Pay down a 3.25% 15-year mortgage?

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hyperpigment26
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Pay down a 3.25% 15-year mortgage?

Post by hyperpigment26 » Mon Nov 13, 2017 5:42 pm

TL; DR: Should I pay down a 3.25% 15-yr fixed for the freedom to move to a more desirable city later easier?


Two mortgages:
3.99% 30Y fixed with a $211K balance (primary residence)
3.25% 15-yr fixed with a $208K balance (rental unit)

We live in a city that's not so desirable, mainly to save and invest given the higher salary and average cost of living here. We could tough it out and stay, but ideally would like the option to move to another city later.

Our rental income doesn't cover its mortgage and we've had significant trouble selling it for various reasons (more competition, lousy neighbors, limited potential buyers, inherent complexities with the property). So let's assume that we'd have to continue to rent it out with a negative cash flow of $1,300/month (including the mortgage). After the mortgage is paid, the unit would cash flow about +$200/month. (I understand that one typically ignores the mortgage for such calculations, but let's include it for this example.) We have 8 years left on the mortgage. My concern is that if we try to move now with the mortgage in place, we'd have to pay the $1,300/month and live in the more expensive city with potentially less income. We have older, ailing parents, so future healthcare expenses could creep up.

Should we pay down the rental unit mortgage or just continue to invest in the market? After discretionary expenses, 401K investments (maxed), and 529 plans, we average about $3K/month that goes toward market investing while paying the minimum on the mortgages.

-Net worth is about $825K including the above two properties
-6-month emergency reserve funded
-529 plans are about 1/4 funded (college is 12 years away)
-No other debt
-Highest tax bracket
-39 year-old couple
-Population growth where we live is ~1%/yr

I don't like the idea of paying down the mortgage on the primary home since it would technically work against the SEC rules for angel investing (net worth excludes the primary residence). I also don't foresee any issue selling our primary home since it's in a very desirable area and we routinely get flyers from real estate agents.

One option that I thought about was to do a 30-yr refi on the rental unit, but paying the extra money to pay more in interest while going through an ugly appraisal on the unit isn't so palatable.
Last edited by hyperpigment26 on Wed Nov 15, 2017 10:35 pm, edited 1 time in total.

EHEngineer
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Re: Pay down a 3.25% 15-year mortgage?

Post by EHEngineer » Tue Nov 14, 2017 12:26 am

Hi hyperpigment26,

Welcome to the forum.

I understand your issue. You have $3,000 per month, post tax dollars, to invest as you wish. You can pay down either of two mortgages, or you can invest in the market.

I have a few questions
1) based on the change in cashflow from negative $1300 to positive $200, I believe your rental mortgage payment is $1500. However it doesn't make sense that this loan is $208,000 princpal balance, 3.25% apr and only 8 years remaining. By my calculations, that payment should be $2463, not $1500. Maybe it was initially a $208,000 loan and is now about $127,000 principal balance?

2) I think you are forgetting about the tax treatment for the two different mortgages. For a primary residence the interest is deductible, IF you have itemized deductions greater than the standard deduction. With a $211k loan at 4% you don't reach the MFJ standard deduction, so your 4% mortgage interest is effectively an after tax payment. Do you have other deductions that add to this? Do you itemize?

3) I have never owned a rental, but I understand tax treatment for a rental property mortgage is an expense. If you have negative cashflow are you able to reduce your income tax bill? Also, are you depreciating your rental to reduce your taxes?

4) How are you dealing with the liability risk of the rental? do you have it in an LLC or possibly just a large umbrella policy? If you have it in an LLC, any additional equity would be at-risk.

5) When you consider moving, cash flow is cash flow. If you have a bunch of primary residence equity, it will reduce the loan and payment on the new primary residence. If you have rental house equity, it will reduce the rental house payment, but you will have a larger primary residence payment.

I think the real issue you have is that for every $3000 of addional princpal payment, the rental mortgage cashflow improves by about $35. If you use the same $3000 to pay down the primary mortgage you improve cashflow by $14. But the $35 was only $7.4 of interest (about 21% interest). The $14 was $9.50 of interest (about 69% interest). If you consider your equity as "savings" then it is better to pay off the primary residence. And this does not account for the favorable tax treatment of the rental interest, or the tax savings by depreciation of the rental.

