Should I pay off my mortgage early or invest in another Rental Property?
A Rental Property is certainly going to get you wealthy. But, the way you handle the cash flow is what you need to understand in the first place. Let me start this by asking you. What would you do if you have saved $30,000? Will you pay off your mortgage on your rental property or invest that money to buy another rental property?
You should pay off your mortgage early if you feel paying off your rental property can give you enough cash flow to live on for the rest of your life. Else, don`t rush to pay off your mortgage and invest to buy another cash flowing rental property. Investing for more cash makes more sense than it does in the past due to the larger tax brackets and ever low mortgage rates today.
Should you Pay off your Mortgage or Invest to buy more Rental Property?
Choosing from either paying off the mortgage early or investing in another property totally depends upon your situation of what as an investor you want with your money. Though I may debate with you why not plant more fruit-producing trees when you can comfortably water them?
But what if you don’t feel watering more trees and you want to surf in Hawaii? Go on pay off your mortgage and enjoy yourself surfing. But if you are motivated to become a real estate mogul someday, you need to reinvest your profits in more cash flowing properties today.
Pay off Mortgage or Invest-What I am doing right now?
Recently, I have finished reading the book “The Richest Man in Babylon” and stuck to a line that summarizes the idea of investing for me. Every gold that you save is a slave to work for you and the copper it can earn is its child that also can earn for you. To become wealthy with the rental business, you need to duplicate the same. Save some from the cash flow and invest it to generate more.
Is there any Advantage to Pay off the Mortgage on your Rental Property?
There should be some kind of advantage in paying off a mortgage if you still consider it worthy than investing to buy more. Indeed there are some if you go by the conventional wisdom that says less debt means fewer worries. Even better no debt, no worries.
Yes, it is true to some extent and certainly, a completely paid off rental property can give you peace of mind. But that is far away from achieving the dream of financial freedom unless
- You are having enough cash flow to retire.
- Have a plan to pull out equity to invest somewhere much better.
- You have a negative cash flow rental property.
- You are at an age where investing for more doesn’t make sense.
Anyway, let me tell you some of the advantages of paying off the rental property and not investing for more.
- Less work in managing fewer rentals.
- No Stress of Monthly Mortgage Payments
- Vacancies will not hurt you the same way
- Increased Cash Flow (Read: How to increase cash flow from your Rental Property)
- Assured Return on your money (Interest Rate you were paying to the bank earlier)
Pay off Mortgage will not Build Wealth. Investing will
Have you ever considered how much wealth you want to build with your rental business? If yes, what is your plan for it? And if your plan includes paying off the mortgage on your rental property with the cash flow you are getting. You are in the wrong place, my friend.
Scenario 1: Paying Off Mortgage
Imagine you have a rental property that is valued at $500,000 today. You have a 30 year fixed mortgage at a rate of 4% with monthly payments of $1910. Let’s suppose your net cash flow from your property is $1000 after paying all the expenses. You will be able to save 60% of this cash flow every month and additionally make $600 payments along with your monthly mortgage payments.
- Rental Property Value: $500,000
- 30 Yr Fixed Mortgage Rate: 4%
- Monthly Mortgage Payment: $1910
- Net Monthly Cash Flow: $1000
- Addition to Monthly Mortgage Payments: $600
This way your mortgage repayment will be shortened by 11 years and you will save $116,000 approximately. The total you will pay for owning this property in 19 years will now be $571,460. Let’s take into account the appreciation of this property in 19 years at a rate of 3% per annum. After 19 years, this property will be valued at $876,000.
What if you decide to sell off this property after 19 years? You will now have $304,540 worth of equity in your hand if I neglect all the taxes on the sale of the property. Even if you keep the rental property, you will then be having a net cash flow of $2910 (adding mortgage payments in an earlier $1000 cash flow).
With this scenario, you will be able to build $876,000 worth of equity if you hold this rental property which will be giving you a monthly net cash flow of $2910.
Scenario 2: Invest to Buy Another Property
In this scenario, let us suppose you saved the same cash of $600 per month for the next 10 years and don`t even put it in any savings or a CD account. You will then have $72,000 saved with you after 10 years. Now you decide to buy another rental property.
