Investing in taxable account or pay more for rental mortgage

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lepa71
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Investing in taxable account or pay more for rental mortgage

Post by lepa71 » Tue Sep 11, 2018 4:00 pm

Hi all

I have a couple rental properties and wondering. Should I invest in a taxable account or pay more for rental mortgage? I'm about 15 year in out of 30. The interest rate is 5% for one duplex property with PI $1350. I have started to accelerate the payment and paying now $2000.

What do you guys think? I already maxed out $18.5K in company 401K and $5500 for tIRA.

Thanks

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FiveK
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Re: Investing in taxable account or pay more for rental mortgage

Post by FiveK » Tue Sep 11, 2018 10:37 pm

lepa71 wrote:
Tue Sep 11, 2018 4:00 pm
The interest rate is 5% for one duplex property with PI $1350.
That's the before-tax interest rate. What is the after-tax rate? In other words, what is 5% * (1 - your_marginal_tax_rate)?

lepa71
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Re: Investing in taxable account or pay more for rental mortgage

Post by lepa71 » Wed Sep 12, 2018 7:31 am

I'm in 22% tax bracket. I understand that 5% is not really 5%. There are write-offs that will get lost.

Is that the formula 5*(1-0.22)?

stan1
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Re: Investing in taxable account or pay more for rental mortgage

Post by stan1 » Wed Sep 12, 2018 7:43 am

It's all about liquidity. Rental properties are a business. Do you want to be a landlord or are you a reluctant landlord? Are you planning to buy more? Do you have a positive cash flow on the business? If you are buying more property you'd want the liquidity to do so. Taxable accounts are very liquid but value can fluctuate. You can sell holdings and have cash back in your checking account within a few days. Personally I would put the extra money into a taxable account up to low six figures before paying down a loan on a successful business. If the business had a long term negative cash flow there's a lot of other things to consider.

lepa71
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Re: Investing in taxable account or pay more for rental mortgage

Post by lepa71 » Wed Sep 12, 2018 7:59 am

I have a day job. I consider a well-paid job to me (120K). I started rental as a retirement plan. My thoughts are simple, somebody pays the mortgage + tax+maintanance and in 30 years it will become a pure profit. I'm not a reluctant landlord for sure. Bought couple properties in 1999 with a friend. In a couple of years, we sold it for 100% ROI. Then I did 1031 exchange into my own properties. I would love to buy more but it's pretty much impossible where I live. I also believe that real estate will grow in value no matter what. It will go up and down but eventually up.

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FiveK
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Re: Investing in taxable account or pay more for rental mortgage

Post by FiveK » Wed Sep 12, 2018 11:33 am

lepa71 wrote:
Wed Sep 12, 2018 7:31 am
I'm in 22% tax bracket. I understand that 5% is not really 5%. There are write-offs that will get lost.

Is that the formula 5*(1-0.22)?
Yes. It costs you ~5% of the unpaid principal each year. Then you deduct that amount from your income, so you pay tax on that much less.

Given that, the apples to apples comparison is the after-tax return on your investments. For ordinary interest, the tax rate would be the same 22%. For qualified dividends and long term capital gains, it would be 15%. And "...plus state tax" applies to all the above.

And then there's the issue of the mortgage payment being a guaranteed return and investment returns not being guaranteed. But there's no law-of-nature math to account for that difference. Similarly, liquidity differences don't translate unambiguously into return rate comparisons.

lepa71
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Re: Investing in taxable account or pay more for rental mortgage

Post by lepa71 » Wed Sep 12, 2018 2:17 pm

FiveK wrote:
Wed Sep 12, 2018 11:33 am
lepa71 wrote:
Wed Sep 12, 2018 7:31 am
I'm in 22% tax bracket. I understand that 5% is not really 5%. There are write-offs that will get lost.

Is that the formula 5*(1-0.22)?
Yes. It costs you ~5% of the unpaid principal each year. Then you deduct that amount from your income, so you pay tax on that much less.

Given that, the apples to apples comparison is the after-tax return on your investments. For ordinary interest, the tax rate would be the same 22%. For qualified dividends and long term capital gains, it would be 15%. And "...plus state tax" applies to all the above.

