Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

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nd3423
Posts: 2
Joined: Fri Oct 13, 2017 1:50 am

Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by nd3423 »

Hi Bogleheads,

I have question regarding my situation with Rental Investment, New Home and Mortgage deduction interest.

Scenario:

1) We are planning to move from our current home to a bigger home. Plan is to convert current home into Rental.
2) Current home Loan - $190K, 15 years term, Payment ($1350 - Principal, $458 - Interest). Loan maturity 02/01/2028, Home Value = $450K
3) New home ~ $850K and I will be paying 20% down. Loan amount = $680K, 30 yr Loan @ 4%

I have additional $200K capital (after paying 20% down on new home), which I can either payoff my current home or lower my new home loan to $480K.

Considering mortgage interest deduction, Is it wise to payoff my current home (future rental) or reduce new home loan? We are in 28-30% Tax bracket.

Appreciate the insight. Thanks..
Grt2bOutdoors
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Location: New York

Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by Grt2bOutdoors »

Payoff your castle (home you live in) before you paydown or payoff rental property. The idea is to secure your residence, you let the rental pay for itself until you are in a stronger financial position.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions
dbltrbl
Posts: 900
Joined: Thu Mar 01, 2007 11:52 am

Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by dbltrbl »

Check with your current bank, holding mortgage. Terms will not be same if you convert it to a rental. Investment properties are treated differently. As to your question about paying off, I would pay off the current home (your future rental). This way you are dealing with less paperwork with a financial institution.
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ResearchMed
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Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by ResearchMed »

dbltrbl wrote: Fri Oct 13, 2017 7:10 am Check with your current bank, holding mortgage. Terms will not be same if you convert it to a rental. Investment properties are treated differently. As to your question about paying off, I would pay off the current home (your future rental). This way you are dealing with less paperwork with a financial institution.
It doesn't sound like there will be a new mortgage on their current-home-to-become-a-rental.
I haven't (yet) encountered a mortgage for a primary residence such that after several years, it would be voided if the property were later changed to a rental.

But I agree with previous comment about paying off your own mortgage if you have extra money, unless the interest rate on the current home is much higher.

I assume that OP has more than this $200k, so there is adequate emergency money, etc.

RM
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Grt2bOutdoors
Posts: 23157
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Location: New York

Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by Grt2bOutdoors »

dbltrbl wrote: Fri Oct 13, 2017 7:10 am Check with your current bank, holding mortgage. Terms will not be same if you convert it to a rental. Investment properties are treated differently. As to your question about paying off, I would pay off the current home (your future rental). This way you are dealing with less paperwork with a financial institution.
Not true. Bank holding mortgage requires at the time of initial underwriting full disclosure as to what the use of property will be - primary residence or investment property. Once the mortgage has closed, it has closed! No need to notify the bank of anything, the bank is just concerned that they receive the agreed upon mortgage principal and interest. However, should the primary residence be converted to a rental, the OP should immediately call their home insurance company and notify them that residence is now a "business rental" as the underwriting classification will need to be changed. Also, the OP if they do not have one currently, should obtain a personal umbrella policy for a minimum of $1MM.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions
petulant
Posts: 1901
Joined: Thu Sep 22, 2016 1:09 pm

Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by petulant »

ResearchMed wrote: Fri Oct 13, 2017 7:29 am
dbltrbl wrote: Fri Oct 13, 2017 7:10 am Check with your current bank, holding mortgage. Terms will not be same if you convert it to a rental. Investment properties are treated differently. As to your question about paying off, I would pay off the current home (your future rental). This way you are dealing with less paperwork with a financial institution.
It doesn't sound like there will be a new mortgage on their current-home-to-become-a-rental.
I haven't (yet) encountered a mortgage for a primary residence such that after several years, it would be voided if the property were later changed to a rental.

But I agree with previous comment about paying off your own mortgage if you have extra money, unless the interest rate on the current home is much higher.

I assume that OP has more than this $200k, so there is adequate emergency money, etc.

RM
Some of the first time home buyers programs have a residency requirement where the mortgage becomes due the day the borrower is no longer living in the property. It's doubtful the rental-to-be falls under that program, but it's worth checking over the paperwork. Otherwise, yeah, typically you keep the owner/occupancy mortgage even if you move out.
Grt2bOutdoors
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Location: New York

Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by Grt2bOutdoors »

petulant wrote: Fri Oct 13, 2017 7:58 am
ResearchMed wrote: Fri Oct 13, 2017 7:29 am
dbltrbl wrote: Fri Oct 13, 2017 7:10 am Check with your current bank, holding mortgage. Terms will not be same if you convert it to a rental. Investment properties are treated differently. As to your question about paying off, I would pay off the current home (your future rental). This way you are dealing with less paperwork with a financial institution.
It doesn't sound like there will be a new mortgage on their current-home-to-become-a-rental.
I haven't (yet) encountered a mortgage for a primary residence such that after several years, it would be voided if the property were later changed to a rental.

