Which mortgage would you prepay?

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wxl31
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Joined: Sat Jun 15, 2013 6:52 am

Which mortgage would you prepay?

Post by wxl31 »

Consider two possible mortgages that I can prepay:

Mortgage 1
Primary residence
Assume that standard deduction will be used for 2018
Balance: $80k
Interest rate: 4.125%
Anticipated pay-off date: 01/01/2025

Mortgage 2
Rental property
Making a small profit yearly, assume federal marginal tax rate of 32% and state tax rate of 9.3%
Balance: $350k
Interest rate: 3.875%
Anticipated pay-off: 12/01/2035

Say I have $80k available to prepay principal towards either of the mortgages (please don't discuss other uses for the cash, assume retirement accounts/529s are fully funded, etc.)

I always thought it would be a no-brainer to prepay the primary residence as the interest is no longer deductible and the interest rate is higher (I have actually been doing this intermittently over the last couple years which is why the balance on it is relatively low and the pay-off date is relatively near compared to the rental property).

However, after plugging it into an amortization calculator, it appears I would save more in interest I paid $80k towards mortgage 2 (probably because the balance is higher and the time to anticipated pay-off is longer) instead of mortgage 1. However, I also have to factor in that prepaying mortgage 2 will increase taxes due to increased yearly rental profit.

I cannot wrap my mind around this problem and determine mathematically what is the most financially-advantageous thing to do. Can somebody with a clearer mind help reason this out for me?
Iridium
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Re: Which mortgage would you prepay?

Post by Iridium »

wxl31 wrote: Wed Sep 19, 2018 2:40 am However, after plugging it into an amortization calculator, it appears I would save more in interest I paid $80k towards mortgage 2 (probably because the balance is higher and the time to anticipated pay-off is longer) instead of mortgage 1. However, I also have to factor in that prepaying mortgage 2 will increase taxes due to increased yearly rental profit.
Your analysis is leaving out what happens after the mortgage is paid off. Pay off the primary, then apply its old payments to the rental until the time that the primary would have been paid off and you will be slightly better off than if you had applied the funds to the rental and kept paying your primary mortgage until it is paid off.
Ron Scott
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Re: Which mortgage would you prepay?

Post by Ron Scott »

I’ll try but would like to hear from others.

Pay off #1.

What Iridium said, plus the amortization calculator assumes holding #2 until 2035 which is questionable and probably isn’t factoring in time value/inflation on the savings. BTW, you are writing off the mortgage payment in #2 as an expense.

If #2 is a pure financial play consider selling it. A “small profit” that can turn into a loss between tenants may not be worth it compared to redeploying the market value to your investment AA. And a single house isn’t helping you diversify.
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.
Valuethinker
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Re: Which mortgage would you prepay?

Post by Valuethinker »

Iridium wrote: Wed Sep 19, 2018 3:50 am
wxl31 wrote: Wed Sep 19, 2018 2:40 am However, after plugging it into an amortization calculator, it appears I would save more in interest I paid $80k towards mortgage 2 (probably because the balance is higher and the time to anticipated pay-off is longer) instead of mortgage 1. However, I also have to factor in that prepaying mortgage 2 will increase taxes due to increased yearly rental profit.
Your analysis is leaving out what happens after the mortgage is paid off. Pay off the primary, then apply its old payments to the rental until the time that the primary would have been paid off and you will be slightly better off than if you had applied the funds to the rental and kept paying your primary mortgage until it is paid off.
Does it make sense to prepay a mortgage on a rental property?

I am not au fait with the US tax system.

However I would have thought the goal is to minimize taxable income - i.e. to maintain the mortgage for as long as possible? Given the interest is offset against rental income.
riverguy
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Re: Which mortgage would you prepay?

Post by riverguy »

Easily 1. Not deductible, higher interest rate. No brainer.
m@ver1ck
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Re: Which mortgage would you prepay?

Post by m@ver1ck »

Another reason for 1:
Currently, if you wanted to buy a third property, the mortgage on your primary residence counts towards your debt to income ratio.
Once 1 is paid off, if you were to apply for another loan, that $$$ amount per month won't be included in the monthly debt to income ratio, making it easier to get a loan.
m@ver1ck
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Re: Which mortgage would you prepay?

Post by m@ver1ck »

Ron Scott wrote: Wed Sep 19, 2018 4:07 am I’ll try but would like to hear from others.

Pay off #1.

If #2 is a pure financial play consider selling it. A “small profit” that can turn into a loss between tenants may not be worth it compared to redeploying the market value to your investment AA. And a single house isn’t helping you diversify.
Even if it's a small monthly loss, he's essentially got the tenant slowly chipping away at his mortgage. for maths sake - If it's a million dollar home, and he's got 200000 down, over time the rentor has bought him his house . So over 30yrs, 200K becomes 1million + whatever appreciation on 1million happens .

Not sure if 200K invested in stocks over 30yrs would give you the same appreciation. What am I missing?
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Watty
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Re: Which mortgage would you prepay?

