The issue at hand– You have a chunk of money (perhaps you received an inheritance, an annuity matured, you sold an asset, etc.), or you have a monthly increase (a raise, a debt paid, a rental property mortgage paid off). The question– Should I pay down/off my home mortgage, pay off a current rental property mortgage, or invest in an additional property? There are many variables, experiences, and personal values/goals involved, making each situation its own. Here’s some information to help you make the right decision for you.
Benefits of paying down/off my mortgage –
Choosing to pay down or off your mortgage is usually based on the risk factor and your mortgage cost.
Risk Factor: There is always the potential that the economy will take an abrupt downturn (a lesson well-learned in 2020 with the pandemic), or a personal situation arises, such as an unexpected medical crisis or job loss, which results in an inability to pay your bills. Suddenly, your personal solvency is at risk –IF you haven’t established a backup plan. If you have six months or more living expenses, including mortgage and debt payments, insurance payments, cost of daily living, etc., stashed away in secure but accessible savings, your risk is relatively low. On the other hand, if you don’t, your risk is high. If your risk is high, and you can pay off your mortgage with your windfall, do it. If your increased cash flow means you are paying it down much quicker rather than eliminating it, then perhaps it would be best to create those savings before you visit the question of paydown vs. an investment.
The cost of your mortgage factor:
1. If your current interest rate on your mortgage is higher than the percent of inflation, then every month of continuing mortgage means you are falling behind. It encourages a pay–off.
2. But if your fixed mortgage interest rate is lower than inflation, then your mortgage is theoretically earning money. The value of your home is increasing with inflation, while the payment does not.
3. Likewise, if your interest rate is lower than the percentage of return on your investment, then there is a “cost” to paying off your mortgage. Of course, you may consider the cost is worth the peace of mind and satisfaction of owning your home free and clear.
Risk and cost aside, there are benefits to paying off a mortgage.
1. You will have an immediate increase in cash flow.
2. Your return on investment is clear. If you have a mortgage rate of 3.4%, and you pay it off, then you earned 3.4% on whatever your remaining balance was because that is the amount you saved in interest. (Bear in mind, it is important to compare your interest savings with your interest potential should you choose to invest instead.)
3. Equity – There is value, as well as satisfaction in owning a property. Furthermore, that equity is in your favor, should you either hit a financial crunch time or later want to borrow and invest in another property.
4. Freedom – When you are debt-free, no one ‘owns’ you. There is an old proverb that says, “The borrower is servant to the lender.”
5. Flexibility – If the mortgage you paid off was a rental property, owning it free and clear gives you breathing space, should a tenant get behind in rent or you have a vacancy for a time. Not having a mortgage payment takes the pressure off.
Benefits of investing in a rental property –
1. The mortgage on your home – or current rental property – does not affect its value. In other words, the value of your property is the same, whether or not you have a mortgage on it.
2. It also is guarded against inflation. While the price of everything else is going up, your loan payments stay the same.
3. If the mortgage you are considering paying off is a rental investment, the property’s equity is not necessarily an advantage since it isn’t a liquid asset. You would have to sell the property to use the equity. Rather than have one rental fully paid, having two rentals at 50% equity or three rentals at 33% equity, etc., will build your portfolio faster.
4. If the mortgage you would be paying down is your residence, consider the interest rate. Typically, home mortgages have the lowest interest rates. Instead of erasing that debt, using an extra chunk of cash as a down payment on a rental property will reduce the amount you have to borrow at a higher rate. If you have an increase in cash flow, using the money for the loan with the highest rate makes the most sense.
5. The main reason to not pay off your mortgage and instead invest in rental property is cash flow. The idea is that if you buy a rental property, the cash you would have used to pay off your mortgage will make you money. It does this by generating cash flow from the rental property. Of course, you must factor in the costs of owning a rental property, including property taxes, repairs and maintenance, insurance, utilities, potential weeks of vacancy, and more. If a careful analysis of costs still shows a solid monthly cash flow, then you should be getting more for your money than what you save in interest when paying down your mortgage.
In the end, begin by establishing a 6-month cushion for emergencies. Then consider the advice offered by financial planner Justin Goodbread. He points out six variables to consider before making your final decision.
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- Your home’s current value
- Your mortgage interest rate
- Home appreciation in your area
- Your income tax
- Expectations for inflation
- An assumed rate of investment return
Real estate is typically a sound investment and source of passive income. For some investors, it eventually replaces their current source of income and becomes a business.
About Rentals America
Rentals America provides full-service property management for residential rental properties. Our team is completely dedicated to property management and we’re here to help landlords navigate the rental market.
