Summary: In this article, we will discuss the question: Should I pay off my rental property mortgage or not? Topics include, benefits and disadvantages of paying off a rental property mortgage, how your net worth may be impacted by paying off an investment property early, and how to avoid early mortgage payment penalties.
Considering if it’s a smart decision to pay off a rental property mortgage? To be honest, this is a difficult question to answer with a simple yes or no. That’s because everyone’s personal situation is unique, and there are a lot of factors to take into account. This article should help you determine if the benefits outweigh the disadvantages, based on your own unique circumstance.
Three Goals to Achieve Before Paying Off Rental Property Mortgage
To begin, let’s discuss three goals you’ll want to achieve before making the decision to pay off the mortgage on your rental property. If you haven’t done so already, I would highly recommend knocking these out as soon as you can. Then come back to considering paying off your rental property mortgage.
Goal #1: Take Advantage of 401(k) Matching
It’s important to make sure you are taking full advantage of your 401(k) match if your employer offers it. If you are not currently taking advantage of this, you’re essentially giving up free money.
Goal #2: Get Out of High-Interest Debt
The best thing you can do for your finances is to pay off high-interest debt like credit cards, personal loans, and car loans. It’s important to pay off these debts first because the interest you are paying on your rental property mortgage will be less than your consumer debts.
Goal #3: Set Up an Emergency Fund
If you start throwing more money down to pay off your rental property mortgage, it’s difficult to get that money back. If your car breaks down or another costly disaster occurs, you’ll have your emergency fund to fall back on.
Should I Pay Off Rental Property Mortgage to Build Wealth?
As a real estate investor looking to build wealth, may be asking yourself, should I pay off my rental property or not? While paying of your rental property mortgage will indeed increase your cash flow, along with other advantages, there are plenty of reasons some investors choose not to. Keep reading to learn about 11 advantages of paying off an investment property mortgage and the 10 disadvantages of paying off a rental property mortgage.
11 Reasons to Pay Off Mortgage on Investment Property
In the following sections we will list and explain 11 advantages of paying off a rental property mortgage.
1- When You Have Negative Cash Flow on the Property
Real estate investors with a property producing negative cash flow will benefit from paying off their mortgage. You will instantly see positive cash flow every month and turn your investment around and into a success.
2- When You Need Income More Than a Tax Write-Off
One of the great perks about owning a rental property are the many tax write-offs available. If you pay off your rental property mortgage, you will no longer be eligible for some big tax savings. But, if you are in greater need of actual monthly income, then it may be a good idea to pay off the mortgage.
3- When You Want to Retire
A general rule of thumb for those approaching retirement is that all debts should be paid in full. Paying off the mortgage on your rental property can provide instant cash flow going and increase your monthly income leading into retirement. Additionally, if you decide to sell the property at any point, with 100 percent equity, you’ll see a nice cash return.
4- When the Return on the Paid Mortgage is Higher Than Other Investments
Here is another instance where it’s important to run the numbers. Let’s assume the interest rate on your rental property mortgage is 6 percent. Next, look at the annual rate of return on your investment portfolio over the last few years. If you are averaging a 4 percent return on your other investments then paying off your rental property mortgage will ensure a 2 percent increase in ROI.
Keep in mind while you are running these numbers that comparing a potential rate of return on a fixed-rate mortgage is a lot more accurate, because it doesn’t change. Whereas predicting returns on your stock portfolio is difficult with a fluctuating market.
5- For Peace of Mind
For some people, peace of mind is reason enough to pay off their rental property mortgage. The freedom of no obligation to a monthly mortgage payment, not only limits risk, but also lightens the financial burden tremendously. If paying off your rental property mortgage is worth the peace of mind it provides, then go for it.
6- To Become Debt-Free
As I’ve referenced in more than one of my articles, popular finance expert Dave Ramsey maintains a strict no-debt policy. While he has thousands of fans that share his same philosophy, others may be interested in pursuing a different approach. If one of your top priorities is to become debt-free, set your sights on accomplishing that goal.
7- For Big Savings on Interest
In one of my recent articles, I share a disadvantage of paying off your rental property mortgage, relating to the opinion that mortgage interest is relatively cheap. Now, I say this in comparison to other types of loans and the interest rates associated with them. Knocking out your mortgage will not only save you on interest costs every year, but guarantee a return on your investment. Which leads me to our next benefit…
8- For a Guaranteed Return on Investment
Another advantage to paying off a rental property mortgage, as I mentioned in my last article, is that you get a guaranteed rate of return. I know that the word guaranteed can make me question if it’s the real deal or not. But when it comes to paying off a mortgage, you are essentially guaranteed a return on your investment equal to the interest rate on your mortgage.
The example I use in the other article assumes that you have a 5.8 percent interest rate on the loan you wish to pay off early. If 5.8 percent seems like as good of a return as you are going to get on investments elsewhere, then take advantage of it and pay off your rental property mortgage.
