. Prospective borrowers should carefully evaluate the true financial impact of mortgage interest, rather than relying solely on the perceived advantages of tax deductions.

Kevin Sobilo · Answer

@Patience Echem, a few thoughts:

1. The mortgage deduction does not AT ALL offset the income loss. You simply don't have to pay income tax on the revenue because you paid out mortgage interest as an expense. Its just an expense like any other expense.

So, you are correct, that the idea that keeping a mortgage because the interest is deductible as the reasoning is faulty.

2. That said, there are a number of things to consider about whether to pay off a property. For example RISK! A paid off property leaves your ASS-ets hanging out there if someone were to sue you.

3. In your example a loan amount of $150k. If you don't pay that off, you could buy another ~$750k in real estate (with mortgages). If those properties go up JUST 2% in value per year (market appreciation) that is $15k per year or 10% of the $150k you invested!

So, compare that 10% gain versus the 7.125% interest in your example. That does not factor in mortgage paydown, cash-flow, or value-add opportunities either!!!

4. If you are an active investor, often the choice will be to NOT pay off mortgages because you can be more gainful putting that money into new investments.

5. If you are trying to become less active or passive, then you might wish to consolidate and focus on cash-flow and pay off some mortgages. That might not be the most gainful choice but might meet your personal needs/goals at the time.

Aaron Zimmerman · Answer

I think it comes Down to what stage you're in as an investor. If you're in the growth stage, you'll need to take on more debt.

When you're looking to use some of the rental income, paying off debt can make sense.

your math is 100% right but I'd think about paying off the mortgage with this context in mind.

Dan H. · Answer

I am surprised that anyone that invests is not clear on tax credit versus tax deduction.   Tax credit are write offs often dollar off for each dollar spent on items that are being incentivized.   They are unrelated to income.  Tax deductions reduce the taxable income resulting in savings on your taxes based on taxable income but much less than dollar for dollar.

The tax savings are not the primary reason for the use of leverage.   The primary purpose to leverage is to increase ROI and to achieve a growth that otherwise would not be possible.

It is bonus that it results in tax deductions.   Even if you are not in a position to itemize your tax return to benefit from the interest deduction, leverage is still highly desirable.

In my market, doing this for many years, I have yet to see a single underwriting that indicates a property is projected to produce a better return unleveraged than leveraged.

I will go further, in most markets unleveraged RE underwriting does not project a return that justifies the effort and risk of RE.  Note S&P has a historical return near 10%/year.   Why take the effort or risk of RE for anything close to that return.   I have yet to see an underwriting of unleveraged RE without a value add that can justify the effort and risk of RE.

Leverage is what makes RE lucrative to hold.  There is money to be made in value adds and i am a big fan of sophisticated value adds, but they require a value add to make money.  Sophisticated value adds can be done with lower efforts; all value adds require some effort.   If you are going to hold and expect the return to crush passive options, leverage is a must.

Good luck

Dan H. · Answer

>As for Leverage, it is most effective when interest rates are low. In the current market, however, over the past two years, these high rates have meant that leveraging often results in much of my effort benefiting the lender. Which is why after doing the math I found out that paying off my current high interest rate is a better financial decision.I would be very interested in seeing the underwriting that showed zero leverage out produced a heavy leveraged RE at the interest rate you indicated.   It would require a market with very low historical appreciation.   In virtually all markets, the underwriting will clearly favor the leveraged position.   If you dm me, I will provide an email that you can send your underwritings (with and without leverage) to see if I can identify the disconnect.It is a rare market that unleveraged RE can provide a long term ROI that justifies the work and risk of residential RE.   S&p has historical return of ~10%/year.   Residential RE is not passive and has numerous risk items.   To justify a residential RE long term hold, the RE ROI should far surpass passive options.   My threshold is if it does not have personal value, the ROI needs to exceed 20%/year to CONSIDER.  This typically cannot occur without leverage.in most markets the only reasons to go unleveraged is 1) leverage causes you stress.  money is only good if it provides a quality of life improvement.   Stress lowers quality of life.  2) you cannot obtain reasonable financing.   here is rough napkin math on a 0% LTV, 1% rent ratio, 50% expense/vacancy, 4% appreciation return noting 1% ratios are much harder to find in class b areas than they used to be and in class c areas the expense/vacancy is likely to exceed 50%.  Note there is no fixed part of the expenses such as there could be with a fixed rate loan so if rent increases at same rate as expenses, this projected return is ongoing. Note no equity pay down due to no loan.  There is tax benefits but they vary so significantly that I will not project them.6% return cash flow (monthly rent * 0.5 * 12) + 4% appreciation = 10% projected return plus any tax benefits.  Basically own residential RE with the effort and risk for the same return as can be projected long term for the passive S&P.  No thanks.  Use a lower expense/vacancy number to achieve better but realize the challenges of getting a 1% ratio property that can project 50% vacancy/expenses.   Basically I am stating this nderwriting would be aggressive on a very large percentage of rental properties.Good luck

Joe S. · Answer

Depends of course….🤓

For an active skilled investor reinvesting the money instead of paying off, the mortgage can produce a better return. Now, if you took the money and did not reinvest it and simply wasted the money because it was not properly allocated then it probably would be better to pay off your underlining high interest mortgage.

At the end of the day, only you can really decide what you’re going to do though.✅

Patience Echem · Answer

Making decisions especially when one lacks expertise or knowledge in a given subject is hard. It is difficult to determine the best course of action, making it invaluable to seek guidance from those with experience. By engaging with people like you who are knowledgeable I can gain insight that might otherwise be inaccessible. This is the foundation for good decision making. Thank, Joe.

Patience Echem · Answer

The best thing that happened to me in my real estate journey is a colleague telling me about bigger pockets. This site through people like you Aaron, and many others I cannot mention here, along with its podcasts have provided most of all I know about real estate investing.

Patience Echem · Answer

As a newbie, I have often heard advice suggesting that it is better to keep a mortgage due to the potential tax benefits. The prevailing notion is that maintaining a mortgage can result in favorable tax outcomes, making it financially advantageous for investors to avoid paying off their mortgages. Many people believe this strategy always leads to positive financial results. However, I recently learned that there are situations where keeping a mortgage for tax reasons may lead to a negative financial outcome. You are right Aaron, considering everything, not just taxes, is a better way to go.

Patience Echem · Answer

Thanks Kevin,

This offers a more balanced perspective.  Using the money as down payment to acquire more properties with leverage will benefit an investor who is still in the process of acquisition. As a tax strategy only, holding on to mortgage does not always serve an individual.

Patience Echem · Answer

Dan,

No one should be surprised by the varying levels of knowledge individuals possess on any given subject. Recently, I have started to better understand the differences between tax credits and deductions. For a long time, when I heard people mention that an expense was “deductible,” it seemed as though they meant a dollar-for-dollar savings. Discovering that deductions simply reduce the taxable amount—rather than the tax liability itself—was a revelation for me. Thank you for adding to that knowledge.

As for Leverage, it is most effective when interest rates are low. In the current market, however, over the past two years, these high rates have meant that leveraging often results in much of my effort benefiting the lender. Which is why after doing the math I found out that paying off my current high interest rate is a better financial decision. Although the S&P 500 offers respectable returns, its volatility is a concern. This uncertainty is the primary reason why I have diversified my investments to include real estate even when I know I may never complete a major value add project. Diversification provides a measure of stability for me and helps me sleep better at night. Perhaps I should refinance when rates drop to take advantage of leverage?

Should you pay off a high interest rental mortgage or keep it

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