After buying my latest primary residence, I now have four mortgages. Three mortgages felt OK since one was a primary home mortgage, the other is a vacation home mortgage that produces income, and the last one is a rental property mortgage that is cash flowing nicely. But four mortgages feels like too much, and I plan on doing something about it by paying one off!
I’m sure only a small minority of you think having four mortgages is OK. Even though being leveraged in a rising real estate market is good for building net worth, eventually the good times will end.
What’s interesting about personal finance is that we all have different levels of risk tolerance. Some people aren’t comfortable with any debt, hence they don’t borrow anything. I admire such people for their ability to live thoroughly within their means. Other people let lifestyle inflation get the best of them and take out massive debt that is not comfortably supported by their income. Obtaining credit is so easy in America. The only people who annoy me are those who expect others to constantly bail them out.
One of the curiosities about debt is the joyous process of getting into and out of debt. There’s a certain thrill of buying things with debt. Everybody wants something they can’t have or fully afford, including myself. Then once we reach a maximum debt limit, it’s almost equally as fun getting out of debt. Each $1 that is paid down feels like a victory. We tell our friends about our progress and look like heroes. It’s a win both ways!
This post will review my thoughts on the ideal mortgage amount based off the ideal income amount, discuss the history of my first mortgage, share more reasons why I’m paying down that mortgage, and my new mortgage pay down strategy.
THOUGHTS ON THE IDEAL MORTGAGE AMOUNT
The ideal mortgage amount is essentially the maximum amount the government allows you to deduct based off the ideal income level of $200,000. Given the government loves to take advantage of people through a “do it or pay a fine or go to jail” type of rule, it behooves us all to take advantage of anything they allow in return.
The current maximum mortgage indebtedness is $1 million + $100,000 for a Home Equity Line Of Credit (HELOC), which I don’t recommend anybody take because the interest rate is higher and it will just give you more temptation to spend. With mortgage rates under 3% for a 5/1 ARM and under 4.5% for a 30-year fixed, you’re paying $30,000 – $45,000 a year at most in mortgage interest.
Given it’s a good rule of thumb to spend no more than 30% of your gross income on all housing expenses, an income level of around $200,000 +/- $50,000 is optimal. As of 2014, mortgage interest phaseout begins with incomes of $254,200 or more for individuals and $305,050 for married couples filing jointly. All of these numbers coincide with the 500+ survey participants on Financial Samurai who agree that $150,000 – $250,000 is the ideal income for maximum happiness as well.
Whatever your gross income is, multiply it by 30% to figure out how much mortgage interest a year and other expenses you can afford and work from there to get an appropriate mortgage for you. 30% isn’t a hard rule, but a good general estimate based on current rates.
HISTORY OF MY FIRST MORTGAGE
The mortgage I plan to pay off comes from a property I purchased in 2003 for $580,000. It is a two bedroom, two bathroom condo with parking in a prime location in San Francisco that overlooks a park. It’s nothing fancy, but it has everything I wanted as a first time homebuyer. I put down 25% and took out a $435,000 mortgage on an income of roughly $200,000. My initial mortgage interest rate was around 5%, which has since come down to 3.375% thanks to several refinances.
I lived in this property for two years and loved it. Given it was my first property, I wanted to be a little conservative. But I also felt the itch to buy more because my range was up to a $900,000 purchase price with a $720,000 mortgage. One always regrets not buying more in a rising market not only due to rising real estate prices, but also due to rising income levels.
After conducting some mortgage arbitrage on my new house by borrowing $150,000 more than I thought I would at 2.5% to pay down $150,000 worth of my rental property mortgage at 3.375%, I’m left with roughly $118,000 on the rental. It’s been 11 years since I purchased the property, and I’ve been inspired by others around the web who have paid down their mortgages in much shorter periods of time. Sure, they might have smaller mortgages to begin with, but everything is relative since mortgage amounts are dictated by income amounts.
WHY I’M PAYING DOWN MY MORTGAGE EARLY
1) Discomfort. The $118,000 rental property mortgage has now become a nuisance because it feels uncomfortable having four mortgages despite the positive cash flow. Every time I log into my Personal Capital account, all I think about is how great it would be to just delete that liability from my net worth as I seek to minimalize. The nuisance feeling is the same reason why I decided to pay off my MBA student loans after the fourth year, even though the interest rate was under 3%.
One of the biggest fears I have with paying down a mortgage is locking all that money in one asset that might blow up. But given that I’ve purchased another property, I’ve effectively diversified my asset holdings so that my rental property now only accounts for 18% of my total property holdings vs 28% previously. In other words, I feel more comfortable having more money tied up in my rental property because the pie has grown. Once I pay down this rental mortgage, I can then focus on paying down my vacation property mortgage and so forth.
