Today’s guest post comes from Patricia Sanders who is a freelance writer with a knack for rentals and mortgages. Take it away Patricia!
If you decide to purchase a rental property, you should consider it as a big investment. If you don’t, you can’t analyse the cost of capital and the return on your investment. After that, you must compare such investment returns with the mortgage interest rate you are paying off.
Many of us might think that paying off your rental property mortgage early is not a good idea. Instead, investing in other sectors or investing in more rental properties may be quite a smart move.
Now, this concept is highly debatable as multiple factors should be considered before making any decision. Practically, most of us would want to pay off their rental property mortgage as soon as possible, free up all the home equity, and get rid of monthly payments. But still, you may tangle up between two main objectives here:
- Pay your mortgage off early, OR
- Invest that money to build more wealth
The decision will vary from person to person depending on their financial status and other priorities. But, to help you to make the ultimate decision, I’m going to discuss the Pros and Cons of paying off your rental property mortgage early. Consider these facts, and choose the option that suits you better.
As per Justin Goodbread, a financial planner, you must consider the 6 variables below before making a decision:
- Property’s current value
- The rate of mortgage interest
- Home appreciation in your area
- Your taxable income
- Return on investment rate
- Probability of a recession
The Pros Of Paying Off Your Rental Property Mortgage Early
1. No interest payments at all. Long mortgage terms means interest payments for a longer time. The longer you pay mortgage interest, the higher your interest amount will end up being overall.
The higher the interest rate on a mortgage, the wiser it will be for you to pay it off as early as possible. It’s better to keep your hard-earned money in your own bank account rather than giving it to your lender.
2. Good cash flow in your monthly budget. After paying off your rental property mortgage early you’ll have more more cash flow to play with in your budget. This extra cash flow could then be used to more aggressively pay of other debts or mortgages you might have elsewhere.
3. Less debt means fewer risks. When you have a tight budget and carry a big mortgage on rental properties, a sudden, major expense may utilize all of your cash flow for several months or years.
Similarly, if your tenants fail to pay the rent (HELLO COVID-19!), you’ll be in a more precarious position that you might not be able to recover from. The bottom line is, if you have debts on your rental property, it may create risk. That’s why it is wise to pay off your rental property mortgage as early as possible.
4. Impacts your debt-to-income ratio. The debt-to-income ratio indicates how much you are worthy to carry a new debt based on your current income. The lenders verify an individual’s ability to pay off monthly payments and based on that information and pay debts.
When you pay off your rental property mortgage early, this may reduce your debt-to-income ratio and increase your trustworthiness to the lenders. As a result, you may get approval for another loan easier or be able to get a lower rate on your current loans.
The Cons Of Paying Off Your Rental Property Mortgage Early
1. Lose tax benefits on the interest. The interest amount you pay every month is tax-deductible. If you pay off the rental mortgage totally, then you will no longer need to pay interest. As a result, more of your rental income will be considered taxable as per your regular tax rate. As an investor, if you want to get tax benefits, you should keep this on your mind.
2. No funds available. Paying off your mortgage needs a big amount to pay off the lender. As a result, you may face a shortage of funds to invest in other properties. Many investors may choose to invest the money instead in buying more rental properties with another mortgage. This way you can increase the overall number of assets you own even more.
3. Less liquid money in hand. Paying off a mortgage on rental properties will make yourself less liquid in terms of cash. Less liquid assets denote you have limited cash in the bank to use.
What do you do if you face a sudden large repair bill on that property? What will you do if you don’t have enough cash to handle that situation? Would you take another loan for it?
You will have to choose between the entire rental home equity and a good amount of liquid cash in your bank. The second option will restrict you from paying off the mortgage. But having a good amount of cash can serve many important purposes in your life such as more investments, consolidating credit card debt, retirement savings, insurance coverage, vacation expenses, etc.
4. No leverage. You can’t use the entire money, stored in the form of equity (value of the rental property), to earn more money unless you sell that property or take out a loan by placing it as collateral.
People often refinance their investment property so that they can use the equity to liquidate the asset. After liquidation, they use that fund to buy more properties with more leverage. Those who don’t know what a Leverage is, as per Investopedia – “Leverage can also refer to the amount of debt a firm uses to finance assets. When one refers to a company, property or investment as “highly leveraged,” it means that item has more debt than equity.”
So, clearly, by using leverage you may increase your ROI (return on investment). It can be described with a simple example – What is more profitable to you? Buying a single rental house (with no mortgage) using the capital of $100,000? Or Making a down payment of 20% down payment and buying 5 similar rental properties? Which option will give you more income? Of Course, the second one as you’ll earn more rental income from them!
5. Losing a low borrowing cost. It makes sense to not pay off a rental property mortgage if it comes with a low interest cost. If you carry that mortgage, you may hold onto a low fixed mortgage rate till the loan term ends. You also might not be able to take a new mortgage if you do end up paying it off as times can change and banks can insist on new lending criteria.
Tips To Pay Off Your Rental Property Mortgage Early
If you have decided to pay off your rental property mortgage before its full term, then you should:
A) Analyse financial situation – Review your financial situation and all the life goals, both short-and-long-term. Find out the current rate and term on your loan. Calculate all the debts you have such as credit card debts, or car loans, or other loans.
Consider what is more important to you – completing your life goals or paying off the mortgage. You should assess your insurance coverage and your retirement savings. Last but not the least, review your investment portfolio.
Consider these situations and then decide if you can afford to pay off your rental property mortgage early or not.
B) Look for any prepayment penalties – Always check for mortgage prepayment penalties if you pay off the loan early. You might be charged an extra fee for prepaying the mortgage. Check if you can waive off the charge, contact your lender.
C) Pay off high-interest debts – You must pay off other debts, such as credit cards, payday loans, medical bills, and other high-interest debts ASAP. These high-cost debts usually drain your money more and the interest isn’t tax-deductible. Once you pay off these debts, you can free some space in your monthly budget. Using that money you can then pay off the mortgage early.
D) Remove PMI – Private mortgage insurance or PMI will be charged by lenders if you didn’t pay 20% of the property value as a down payment. But you may get rid of it when you pay down 80% of the mortgage. This will make paying off your investment property mortgage easier.
E) Build up an emergency fund – It is wise to have an emergency fund prepared before making extra payments on rental property mortgage. This way you will be able to maintain some liquidity in cash for emergencies while you use the rest to pay off the mortgage.
The information on this website is for general information purposes only. It is not intended as financial or investment advice and should not be construed or relied on as such. Before making any commitment of a financial nature you should seek advice from a qualified and registered financial or investment adviser.
The benefits include: 1) How to pay off your mortgage faster than 99% of people with one hour a month of work 2) How to get rid of your debt and have the freedom to spend money on the things you love, guilt free 3) Clear outline of how to setup your expenses, mortgage and general finance 4) How offset accounts work and how to get the same result without being gouged by the big banks 5) How to cut through the crap and focus on the things that truly matter when taking down a mortgage 6) How to adjust the strategy so it works for you, even if you have kids, even if you only have one income 7) How to do all of these things and maintain a normal social life (and never be cheap).