Pay Off Rental Property or Keep it Leveraged?

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BHawks87
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Pay Off Rental Property or Keep it Leveraged?

Post by BHawks87 »

My wife and I are in our early 30's and have about $315k in our retirement accounts. About $20k of that is in a taxable account spread between VTSAX and VTIAX. Our current asset allocation is 90/10.

We have a rental property that has a mortgage balance of $56k and is currently at 5.8%. The monthly mortgage payment is $345 and there is about 27 years left.

We currently max our tax advantaged space and put any extra at the end of the month into our taxable account. I was thinking we would continue to do that until our taxable account is > the rental mortgage and then pay it off.

With how high the interest rate is would you do that in my shoes or just let it ride and continue to hold your investments?

The house is currently worth about $80k so with the mortgage paid off it would conservatively yield about $500 per month which is a Return on Equity of 7.5%. Leveraged the Return on Equity is about 13%.
LittleMaggieMae
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Re: Pay Off Rental Property or Keep it Leveraged?

Post by LittleMaggieMae »

Another thing to maybe consider is How does the $3500 or so in interest play with the rest of your income when you file taxes? You are at the beginning of the mortgage so paying the 'most' in interest.
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BHawks87
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Re: Pay Off Rental Property or Keep it Leveraged?

Post by BHawks87 »

LittleMaggieMae wrote: Sun Sep 13, 2020 1:09 pm Another thing to maybe consider is How does the $3500 or so in interest play with the rest of your income when you file taxes? You are at the beginning of the mortgage so paying the 'most' in interest.
Yes that is something I will have to take into consideration as well.
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willthrill81
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Re: Pay Off Rental Property or Keep it Leveraged?

Post by willthrill81 »

Even if you're in the 24% federal tax bracket, that means that you're paying about 4.4% net on that mortgage (minus state income taxes, if applicable). That's quite steep. Unfortunately, it may be hard to do a refinance on such a relatively low balance. Still, I'd look into it.

If the alternative is buying stocks and certainly bonds in taxable, I'd absolutely favor paying down the mortgage instead. If you could bring the mortgage rate down to 4% or lower with a refi, then buying stocks (but not bonds) in taxable instead becomes more plausible.

Where the real question comes up is if you get the opportunity to buy another very attractive rental property. It could be that the returns generated from such a property would outweigh the benefit of paying down the existing mortgage.
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onmyway33
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Re: Pay Off Rental Property or Keep it Leveraged?

Post by onmyway33 »

With that interest rate, I would pay it off aggressively, though not all at once. For example pay an extra $500-1000 per month toward principle, or whatever your budget provides to reach payoff more quickly. I am aggressively paying off a mortgage on my rental currently at 4% interest. This will likely not be an optimal return as investing the money could provide better returns and one can deduct the interest from the mortgage on your schedule E. I would be sure you have adequate liquid cash reserves to handle unexpected or expected expenditures for the property. I maintain a cash cushion to handle expected items (appliance repair/replacement, periodic capital expenditures like roof and flooring, vacancies, repair between tenants, etc).
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Watty
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Re: Pay Off Rental Property or Keep it Leveraged?

Post by Watty »

One thing you might want to look into is if the lender will "recast your mortgage"(Google this) if you make a large prepayment. The way this works is that if you pay the loan down by 25%(or whatever makes sense) then your required monthly mortgage payment will go down by the same percentage. They are not required to do this but they usually will for a processing fee of a few hundred dollars or even for free. The length of the mortgage and the interest rate stay the same. This could be important if something happens like you are laid off or interest rates go a lot higher.
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BHawks87
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Re: Pay Off Rental Property or Keep it Leveraged?

Post by BHawks87 »

Watty wrote: Sun Sep 13, 2020 2:46 pm One thing you might want to look into is if the lender will "recast your mortgage"(Google this) if you make a large prepayment. The way this works is that if you pay the loan down by 25%(or whatever makes sense) then your required monthly mortgage payment will go down by the same percentage. They are not required to do this but they usually will for a processing fee of a few hundred dollars or even for free. The length of the mortgage and the interest rate stay the same. This could be important if something happens like you are laid off or interest rates go a lot higher.
Just Googled and it looks like my lender will do this. I actually have never heard of this.

Mathematically does it make sense to do this? Is there a certain optimal amount to pay it down?
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willthrill81
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Re: Pay Off Rental Property or Keep it Leveraged?

Post by willthrill81 »

BHawks87 wrote: Sun Sep 13, 2020 3:02 pm Mathematically does it make sense to do this? Is there a certain optimal amount to pay it down?
Basically, all it would do is lower your principal & interest payment, thereby improving your cash flow. Recasting is not going to save you any interest expense. A large principal payment will do that whether you recast or not.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings
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Watty
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Re: Pay Off Rental Property or Keep it Leveraged?

Post by Watty »

BHawks87 wrote: Sun Sep 13, 2020 3:02 pm Mathematically does it make sense to do this? Is there a certain optimal amount to pay it down?
It depends on what you are comparing it to and how much the lender will charge for the recast.

If you were going to send the lender extra money to pay down the mortgage without a recast the that would just reduce the interest paid length of the loan.

If they will do a recast for free then there is no downside since you can keep making the higher monthly payment anyway.

The details on your rental were not real clear to me since you would also have maintenance, vacancies, etc so you might not really be cash flow positive when you take those into account. At least to me paying a couple of hundred dollars to make a prepayment to get to the point where you are clearly cash flow positive would be worth it to me.
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BHawks87
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Re: Pay Off Rental Property or Keep it Leveraged?

Post by BHawks87 »

Watty wrote: Sun Sep 13, 2020 3:39 pm
BHawks87 wrote: Sun Sep 13, 2020 3:02 pm Mathematically does it make sense to do this? Is there a certain optimal amount to pay it down?
It depends on what you are comparing it to and how much the lender will charge for the recast.

If you were going to send the lender extra money to pay down the mortgage without a recast the that would just reduce the interest paid length of the loan.

If they will do a recast for free then there is no downside since you can keep making the higher monthly payment anyway.

The details on your rental were not real clear to me since you would also have maintenance, vacancies, etc so you might not really be cash flow positive when you take those into account. At least to me paying a couple of hundred dollars to make a prepayment to get to the point where you are clearly cash flow positive would be worth it to me.

The numbers I provided include vacancies, repairs, etc. The property isn't having a cash flow problem so I'm probably thinking keeping cash or investments on hand for liquidity would be the better play vs recasting.
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Re: Pay Off Rental Property or Keep it Leveraged?

Post by grabiner »

If you don't need the liquidity, paying down the rental loan gives you a risk-free 5.8% return, probably 80% taxable (qualified business income). That is much better than you can get on any low-risk investment, so it's worth doing.

If you would otherwise be investing in stocks, you can still do this; pay down the loan, and move an equal amount from bonds to stocks in your 401(k).
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