2) Low mortgage and interest for a while. 3.375% is a pretty good rate for a rental property mortgage. But 3.375% is still about 1% higher than the current 10-year risk free rate. Because I don’t think interest rates are going to rise by more than 1% for years, the “value” of my 3.375% mortgage is not as great as others who believe interest rates are going to skyrocket. Let’s say a comparable mortgage has an interest rate that climbs to 10% in two years. Then of course I should borrow at 3.375% for as long as possible. But since I highly doubt this will be the case, I’m just going to pay it off. If I’m wrong, I’ve still got three other mortgages at low rates.
3) Lower tax bracket. A mortgage is most beneficial when one is in a high tax bracket. If you’re in the 35% and 39.6% Federal income tax bracket and make less than ~$700,000, you should probably keep your mortgage for as long as possible. The mortgage phaseout will eventually completely nullify the interest write-off potential hence why I wrote “~$700,000.” Now that I can go between the 25% and 33% tax bracket depending on how much I pay myself, the mortgage interest shield is less meaningful. Remember, everybody gets a standard deduction of $6,200 for single filers, $9,100 for head-of-household taxpayers, and $12,400 for married couples filing jointly and qualifying widows/widowers as of 2014. The deduction will only continue to grow over time.
MORTGAGE PAY DOWN STRATEGY OF THE PAST
I basically deployed three mortgage payoff strategies over the past 11 years:
1) Refinanced my mortgage every chance I got. I refinanced my rental property mortgage three times. I originally got a 30-year fixed at around 5%, but soon learned my lesson to switch to a 5/1 ARM a couple years later. The initial mortgage payment used to be divided into 80% interest and 20% principal. But due to a lower rate, the percentage of the payment going to principal doubled. If you haven’t refinanced in a while, now is the time to check the rates online and do so as the 10-year yield has declined from 3% to under 2%. As of 2H2016 I just finished refinancing a 5/1 ARM into another 5/1 ARM at only 2.375%!
2) Randomly threw extra money at the mortgage when times felt good. I never had a systematic mortgage payoff strategy. I originally thought I would pay off the mortgage by 2013 (10 years), but because interest rates kept on going lower, I decided to delay the payoff strategy and reinvest my proceeds elsewhere. When times felt good I’ve gone to the bank to pay down anywhere between $500 to $30,000 of the principal since 2003. But with this post, I’m going to get more methodical now.
3) Paid my mortgage on time. The principal payments each month have grown from roughly $250 a month now to $1,000 a month with refinancing and extra principal payments.
NEW MORTGAGE PAY DOWN STRATEGY
1) Use some after-tax consulting income. Consulting income is considered “bonus” income for me as I never anticipated being a consultant when I left my day job in 2012. But it’s been eight months now of receiving a steady consulting paycheck. I’ve been currently living off a small paycheck I pay myself from my business and the excess rental income in order to never touch principal. Allocating consulting income to paying down a mortgage feels purposeful and will give me added incentive to continue being a consultant. When you don’t need to work, it’s easier to just do whatever you want and lose discipline at work. Monthly mortgage pay down target: $5,000
2) Reallocate $10,000 worth of expiring structured note investments every six months. I buy a structured note in an index or particular stock every two months on average to consistently build my investment portfolio, dollar-cost-average, and diversify my equity investments. The investment amounts range from $5,000 – $50,000 a note, and they are in all sorts of different things. The most recent expired note is a $15,000 LinkedIn, one year note that paid 2.5% interest a quarter if LNKD closed above $168 at expiry. At one point, LinkedIn was under $168 a month (20% below when I first bought the note) before expiration and I would have lost 20%+ of my investment. Because it closed above $168, I got 100% of my investment back plus the 10% interest income. I feel like I escaped with a $3,000 victory and I plan on keeping that victory alive by going for a 100% guarantee by paying down my 3.375% mortgage down. Annual principal pay down contribution target: $10,000 ($833 a month)
3) Utilize 100% of excess income from target rental property. Given the rental income is $3,800 and the rental mortgage is $1,300 a month, there’s a $2,500 spread. Unfortunately, I’ve also got to pay $500 for HOA, and around $7,200 a year in property taxes. The monthly positive cash flow number is $2,000, but only $1,400 if I were to amortize the $7,200 a year in property taxes. All of these figures are before deductions, which makes the cash flow greater. Only $300 of the $1,300 mortgage is interest, so from a net worth building perspective, I’m generating more like $2,400 a month. I like the idea of using the excess rental property income to pay down that particular mortgage. I’ll keep other income generating assets separate. Monthly mortgage pay down target: $1,400
4) Continue to pay my mortgage on time. About $1,000 of the $1,308 a month mortgage is principal. Therefore, $12,000 will be paid off in one year.
