Are you asking yourself: Should I pay off my rental property mortgage early? It's a dilemma given interest rates are low, but less debt is better than more debt. Further, what if you could earn a greater return than the mortgage rate by investing instead?
This article will provide you a rational framework on whether to pay off your rental property mortgage early or invest. I've personally paid off one rental property mortgage early and have never regretted it.
That said, post pandemic, I'm very bullish on investing in rental properties. Being able to benefit from rising rents and rising property values is a powerful wealth creator.
Pay Off Rental Property Mortgage Early Or Not
When you buy a rental property you have to treat it as an investment. When you treat it as an investment, you focus on the cost of capital and the potential returns. Therefore, the easiest first decision you can make is to compare the mortgage interest rate with the potential return of the stock market.
The higher your mortgage rate, the more capital you should allocate to paying it down and vice versa. Here's a framework I've used when it comes time to pay down debt or invest. There's always a split between paying down debt and investing up until the interest rate is 10%. After 10%, all cash flow should be used to pay down debt.
For 12 years, I followed the FS-DAIR framework until I finally I paid off my $465,000 rental mortgage early in 2015. I have no major regrets, but there are several circumstances where you might not want to do that.
Biggest Downside To Paying Off Rental Property Mortgage Early
First, consider the biggest downside. When you’re out of debt, life is easy. Too easy. Taking on a big mortgage when I was 26 made my motivation to work hard shoot through the roof.
If I got a bad work review or got laid off, I’d be screwed! But before I took on the $465,000+ in debt, I was thinking of moving back to Hawaii and being a surf bum after just four years of work post college.
My grandparents owned an 8 acre fruit farm in a rough part of Oahu (Waianae) that needed tending. How wonderful would it be to grow mango, pumelo, and papaya trees, eat mangos, pumelos, and papayas for breakfast, and then drive five minutes to the beach to surf?
At the very least, I’d be super fit and happy as an aimless 20-something year old with not a care in the world.
Motivation is my number one reason not to pay off a mortgage early too young. Keep that albatross on your neck until you’ve done as much as you’ve wanted with your life as possible.
After all, interest rates are still low and the interest paid can generally be deducted from your income up to $750,000 worth of mortgage indebtedness for new loans.
More Reasons Not To Pay Off Your Rental Property Mortgage
Here are the other situations to consider that could make paying off a rental mortgage early a poor choice.
1) You lose your mortgage interest deduction. The mortgage interest is treated like a business expense for rental property. This deduction is most important in high tax brackets.
2) You lose a low borrowing cost. It makes sense to hold onto a low fixed mortgage rate for as long as possible. On the other hand, if you borrowed at a high rate either pay it down or shop around and refinance.
3) You tie up capital in an illiquid asset. Unless you have a very diversified net worth, having a lot of capital tied up in a property can be risky.
4) You miss out on opportunities to invest more efficiently. If you’re an accredited investor, instead of tying up all of your capital in one property, you can invest surgically in multiple properties through real estate crowdsourcing where valuations are much cheaper and never until-year-olds are much higher. I’ve personally diversified my real estate investments by targeting properties vetted by Fundrise in the heartland of America.
5) You decrease your financial returns. If you put 20% down, a 4% appreciation on the property means a 20% cash on cash return thanks to leverage e.g. $100,000 down payment on a $500,000 house that appreciates by $20,000 = $120,000 equity, a 20% increase. If you’ve paid off the other $400,000 in mortgage early, the return falls all the way down to 4%.
Generally Never A Bad Idea To Pay Off Debt
If you no longer need motivation to achieve financial freedom, pay off your mortgage. Not having the tax shield isn’t the end of the world because you still have the non-cash depreciation shield as a landlord.
Your goal should be to become debt free when you absolutely have no desire or ability to work a day job or maintain a rental property. You’ll find that the older you get, the less you want to deal with tenants.
It feels great to not only have no mortgage on one rental property. It feels even better after I sold another rental property and re-invested the proceeds in passive income investments that require no work.
Refinance Your Mortgage
San Francisco-based Credible is a lending marketplace that provides real quotes for free. Instead of applying for a mortgage on different platforms, it’s way more efficient to apply to refinance or get a new mortgage on Credible where multiple qualified lenders will compete for your business.
Take advantage of low interest rates by getting pre-qualified lenders to compete for your business. With mortgage rates so low, it may be better to refinance versus pay off a rental property mortgage or any more. My latest mortgage rate is a 7/1 ARM at only 2.375%.
Achieve Financial Freedom Through Real Estate
Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile, provides utility, and generates income. If you have a rental property mortgage you're considering paying off, then you appreciate the value of owning rental properties and their cash flow. However, you may not want to deal with the hassle.
Take a look at my two favorite real estate crowdfunding platforms where you can invest 100% passively. Both are free to sign up and explore.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the way to go.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio.
About the Author:
Sam began investing his own money ever since he opened an online brokerage account in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at two of the leading financial service firms in the world. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate.
In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $300,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies and writing online to help others achieve financial freedom.
FinancialSamurai.com was started in 2009 and is one of the most trusted personal finance sites today with over 1.5 million organic pageviews a month. Financial Samurai has been featured in top publications such as the LA Times, The Chicago Tribune, Bloomberg and The Wall Street Journal.
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