But I agree with previous comment about paying off your own mortgage if you have extra money, unless the interest rate on the current home is much higher.

I assume that OP has more than this $200k, so there is adequate emergency money, etc.

RM
Some of the first time home buyers programs have a residency requirement where the mortgage becomes due the day the borrower is no longer living in the property. It's doubtful the rental-to-be falls under that program, but it's worth checking over the paperwork. Otherwise, yeah, typically you keep the owner/occupancy mortgage even if you move out.
Most primary mortgages underwritten to conform with Fannie Mae or Freddie Mac require a residency requirement. The reason for that is the banks retain the right to package said mortgages and sell them to Fannie Mae/Freddie Mac under a securitization agreement. Those securities are FNMA or FHMLC certified Mortgage Backed Securities, the same ones that are in the Total Bond Market Index.

The OP should not notify bank of plan to convert from primary to rental, instead should pull out their loan documentation and read it carefully, looking for the section that talks about conditions (if any) when mortgages are immediately due and payable. Since the original mortgage is not a commercial mortgage, chances of seeing language like that are slim to none. But check anyway.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions
StealthRabbit
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Joined: Sat Jun 13, 2009 1:25 am

Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by StealthRabbit »

During your earning yrs / 20%+ tax bracket, I would keep as much loan on the rental as reasonable. (100% interest deduction offset to related income). Your personal mortgage deduction is only a fractional offset on your overall AGI / tax rate / eligible deductions.
Mimmz
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Joined: Thu Dec 24, 2015 10:44 am

Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by Mimmz »

Grt2bOutdoors wrote: Fri Oct 13, 2017 7:58 am
dbltrbl wrote: Fri Oct 13, 2017 7:10 am Check with your current bank, holding mortgage. Terms will not be same if you convert it to a rental. Investment properties are treated differently. As to your question about paying off, I would pay off the current home (your future rental). This way you are dealing with less paperwork with a financial institution.
Not true. Bank holding mortgage requires at the time of initial underwriting full disclosure as to what the use of property will be - primary residence or investment property. Once the mortgage has closed, it has closed! No need to notify the bank of anything, the bank is just concerned that they receive the agreed upon mortgage principal and interest. However, should the primary residence be converted to a rental, the OP should immediately call their home insurance company and notify them that residence is now a "business rental" as the underwriting classification will need to be changed. Also, the OP if they do not have one currently, should obtain a personal umbrella policy for a minimum of $1MM.
This. I went through same process as OP about three years ago, and am about to repeat. I had a HELOC at the time as well, and the bank that held the HELOC did not permit HELOCs on non-owner occupied properties, but they didn’t flinch when I notified them I was moving out and needed the statements sent to my new home. My insurance premium dropped in half on my now rental property when I changed the policy to reflect it being a rental, which more than covered the cost of the umbrella policy.
StealthRabbit wrote: Fri Oct 13, 2017 8:25 am During your earning yrs / 20%+ tax bracket, I would keep as much loan on the rental as reasonable. (100% interest deduction offset to related income). Your personal mortgage deduction is only a fractional offset on your overall AGI / tax rate / eligible deductions.
Grt2bOutdoors wrote: Fri Oct 13, 2017 6:27 am Payoff your castle (home you live in) before you paydown or payoff rental property. The idea is to secure your residence, you let the rental pay for itself until you are in a stronger financial position.
Seconded.

And while cash and debt is fungible, I view the sources and associated cost of those funds differently. My home is a cost center, no matter how hard I may want it to become a profit center, so the mortgage interest deduction is simply a discount to the cost of my impatience to live within my means. My rentals are profit centers, and so using leverage as a tool to maximize return feels more risk appropriate.