You researched the market and narrowed down to a rental property which will cost you $360,000. This property can easily rent at $3000 monthly. You put $72,000 as a down payment and obtain a 20 year fixed mortgage at 3.3% on $288,000. Your monthly mortgage payment will come at $1640. Let’s assume your net cash flow will be only $400 after paying for all the expenses.
Now let’s compare which scenario served you best when you pay off the mortgage or when you bought another property. See where you will be standing if you fast forward only 9 years after buying another rental property. A total of 19 years in both cases.
This means you have paid 19 years of your mortgage on your first rental property and 9 years of your mortgage on the second rental property.
First Rental Property (After 19 Years)
- Market Value: $876,000 (After 19 years)
- Amount paid in 19 years: $496,311
- Amount Remaining: $191,167 (Total to be paid in 30 Yrs: $687,478)
- Equity Built: $379,689
Second Rental Property (After 9 Years)
- Market Value: $469,000
- Amount Paid in 9 Years: $223,935
- Amount Remaining: $169,866 (Total to be paid in 20 Yrs: $393,801)
- Equity Built: $245,065
Now, you again decided to sell off both your rental properties exactly after 19 years of purchasing your first rental property. You will then have a combined equity of $624,754. But if you keep both the properties, you will be having a cash flow of combined cash flow of $1400.
What will be the situation When both the properties will be completely paid off?
Rental Property 1 (After 30 years)
- Market Value: $1,213,613
- Net Cash Flow: $2910
Rental Property 2 (After 20 Years)
- Market Value: $650,200
- Net Cash Flow: $2040
So, when you don’t pay off your mortgage and invest to buy another rental property; your combined equity after 30 Years will be $1,863,813 and your total monthly cash flow will become $4950. But if you pay off your mortgage and have not invested, your equity will be only $1,213,613 and your cash flow will be $2910.
Now see, what if you keep on buying another property after every 10 years. Imagine yourself what will be your net worth and how much equity you will build in all these years. Don`t forget the snowball effect which will start to increase your worth even faster and in much lesser time.
Advantages of not Paying off Mortgage and Investing to buy more Rentals
Enough of numbers. Let`s outright talk about the advantages of not paying off debt and using this money to invest in more rental properties.
1. Hedge against Inflation
Do you know how our economy works and why we suffer inflation? Inflation may seem a bad idea to you. However if you see the same from the perspective of a rental investor, inflation means increased rent prices. But what about your mortgage payment? They will remain the same throughout its term as you have obtained a fixed-rate mortgage. What it means is inflation is causing your debt to worth less every year. Why hurry to pay off the mortgage then?
2. Your Money will Labor For You
You must have known that the money you earn can labor to earn more money for you. But what happens when you pay off a mortgage? You are shoving your saved money into a rental property which will then can`t be put to further use unless you pull out equity again to invest. Money deserves to be utilized well.
3. Grab those Tax Deductions
The IRS allows certain deductions on a rental property. In a nutshell, you can write off most of your expenses from your rental income. A mortgage payment is one of the biggest expenses you have on your rental property. But once you paid off your rental property, you are not allowed to take that deduction.
4. Reduce your Risk
If you are into the landlording business, you must be aware of the risks that come with it. You stay constantly exposed to be sued by your tenant. If ever, your tenant becomes successful in suing you and you haven’t had the right protection; see your assets vanish like a donkey`s horn. When you pay off your mortgage, you are actually exposing more equity to the play.
There is no straight answer to whether you should pay off the mortgage or invest. It depends completely upon you and hence you should analyze your own situation. My friend Brian from Spark Rental says in this case that one should invest when he is young and pay the debts off when near to your retirement. I feel if you have a long term perspective on wealth building and feel rental investing is your way to achieve it. Keep on using the leverage to fund your wealth journey.
My last piece of advice for new investors is to invest wisely. Never ever rush to investing as it is all rainbows. Not all the real estate you consider as a great investment is actually that great. Invest in a deal that makes sense to you and only after performing complete due diligence on it.