Payoff the mortgage or not? Always a big debate – especially for a real estate investor. I’ve always opted to have a mortgage on my primary residence because it was at a 4% rate. I can take the mortgage amount and own rental properties free and clear that yield a better return……so I thought!
Recently, one of the tenants in a property opted to buy the house they were in (lease to own). I owned the property free and clear so it was going to be a windfall of cash (a good thing but I had to have a plan as idle cash loses value).
Of course, I started to immediately scope out if there were any potential houses I could buy to make into rentals. First and foremost, I was surprised. I know the economy is strong. I see my IRA statements. I see my stock statements. I see my company’s sales and revenue. Yes, the economy is hot. But guess what? This affects real estate – it goes up in value. The amount of homes for sale is very minimal. And, those houses for sale are going for 20-30% higher than I was paying a few years ago. This made me pause and really dig into the option of using the proceeds from this sale to pay off my primary mortgage. When I did the math, it was a no brainer. This really surprised me. Here’s the math:
Sale of the rental property: $233,000
New potential rental houses: Approximately $130-135,000 (were $100-110K in 2014-2016)
Potential rent: $1100 per month per house
Primary house mortgage balance: $267,000 (I would have to tap into my savings of $34,000 to pay off)
Basically for $267K, I could buy two rental houses and collect $2200 per month (gross return of 9.9%)
If I paid off my mortgage, I would free up $1356 cash each month (essentially gross 6.1% return)
If I only stopped there, better to buy 2 rental houses for $267K than pay off my mortgage. BUT, these are gross returns. I delved deeper factoring in expense on rentals and interest savings on mortgage. This changes it!
Rental Home Option
Investment: $267K (2 houses)
Rental income: $1100 x 2 (per month)
Expenses (annual) : Property taxes ($1100 x 2); Insurance ($650 x 2); Maintenance ($1200 x 2); Income tax ($2700 total)
Annual profit: $17,800 (net return of 6.7%)
Pay off mortgage option
Investment: $267K (mortgage balance)
Monthly mortgage payment: $1356 ($875 of which is interest)
Note: I plan to sell my house in 6 years and downsize. This is important as it makes the interest on the mortgage very real in terms of cash in 6 years when I sell. (If I keep the mortgage until I sell in 2024, I pay additional $63K ($875 x 72), ouch)
Net monthly cash: $1356 (monthly payment) plus the $875 savings in interest = $2231
Annual “profit”: $2231 x 12 = $26,772 (net return of 10.0%)
And, I don’t have to deal with maintenance on 2 houses vs. maintenance on my own house plus tenant issues. This has some value.
In the end, the option to pay off my primary residence was a no-brainer vs. buying 2 rental properties. 6.7% vs. 10.0% (annual net cash difference of $26,772 - $17,800 = $8972). The 4% mortgage interest rate is deceiving because mortgages are front loaded with interest – this is a BIG deal. The bank gets theirs upfront, screwing you the mortgagee.
I did pay off my mortgage in early April. Last week I got the lien release and deed. This month, it was very cool NOT to send a mortgage payment to the Credit Union. What did I do with that cash? Invested it of course! (See my post on the Boiled Frog Syndrome)