With that said, a less-than-boglehead argument can be made that with what amounts to a significant safety cushion and a low cost of debt, investing that $200k in accordance with your targeted investment allocation may be the most optimal solution from a sheer dollars and cents standpoint. Then again, while my investment strategy is very boglehead, my views on leverage are much less so.
Last edited by Mimmz on Sat Oct 14, 2017 10:19 am, edited 1 time in total.
mx711yam
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Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by mx711yam »

I was in a similar situation to you and paid off the rental house for the extra monthly cash flow. It allowed me to quit my job and start a business. Although it wasn't the best way to reduce taxes it was the best way to gain freedom.
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Nate79
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Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by Nate79 »

Are you really sure that you want to potentially lose $260k of equity that you could bank tax free by selling instead of converting this to a rental? Are you also sure that you are going to be adequately compensated for a $450k rental property?
petulant
Posts: 1901
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Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by petulant »

Grt2bOutdoors wrote: Fri Oct 13, 2017 8:05 am
petulant wrote: Fri Oct 13, 2017 7:58 am
ResearchMed wrote: Fri Oct 13, 2017 7:29 am
dbltrbl wrote: Fri Oct 13, 2017 7:10 am Check with your current bank, holding mortgage. Terms will not be same if you convert it to a rental. Investment properties are treated differently. As to your question about paying off, I would pay off the current home (your future rental). This way you are dealing with less paperwork with a financial institution.
It doesn't sound like there will be a new mortgage on their current-home-to-become-a-rental.
I haven't (yet) encountered a mortgage for a primary residence such that after several years, it would be voided if the property were later changed to a rental.

But I agree with previous comment about paying off your own mortgage if you have extra money, unless the interest rate on the current home is much higher.

I assume that OP has more than this $200k, so there is adequate emergency money, etc.

RM
Some of the first time home buyers programs have a residency requirement where the mortgage becomes due the day the borrower is no longer living in the property. It's doubtful the rental-to-be falls under that program, but it's worth checking over the paperwork. Otherwise, yeah, typically you keep the owner/occupancy mortgage even if you move out.
Most primary mortgages underwritten to conform with Fannie Mae or Freddie Mac require a residency requirement. The reason for that is the banks retain the right to package said mortgages and sell them to Fannie Mae/Freddie Mac under a securitization agreement. Those securities are FNMA or FHMLC certified Mortgage Backed Securities, the same ones that are in the Total Bond Market Index.

The OP should not notify bank of plan to convert from primary to rental, instead should pull out their loan documentation and read it carefully, looking for the section that talks about conditions (if any) when mortgages are immediately due and payable. Since the original mortgage is not a commercial mortgage, chances of seeing language like that are slim to none. But check anyway.
We may be saying the same thing, but I want to be clear. Most residential mortgages to be sold for repackaging or insured through PMI/FHA have a residency requirement that is simply intent to owner-occupy. Without getting into specifics across these programs, a person who moves in and lives somewhere for a couple years can generally move out and convert to rental with no problem.

However, some first-time homebuyer programs, typically subsidized by the feds and operated by state or local agencies, have a much more strict requirement where the mortgage is due in full on the day the borrower moves out. Again, it is unlikely OP relied on such a program, but it is worth reviewing loan paperwork.
ralph124cf
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Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by ralph124cf »

The question of which mortgage to apply the "spare" $200,000 to is dependent on the profitability of the rental. If the rental is profitable, then the mortgage interest is fully deductible from AGI. Assuming the OP has an AGI above $150,000, which seems likely given the housing costs and tax rates quoted, if the rental is not currently profitable then the loss is suspended until the rental starts turning a profit, or the property is sold. The suspended loss is offset against the future profit to reduce future taxes. The loss is also available when the property is sold, even if the sale is at a loss.


Ralph
gougou
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Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by gougou »

I did a simple calculation $458 x 12 / $190K = 2.89% interest. Which is lower than the 4% interest you are getting. So it makes more sense to lower your new mortgage.

Both mortgages are tax deductible. The mortgage interest on the rental reduces your rental income, while the primary home mortgage interest reduces your personal income. So you only need to consider which mortgage has higher interest rate.

What if you get a 15-year mortgage or an ARM instead? Your mortgage interest will be around 3%.
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unclescrooge
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Re: Payoff Rental or lower Primary Loan -> Mortgage Deduction Interest Question

Post by unclescrooge »

nd3423 wrote: Fri Oct 13, 2017 2:11 am Hi Bogleheads,

I have question regarding my situation with Rental Investment, New Home and Mortgage deduction interest.

Scenario:

1) We are planning to move from our current home to a bigger home. Plan is to convert current home into Rental.
2) Current home Loan - $190K, 15 years term, Payment ($1350 - Principal, $458 - Interest). Loan maturity 02/01/2028, Home Value = $450K
3) New home ~ $850K and I will be paying 20% down. Loan amount = $680K, 30 yr Loan @ 4%

I have additional $200K capital (after paying 20% down on new home), which I can either payoff my current home or lower my new home loan to $480K.

Considering mortgage interest deduction, Is it wise to payoff my current home (future rental) or reduce new home loan? We are in 28-30% Tax bracket.

Appreciate the insight. Thanks..
neither, buy another rental.
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