Total mortgage pay down a month: $5,000 from consulting + $833 from structured notes + $1,400 from rental income + $1,000 from mortgage payment = $8,233 a month. Given I’ve got $118,000 left, I should be able to pay off the mortgage in 14 months. Update as of 6/1/2016 is that I have successfully paid off my rental property mortgage and couldn’t feel better. I have no regrets not using the money to invest in the stock market, bond market, or private equity market.
COME UP WITH YOUR OWN PLAN
I know very few people who actually take 30 years to pay off their mortgage(s). Part of the reason is because the average homeowner moves every 7-8 years. Another reason is because incomes generally rise over time while mortgage payments stay fixed. This fact is one of the real beauties of property ownership, my favorite investment class to build wealth. Not only are our incomes rising, but so too are rents and the value of our properties. As a result, homeowners tend to throw extra cash towards paying down their mortgage and solidify a strong financial future as well.
If you can relate to any of the three reasons above on why I’m paying down my mortgage early (discomfort, belief in low interest rates, move from higher to lower tax bracket), then certainly try and pay down your mortgage quicker. Here are some further general guidelines I’d follow before initiating your own Operation Mortgage Pay Down.
1) Ascertain all your liquidity needs. With rates so low, there’s really no hurry to paying off your mortgage quickly due to alternative investments that can easily provide at least a 2% risk-free return. The real decision has to come from analyzing your current and upcoming expenses. Money is most expensive to borrow when you need it most. Therefore, it’s always good to have some type of liquidity cushion. The minimum I recommend is three months of living expenses and one year of future large expenses covered e.g. next year’s tuition. Let’s say a family of three has $7,000 a month in after tax expenses and college tuition is $20,000 a year. I would shoot for having $41,000 liquid. All other money can be used to pay down mortgage principal at a rate based on your comfort level. The more you track your finances, the more comfortable you will be about managing cash flow.
2) Know the alternatives. Paying down principal is a good thing, unlike getting into credit card debt. So one should feel great paying down a mortgage. But it’s always good to know the alternatives just in case you lose your job or have much larger expenses than anticipated. Do you have your insurance coverage needs updated? Do you know what your house could realistically sell for after paying onerous commission fees? Do you have the ability to earn other income streams? What other assets can you sell and what are the penalties for selling early, if any? The more alternatives you have, the more comfortable you should feeling paying down your mortgage.
3) Assess how bad you will feel for missing out. If you paid down your sub 5% mortgage in 2009, you’ve missed out on 18%+ annual gains for five years in a row in the stock market on that money. Nobody knows the future with certainty, therefore, it’s a good idea to diversify your money by paying down debt and investing at the same time. Because interest rates are so low, I would use a 20% debt / 80% invest ratio. In fact, a good guideline to have is using your mortgage rate as the percentage allocation for paying down debt vs. investing. For example, given my rental property mortgage is 3.375%, I will allocate 33.75% of my cash flow to pay down the mortgage. If the mortgage rises to 6%, I will use 60% of my savings to pay down the mortgage and 40% to invest.
4) Calculate your realistic retirement age. It’s a good idea to pay off all debt by the time you reach retirement age. Most people in retirement will not earn as much as they did during their working years. But once you’ve got a home fully paid off, it really doesn’t cost that much to live a comfortable retirement life. Let’s say you’ve been allocating 30% of your after-tax income to homeownership, saving 30% of your after-tax income for retirement, and spending 40% of your after-tax income on everything else. Once you’re in retirement, you no longer need to save 30% of your after-tax income. And once you’ve paid off your home, all you need to do is replicate 40% of your after tax income to live the exact same lifestyle.
BE FOCUSED ON PAYING DOWN DEBT
I thought I would be mortgage free by now after 11 years, but I’m not because I wasn’t deliberate enough with my mortgage pay down system. Now that I’ve written out three extra strategies beyond my monthly mortgage payment, I strongly believe my mortgage will be paid off in a year. If it isn’t, you guys can always chip in a thousand bucks or two!
Update 2H2017: Not only did I fully pay off my Pacific Heights 2/2 condo mortgage in 2015, I also paid off $810,000 of my Marina rental home mortgage in June, 2017 because I finally sold the house I owned since 2005! I tried my best for 45 days to fine renters, and couldn’t, even at $1,000 LESS a month. Luckily, I got a strong buyer for $2,732,500, a full $1,000,000 more than I would have sold it for in 2012 when I had it on the market for 28 days. Hallelujah it feels amazing to have less debt and more flexibility. Check out my Debt Optimization Framework post for financial independence seekers.
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