And then there's the issue of the mortgage payment being a guaranteed return and investment returns not being guaranteed. But there's no law-of-nature math to account for that difference. Similarly, liquidity differences don't translate unambiguously into return rate comparisons.
That was a little bit confusing to me. Can you simplify it?

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FiveK
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Re: Investing in taxable account or pay more for rental mortgage

Post by FiveK » Wed Sep 12, 2018 2:31 pm

lepa71 wrote:
Wed Sep 12, 2018 2:17 pm
FiveK wrote:
Wed Sep 12, 2018 11:33 am
lepa71 wrote:
Wed Sep 12, 2018 7:31 am
I'm in 22% tax bracket. I understand that 5% is not really 5%. There are write-offs that will get lost.

Is that the formula 5*(1-0.22)?
Yes. It costs you ~5% of the unpaid principal each year. Then you deduct that amount from your income, so you pay tax on that much less.

Given that, the apples to apples comparison is the after-tax return on your investments. For ordinary interest, the tax rate would be the same 22%. For qualified dividends and long term capital gains, it would be 15%. And "...plus state tax" applies to all the above.

And then there's the issue of the mortgage payment being a guaranteed return and investment returns not being guaranteed. But there's no law-of-nature math to account for that difference. Similarly, liquidity differences don't translate unambiguously into return rate comparisons.
That was a little bit confusing to me. Can you simplify it?
Sure - which part, and what is your best guess as to what it means?

lepa71
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Re: Investing in taxable account or pay more for rental mortgage

Post by lepa71 » Wed Sep 12, 2018 2:44 pm

FiveK wrote:
Wed Sep 12, 2018 2:31 pm
lepa71 wrote:
Wed Sep 12, 2018 2:17 pm
FiveK wrote:
Wed Sep 12, 2018 11:33 am
lepa71 wrote:
Wed Sep 12, 2018 7:31 am
I'm in 22% tax bracket. I understand that 5% is not really 5%. There are write-offs that will get lost.

Is that the formula 5*(1-0.22)?
Yes. It costs you ~5% of the unpaid principal each year. Then you deduct that amount from your income, so you pay tax on that much less.

Given that, the apples to apples comparison is the after-tax return on your investments. For ordinary interest, the tax rate would be the same 22%. For qualified dividends and long term capital gains, it would be 15%. And "...plus state tax" applies to all the above.

And then there's the issue of the mortgage payment being a guaranteed return and investment returns not being guaranteed. But there's no law-of-nature math to account for that difference. Similarly, liquidity differences don't translate unambiguously into return rate comparisons.
That was a little bit confusing to me. Can you simplify it?
Sure - which part, and what is your best guess as to what it means?
I will simplify the numbers. The way I was looking at it is that it is guaranteed 5%. So the unpaid principal is 165K. Take 5% and it will be $8k. Taxable income last year was about let say 80K. So I would pay 22%( federal) and 7.5% (state) on the income of 72K but I think for federal it's not 22% and more like 19%. I also understand that to do the true comparison I would have to calculate how much taxes I will pay on increased income by investing into the taxable account.

So the confusion is for all this volatility in the market vs "guaranteed 5%". Does it make sense to maybe play safe for right now and take that 5%?

Thanks

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FiveK
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Re: Investing in taxable account or pay more for rental mortgage

Post by FiveK » Wed Sep 12, 2018 3:35 pm

lepa71 wrote:
Wed Sep 12, 2018 2:44 pm
I will simplify the numbers. The way I was looking at it is that it is guaranteed 5%. So the unpaid principal is 165K. Take 5% and it will be $8k. Taxable income last year was about let say 80K. So I would pay 22%( federal) and 7.5% (state) on the income of 72K but I think for federal it's not 22% and more like 19%.
It's 22% + 7.5% = 29.5% (unless that 7.5% is an effective rate). The marginal rate is the one to use, not the effective rate. With a bit more income the federal rate would be 24%.
I also understand that to do the true comparison I would have to calculate how much taxes I will pay on increased income by investing into the taxable account.
Assuming 15% federal and 7.5% state (same qualifier as above) is probably reasonable for a good investment strategy.
So the confusion is for all this volatility in the market vs "guaranteed 5%". Does it make sense to maybe play safe for right now and take that 5%?
Maybe it does and maybe it doesn't. If you don't mind the liquidity decrease and would sleep better with less money invested, 5% pre-tax is not too bad.