Additionally, you are currently saving this $3k/month as a taxable investment for retirement. Will your retirement savings be sufficient to meet your goals if you stop saving for retirement?

Based on what you have said, my gut is that you should pay down the primary mortgage, and refi the rental to a 30-yr. If you go from 8 years to 30 years I think the payment will drop from $1500 to $600 per month.
Or, you can ... decline to let me, a stranger on the Internet, egg you on to an exercise in time-wasting, and you could say "I'm probably OK and I don't care about it that much." -Nisiprius

chevca
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Re: Pay down a 3.25% 15-year mortgage?

Post by chevca » Tue Nov 14, 2017 7:00 am

I agree, it's a little tough to follow your numbers. What could you sell the rental for? What's the mortgage payment and rental income on the rental?

From the looks of it, negative cash flow, and all, it sounds like selling the rental ASAP would be better, IMO. Get rid of that anchor. You may have to sell for less than you'd like to, but, why hang onto it? What's the difference between paying down the mortgage, or selling for less money and covering the difference?

student
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Re: Pay down a 3.25% 15-year mortgage?

Post by student » Tue Nov 14, 2017 7:43 am

I also think that you should sell the rental even if you take a loss that is in the $20,000-$30,000 range as you have a $1,300 negative cash flow per month.

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Watty
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Re: Pay down a 3.25% 15-year mortgage?

Post by Watty » Tue Nov 14, 2017 8:26 am

student wrote:
Tue Nov 14, 2017 7:43 am
I also think that you should sell the rental even if you take a loss that is in the $20,000-$30,000 range as you have a $1,300 negative cash flow per month.
+1

I would take a hard look at this.

How much you could clear, or would have to pay, after taxes if you sold the place. Any place will sell at some price.

Even in a less desirable city the housing market it is likely stronger than it was a few years ago for both renting and selling. If you keep it then one risk is that housing market could weaken and the rent on an undesirable property could drop like a rock and the rental could be vacant a lot, and it could be very hard to sell it at any price in a bad housing market.

DrGoogle2017
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Re: Pay down a 3.25% 15-year mortgage?

Post by DrGoogle2017 » Tue Nov 14, 2017 11:46 am

I agree to sell the rental and take a loss. Maybe you can offset future capital gain from something later on. I don’t see any reason to keep the rental.

hyperpigment26
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Re: Pay down a 3.25% 15-year mortgage?

Post by hyperpigment26 » Tue Nov 14, 2017 12:44 pm

Appreciate all the help for this.

I'll try to address the points for you, EHEngineer:

1) Sorry, typo - after paying the mortgage on the rental, it would cash flow approximately $600/month. The negative cash flow is actually steeper than the $1,300 originally stated. I put a back-of-the-envelope calculation below after updating with new rates.
2) Yes, we have itemized deductions greater than the standard deduction due to home mortgage interest, charitable contributions, state income taxes, etc.
3) The mortgage payment for the rental unit doesn't reduce our tax bill since our income phases out favorable treatment of rental property losses. However, we do take the depreciation expense (about $15K/yr).
4) We have a large umbrella policy.

We purchased the rental unit at $420K (it appraised at $425K) in 2009, and took a 0% down loan for the full $420k, saving/investing what we had left. We did a 15-yr refi in 2012 to take advantage of a lower rate and paid additional money at the refi closing, bringing the loan balance down.

I listed it for $339,900 this spring and it still didn't sell. Yeah, ouch. I used a really well-rated agent and averaged 1 showing a week for several months. Web listings, open houses, tried to get the word out. The unit is actually pretty nice, but it has a steep driveway and as such whether founded or not is a pretty big turn-off for our winters. It MAY sell for $285K based on a verbal offer from a prior tenant, ignoring closing costs and commissions. I began renting it out in the fall.