Post by Watty »

riverguy wrote: Wed Sep 19, 2018 4:40 am Easily 1. Not deductible, higher interest rate. No brainer.
+1

and it would free up some cash flow each month.
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Nate79
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Re: Which mortgage would you prepay?

Post by Nate79 »

Unfortunately people get mixed up when they look at amortization schedules. The return of a prepayment is the interest rate on the loan. The amount of interest you pay on a mortgage is just the interest rate times the outstanding principle on a monthly basis.
Iridium
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Re: Which mortgage would you prepay?

Post by Iridium »

Valuethinker wrote: Wed Sep 19, 2018 4:20 am
Iridium wrote: Wed Sep 19, 2018 3:50 am
wxl31 wrote: Wed Sep 19, 2018 2:40 am However, after plugging it into an amortization calculator, it appears I would save more in interest I paid $80k towards mortgage 2 (probably because the balance is higher and the time to anticipated pay-off is longer) instead of mortgage 1. However, I also have to factor in that prepaying mortgage 2 will increase taxes due to increased yearly rental profit.
Your analysis is leaving out what happens after the mortgage is paid off. Pay off the primary, then apply its old payments to the rental until the time that the primary would have been paid off and you will be slightly better off than if you had applied the funds to the rental and kept paying your primary mortgage until it is paid off.
Does it make sense to prepay a mortgage on a rental property?

I am not au fait with the US tax system.

However I would have thought the goal is to minimize taxable income - i.e. to maintain the mortgage for as long as possible? Given the interest is offset against rental income.
It makes roughly as much sense to pay down the rental as to purchase a 3.875% taxable bond. To be clear, I am not necessarily suggesting this as an action, as OP has not given is enough info to make that decision and specially told us to not suggest other uses of the money. The scenario I described is strictly better than paying down the rental in that for the same amount of payments results in a lower rental mortgage balance.

The way that OP analyzed the amortization tables, it is as if s/he had paid off the primary, then stuck the saved mortgage payments into a mattress. That, of course, shows as less profitable than putting the money into the rental mortgage, where the prepayment has more time to eat into the principal. It is also a nonsense scenario, as the OP would presumably so something more profitable than earn 0% interest.
ofckrupke
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Re: Which mortgage would you prepay?

Post by ofckrupke »

Watty wrote: Wed Sep 19, 2018 9:34 am
riverguy wrote: Wed Sep 19, 2018 4:40 am Easily 1. Not deductible, higher interest rate. No brainer.
+1

and it would free up some cash flow each month.
Agreed. Also less term risk than #2.

Another way of viewing the change in cash flow is as the monthly maturity proceeds from a sinking ladder/portfolio of 4.125%-after-tax-yielding bonds effectively bought by paying the loan off with the $80k. This portfolio is exhausted on 1/1/2025. It will be reduced to roughly half its original value at roughly halfway to 1/1/2025, in late 2021; its duration today is just over three years. Just try finding an alternative credit-riskless fixed income investment today with that post-tax yield and duration.
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grabiner
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Re: Which mortgage would you prepay?

Post by grabiner »

Valuethinker wrote: Wed Sep 19, 2018 4:20 am Does it make sense to prepay a mortgage on a rental property?

I am not au fait with the US tax system.

However I would have thought the goal is to minimize taxable income - i.e. to maintain the mortgage for as long as possible? Given the interest is offset against rental income.
The goal is to optimize spendable money. Reducing taxes is one way to do this, but so is reducing expenses, which is what you get by paying down a deductible mortgage.

So the question is whether paying down the mortgage is the best use of the money. Paying down a 3.875% rental mortgage is equivalent to buying a taxable bond yielding 3.875%; an extra $10,000 payment will increase your net worth by $387.50 next year in reduced interest, but you will increase your taxable rental income by the same amount.

And in the OP's case, with 17 years left on the mortgage and a 41.3% tax rate, I don't think that is a good investment, as the after-tax return is only 2.27%; municipal bonds earn more than that, and are liquid.
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Topic Author
wxl31
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Re: Which mortgage would you prepay?

Post by wxl31 »

Iridium wrote: Wed Sep 19, 2018 3:50 am
wxl31 wrote: Wed Sep 19, 2018 2:40 am However, after plugging it into an amortization calculator, it appears I would save more in interest I paid $80k towards mortgage 2 (probably because the balance is higher and the time to anticipated pay-off is longer) instead of mortgage 1. However, I also have to factor in that prepaying mortgage 2 will increase taxes due to increased yearly rental profit.
Your analysis is leaving out what happens after the mortgage is paid off. Pay off the primary, then apply its old payments to the rental until the time that the primary would have been paid off and you will be slightly better off than if you had applied the funds to the rental and kept paying your primary mortgage until it is paid off.
Thank you so much for pointing this out. Could not wrap my head around why paying a lower interest mortgage was more advantageous according to the amortization calculator, but your explanation was just what I needed.
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