5% * (1 - 29.5%) / (1 - 22.5%) = 4.6% is the investment return you would need for the same pure math result. Will your investment choices return more than 4.6%? Based on history, "probably yes" - aka, maybe they will and maybe they won't. ;)

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grabiner
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Re: Investing in taxable account or pay more for rental mortgage

Post by grabiner » Wed Sep 12, 2018 8:54 pm

See Paying down loans versus investing on the wiki.

At your 29.5% marginal tax rate, you would earn a risk-free 3.53% by paying down the rental mortgage. You can't earn 3.53% risk-free in your taxable account; the current yield on low-risk long-term munis is 2.95% (Vanguard Long-Term Tax-Exempt), and that is subject to state tax. That is the fair comparison, because it compares two options at similar risk levels; whether you pay down the mortgage or not, you can sell bonds to buy stocks or vice versa to get your desired risk level.

I do agree with maxing out your 401(k) and IRA. You can earn more than 3.53% in a low-risk long-term investment there, such as 3.85% in Vanguard Long-Term Bond Index. In addition, you gain the benefit of getting more money to grow tax-deferred.
Wiki David Grabiner

lepa71
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Re: Investing in taxable account or pay more for rental mortgage

Post by lepa71 » Wed Sep 12, 2018 9:33 pm

Do you guys count in the interest saving or it does not matter? If paying extra $1k I can pay it off in 2024 and save about $37K in interest.

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FiveK
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Re: Investing in taxable account or pay more for rental mortgage

Post by FiveK » Wed Sep 12, 2018 10:05 pm

lepa71 wrote:
Wed Sep 12, 2018 9:33 pm
Do you guys count in the interest saving or it does not matter? If paying extra $1k I can pay it off in 2024 and save about $37K in interest.
If you invest the extra $1K you will earn some amount in "interest" instead. Perhaps not interest per se - more likely, capital gains and dividends - but that is what we are comparing: the guaranteed mortgage interest saving vs. the speculative investment returns.

If one compares options with the same risk, as grabiner notes, the one with the higher after-tax return is presumably better.

It's more subjective when comparing options with different risk and different expected returns. Some will choose a safer option with lower expected return, and some will choose a riskier option with higher expected return. Both choices are defensible, although only one will be "correct" in hindsight.

lepa71
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Re: Investing in taxable account or pay more for rental mortgage

Post by lepa71 » Thu Sep 13, 2018 9:36 am

FiveK wrote:
Wed Sep 12, 2018 10:05 pm
lepa71 wrote:
Wed Sep 12, 2018 9:33 pm
Do you guys count in the interest saving or it does not matter? If paying extra $1k I can pay it off in 2024 and save about $37K in interest.
If you invest the extra $1K you will earn some amount in "interest" instead. Perhaps not interest per se - more likely, capital gains and dividends - but that is what we are comparing: the guaranteed mortgage interest saving vs. the speculative investment returns.

If one compares options with the same risk, as grabiner notes, the one with the higher after-tax return is presumably better.

It's more subjective when comparing options with different risk and different expected returns. Some will choose a safer option with lower expected return, and some will choose a riskier option with higher expected return. Both choices are defensible, although only one will be "correct" in hindsight.
I understand what you are saying. Here is what I think. I'm 46 right now. I would like to retire at 55. By paying off most of my mortgage for rentals I would generate about $3K/month consistent income. I have been putting extra $600 towards the mortgage for the last years or so but was thinking to do more. You are both right about liquidity. Once it is in paid into the mortgage I can't really take it out but if it is in the taxable account than I would have more flexibility. Maybe I will continue to do some into the mortgage and some into taxable.

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