9- For 100% Equity in Your Rental Property
Having full ownership of your investment property may be appealing to many investors. Especially if you have the capital to do so. You may be able to pay off your mortgage and obtain full equity of your property, with enough cash reserves to safely do so.
10- To Reduce Your Cost of Living
I think that in most people’s minds, there’s a difference in priority regarding the decision to pay off a mortgage on a primary residence or a rental property. There may be more urgency to pay off a primary residence than an investment property, simply based on reducing monthly expenses. Paying down your debt on any type of loan, including a mortgage, should reduce your cost of living and is definitely worth considering.
11- For Special Protections of Equity in a Property
The equity you have in your investment property is protected in most states. Meaning, the equity in your property is protected from bankruptcy and creditor claims. Other accounts like a 401(k), IRA and specialized retirement accounts usually offer the same protections. However, any cash investments are not protected. If you’re interested in protecting your assets, the money you put toward the pay off of your property will be safe.
10 Reasons Not To Pay Off a Rental Property Mortgage
The next sections discuss 10 disadvantages and reasons not to pay off a rental property mortgage.
1- When You Need To Use Leverage to Buy Another Rental Property
A mortgage essentially represents capital. And the biggest thing that real estate investors need is capital, a lot of it. Paying off a rental property mortgage means you lose access to money. If you have plans to buy future rental properties, it may be very difficult to do so without a mortgage to use as leverage.
2- When You Need a Tax Write-Off
In certain situations, rental property owners need a write off to reduce taxable income. Paying off your mortgage will not allow you to take advantage of that tax break. If your property is at least breaking even on the cash front, but depreciation expense is creating a taxable loss, you will definitely want to keep the mortgage on your rental property.
3- When You Have Positive Cash Flow
You probably won’t want to pay off your investment property mortgage if it’s consistently producing positive cash flow. In other words, the rental income you’re making more than covers the cost of mortgage, insurance, maintenance, repairs and other expenses.
A successful real estate investment does two things. The first is monthly profit and the second is someone else paying down your mortgage until it’s gone. Thus producing more and more cash flow.
4- When There’s an Opportunity Cost
Here’s where it is important to look at the big financial picture. Being debt-free can be amazing, it’s better to have a small amount of debt and a bunch of money in the bank than no debt and no savings. Before deciding to pay off your rental property mortgage, consider the impact it may have on your net worth (more on that later in the article).
5- When Your Return on Investment is Low
Even though paying off your rental property mortgage guarantees a return on your investment, it doesn’t mean the return is going to be good. That’s because mortgage interest rates are relatively low and your rate of return if you pay off your loan will be only as much as your interest rate.
So if your interest rate is anywhere between 4.5 percent and 5.8 percent, you will more likely see a better return investing your money elsewhere than paying off your mortgage early. For instance, the S&P has produced yearly returns around 10 percent, which is about double the return compared to choosing to pay off a rental property mortgage.
6- When There is a Loss of Tax Breaks for Mortgage Interest
A lot of taxpayers take advantage of mortgage interest tax deductions. But with changes to the tax laws in 2017, there are new limitations to deduct mortgage interest for certain borrowers while also raising the standard deduction significantly.
7- When You Miss Out on Tax Breaks for Retirement Savings
I’m going to let the math do the talking on why missing out on retirement savings could be a big disadvantage to paying off your investment property mortgage.
Here’s an example:
Let’s say you put an extra $6,000 per year toward paying off your rental property mortgage, instead of putting $6,000 into your 401(k) or IRA. In turn, you would be giving up $1,230 in tax breaks, if you are in the 22 percent bracket. Basically, you will most definitely miss out on tax savings if you are paying off your rental property mortgage rather than maxing out your tax-advantaged accounts.
8- When You Need Liquid Assets
Something to keep in mind regarding real estate investments is that just because you have a lot of money or equity in your property, doesn’t mean you have access to your invested money. If you decide to sell your property for more liquidity, it will probably take longer and be more costly than anticipated. If you prefer quick access to your investments, I wouldn’t recommend putting all your cash toward a rental property mortgage.
9- When You Need to Diversify Your Assets
One of the fundamentals of investing includes a diversified, or balanced portfolio. The main reason it’s so important, is that it helps minimize risk for investors if and when different markets decline. If you are putting more money toward paying off your rental property mortgage, then you are essentially investing heavily in real estate. What if your property loses value? Your net worth will be impacted because you don’t have money in other assets.
10- When Inflation Reduces the Savings From Paying Off Your Rental Property Mortgage
In my last article of this series, I explained how inflation erodes debt. The basic idea is that the worth of your rental property mortgage will decrease over time, due to inflation. If we experience a 2 percent inflation rate over the next 25 years, a $2,000 monthly payment on a fixed-rate mortgage will be worth just $1,000. The expected future savings if you pay off your mortgage early should be discounted due to inflation.
Finally, there are so many things to consider before determining if you should pay off a rental property mortgage. Again, it all depends on individual circumstances. Be sure to consider your mortgage interest rate along with what else you could be doing with the money (opportunity cost), instead of paying off your rental property mortgage.