Annualized calculations for the rental unit, ignoring mortgage:

Gross Rental Income
$18,900 ($1,750/month at a 90% utilization rate)

Expenses
Maintenance: $960
Mngt Fee: $1400
HOA Dues: $3384
Taxes: $5594
Insurance: $463

Total Exp: $11,601

Net Income: $7,299
Per month: $608

chevca: Mortage payment on rental: principal: $1738.84, interest: $565.92. (Escrow varies but is currently around $515)
Last edited by hyperpigment26 on Tue Nov 14, 2017 1:01 pm, edited 1 time in total.

DrGoogle2017
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Re: Pay down a 3.25% 15-year mortgage?

Post by DrGoogle2017 » Tue Nov 14, 2017 1:01 pm

Two questions I have:
1) why is such high depreciation expense, you can only depreciate building and not land value.
2) Does the mortgage payment including in the expenses, it doesn’t seem like it at first glance.

chevca
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Re: Pay down a 3.25% 15-year mortgage?

Post by chevca » Tue Nov 14, 2017 1:04 pm

Ouch!!

I imagine you'd like to keep the rental until it evens out some? I don't know that it will. Call it a lesson learned, as it sounds like you have only lost money on that thing. Unlike a primary residence, since it's always been a rental you can take/claim the loss. Although I don't know exactly how that works or how much can be claimed. But, some good might come from that. I'd list it at $300k and take what you can get near that. Get rid of that thing, is my take on it anyway.

hyperpigment26
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Re: Pay down a 3.25% 15-year mortgage?

Post by hyperpigment26 » Tue Nov 14, 2017 1:05 pm

1) Hmm - was looking at an older tax return. Might have been due to a long vacancy during the year? In any case, we're taking the depreciation.
2) Correct, I did not include the mortgage payment in the expense.

chevca
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Re: Pay down a 3.25% 15-year mortgage?

Post by chevca » Tue Nov 14, 2017 1:07 pm

Sounds like it's a condo type building? If so, there's probably not much land value. The depreciation sounds about right on $420k.

hyperpigment26
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Re: Pay down a 3.25% 15-year mortgage?

Post by hyperpigment26 » Tue Nov 14, 2017 1:09 pm

Right, easier said than done on "get rid of that thing."

As far as a lesson learned, I struggle with that part too. Remember, it appraised higher than our purchase price and we bought in one of America's deepest down markets, getting a zero-down rate.

It was our primary home at the time. Yes, condo.
Last edited by hyperpigment26 on Tue Nov 14, 2017 1:21 pm, edited 1 time in total.

chevca
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Re: Pay down a 3.25% 15-year mortgage?

Post by chevca » Tue Nov 14, 2017 1:20 pm

Anything will sell for the right price. That part is easy. The hard part is how much of a loss you're willing to take. This is simply a business decision though. Leave personal feelings about it at the door.

You have lost money from the start on this thing and continue to lose money on it. Stop the bleeding.

No offense, but buying a rental for $5k under appraisal and zero down on a pretty spendy single rental property was bad decision no matter what the timing of it.

DrGoogle2017
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Re: Pay down a 3.25% 15-year mortgage?

Post by DrGoogle2017 » Tue Nov 14, 2017 1:30 pm

I don’t know where you are but most condos have recovered from the housing bubble in many areas. The fact that your condo keeps losing money in this recovery is not a good sign. If we have a downturn again, it surely will lose more money.
Maybe this will help you make the decision, what if your condo will lose half of its value on the next down turn. Would you sell now?

hyperpigment26
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Re: Pay down a 3.25% 15-year mortgage?

Post by hyperpigment26 » Tue Nov 14, 2017 1:40 pm

So what number would you suggest?

chevca
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Re: Pay down a 3.25% 15-year mortgage?

Post by chevca » Tue Nov 14, 2017 1:41 pm

Here's a couple articles on selling a rental at a loss...

https://www.nolo.com/legal-encyclopedia ... -loss.html
http://www.quickanddirtytips.com/money- ... f-a-rental

If you have been claiming $15k/year for depreciation for 7 or 8 years, there's $100k or more off the purchase price already. Actually the gov't would take that if you claimed it or not, but you probably know that and have claimed it anyway. You're probably not looking at all that big of a loss if you sold. Obviously a rental bought for $420k and looking at selling for $300k or less, looks like a huge loss. But, once all the numbers get run...

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whodidntante
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Re: Pay down a 3.25% 15-year mortgage?

Post by whodidntante » Tue Nov 14, 2017 1:45 pm

That "investment" property sounds awful. I would put it on the market today.

DrGoogle2017
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Re: Pay down a 3.25% 15-year mortgage?

Post by DrGoogle2017 » Tue Nov 14, 2017 1:55 pm

hyperpigment26 wrote:
Tue Nov 14, 2017 1:40 pm
So what number would you suggest?
Whatever the market gives you. Get the more accurate quote from realtors. But prepare mentally for the loss.

hyperpigment26
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Re: Pay down a 3.25% 15-year mortgage?

Post by hyperpigment26 » Tue Nov 14, 2017 2:24 pm

DrGoogle2017 wrote:
Tue Nov 14, 2017 1:55 pm
hyperpigment26 wrote:
Tue Nov 14, 2017 1:40 pm
So what number would you suggest?
Whatever the market gives you. Get the more accurate quote from realtors. But prepare mentally for the loss.
But wouldn't there be a floor value?

soccerrules
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Re: Pay down a 3.25% 15-year mortgage?

Post by soccerrules » Tue Nov 14, 2017 3:13 pm

put the rental unit on the market.
It is worth what someone is willing to pay for it and how long you are willing to wait (to get your price) to reduce your losses.
You have not painted a pretty picture of this RE investment, I'd work on getting rid of it.
Don't let your outflow exceed your income or your upkeep will be your downfall.

InsideTheBeltway
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Re: Pay down a 3.25% 15-year mortgage?

Post by InsideTheBeltway » Wed Nov 15, 2017 2:07 pm

You need to sell your rental ASAP at current market prices. Sorry to hear you made a bad investment but time to face that fact and sell. Use the $3,000 a month extra to cover the expected loss.

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Meg77
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Re: Pay down a 3.25% 15-year mortgage?

Post by Meg77 » Wed Nov 15, 2017 2:50 pm

Based on your numbers, you are breaking even on the investment or making $100 or so a month, even after taking the mortgage interest expense into account. That's not great of course, but it's not bad enough for me to be in a hurry to lock in a 6 figure loss on the place either.

I wouldn't be in a huge rush to sell unless you think the value is likely to decrease further in years to come, or if you're pretty sure it's not likely to rise. The negative cash flow isn't an issue for you since you still have $3k a month to invest even after maxing out retirement accounts. However there is the opportunity cost of the money you have tied up in it, which could be growing if invested in a better rental or in the stock market.

It doesn't make sense to pay extra on the rental mortgage unless your goal is to get it sold ASAP and you don't have the liquidity to pay the difference. You are already paying down this loan faster than you would have otherwise. That's what refinancing into a 15 year mortgage did, which is why you have such a negative cash flow. If you make additional principal payments, the only thing you really accomplish is having an even more negative cash flow.

If you're just looking for the best place to put $3K a month, paying off a loan with an effective rate of around 2% (depending on your state tax bracket) is only about as good as inflation. You ARE getting the tax deduction on the rental mortgage interest, you just can't realize it every year because of your income. Passive losses roll over from year to year and are recognized when you ultimately sell the property.

I'd use the $3K to a) max out other retirement accounts if you aren't doing backdoor Roths or an HSA, b) save up cash for a down payment on a new home c) invest in taxable d) put more in 529s or e) pay down your primary home even if it delays you reaching accredited investor status. At the end of the list would be paying extra on the rental mortgage.
"An investment in knowledge pays the best interest." - Benjamin Franklin

hyperpigment26
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Re: Pay down a 3.25% 15-year mortgage?

Post by hyperpigment26 » Wed Nov 15, 2017 10:07 pm

Meg77 wrote:
Wed Nov 15, 2017 2:50 pm
Based on your numbers, you are breaking even on the investment or making $100 or so a month, even after taking the mortgage interest expense into account. That's not great of course, but it's not bad enough for me to be in a hurry to lock in a 6 figure loss on the place either.

I wouldn't be in a huge rush to sell unless you think the value is likely to decrease further in years to come, or if you're pretty sure it's not likely to rise. The negative cash flow isn't an issue for you since you still have $3k a month to invest even after maxing out retirement accounts. However there is the opportunity cost of the money you have tied up in it, which could be growing if invested in a better rental or in the stock market.
Yes! This is what I see too. I have been leaning toward selling - I just don't know whether taking such a deep loss is worth it relative to breaking even by renting in the short-term. Unless there was some sure investment staring me in the face with a high return, am I really in a hurry to do this? There is, of course, the chance of a major unexpected cost that can happen with rental units. For this reason alone, I don't plan to keep it for a very long period.

With a population growth of about 1% and the overall buildout in the last two decades, pricing is not likely to skyrocket like you see in other cities but just sort of hum along slowly. I am concerned about over supply through new condo developments, but I would imagine the market would sort that out over time.
Meg77 wrote:
Wed Nov 15, 2017 2:50 pm
It doesn't make sense to pay extra on the rental mortgage unless your goal is to get it sold ASAP and you don't have the liquidity to pay the difference. You are already paying down this loan faster than you would have otherwise. That's what refinancing into a 15 year mortgage did, which is why you have such a negative cash flow. If you make additional principal payments, the only thing you really accomplish is having an even more negative cash flow.
Makes sense.
Meg77 wrote:
Wed Nov 15, 2017 2:50 pm
If you're just looking for the best place to put $3K a month, paying off a loan with an effective rate of around 2% (depending on your state tax bracket) is only about as good as inflation. You ARE getting the tax deduction on the rental mortgage interest, you just can't realize it every year because of your income. Passive losses roll over from year to year and are recognized when you ultimately sell the property.

I'd use the $3K to a) max out other retirement accounts if you aren't doing backdoor Roths or an HSA, b) save up cash for a down payment on a new home c) invest in taxable d) put more in 529s or e) pay down your primary home even if it delays you reaching accredited investor status. At the end of the list would be paying extra on the rental mortgage.
Aside from maxed out 401K, we do an HSA and invest in taxable. I did look at a backdoor some time ago but will look into it again since it was somewhat time-consuming to go through. Why pay down the primary home? Just due to the interest rate?

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grabiner
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Re: Pay down a 3.25% 15-year mortgage?

Post by grabiner » Thu Nov 16, 2017 10:12 pm

Paying off the rental mortgage will improve the cash flow, but it won't really improve the economic situation. Cash flow is not profit or loss, since it includes principal payments which increase your equity in the property.

If you don't want to sell the rental, then the fact that the mortgage is on a rental is irrelevant. You will get a risk-free, but taxable (since the interest is deductible) 3.25% return on any prepayment. In the top tax bracket, that return is only 1.97%, which is slightly less than you can get on an 8-year municipal bond; Vanguard Long-Term Tax-Exempt Admiral shares yield 2.39%. Therefore, it's probably better to invest the money, which keeps it more liquid.
David Grabiner

CurlyDave
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Re: Pay down a 3.25% 15-year mortgage?

Post by CurlyDave » Fri Nov 17, 2017 1:50 pm

There are non-monetary costs of this rental I have not seen discussed.

One is the human capital cost -- you only have so much time in your life and managing a non-performing asset is not a good use of this time.

Second is the opportunity cost. The equity in the unit can and should be used for an investment which will outperform.

I would serious consider a section 1031 exchange, where you sell this rental and roll the money over into a better one. DW and I have done very well in real estate, but we were very selective in choosing rental properties.

If you select the right property you can postpone the loss and offset it with a gain from a well-chosen unit. In all but the most expensive area, a house is a much better investment than a condo.

And, if you look around you could quite possibly get a real estate agent who would negotiate a bit on commission if he know he was getting both a sale and a purchase. Think about buying a multi-family unit. Duplex or even a 4-plex. These produce more cash flow than a SFH.

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