Should you ever pay off the mortgage on your rental property early? That’s a complicated question. And, as with anything else in investing, the answer depends on a number of factors, like your reasons for investing in real estate and your long-term goals. If you’re in the game to grow your net worth, for example, your perspective will likely be very different from someone who’s in need of cash flow.
If paying down the mortgage on a rental property is a decision you’ve been pondering, it likely means that you’ve come into enough liquidity to make it happen. But is eliminating a mortgage the wisest use of that windfall? Here’s a look at when it might be smart to pay off a rental property, and when it might not.
When to consider paying off your rental property
When determining whether to pay off your rental property mortgage, an option to start your evaluation is to take a good look at your cash flow. You’ll find one of three scenarios -- negative, zero, or positive. Having a zero cash flow property can be an advantage, especially if you’re considering a 1031 Exchange. And if your cash flow is positive, that’s real income that’s going into your pocket.
If you have a negative cash flow on the property, though, with more money going in than coming out, one way to turn that situation around is to pay off the mortgage. With a clean title, every penny of rental income after expenses is yours to keep.
Here’s a quick example:
You currently own a rental property that costs $18,000 a year in mortgage payments and interest, and it currently has a negative cash flow of $5,000. If you eliminate that $18,000 a year payment, and assuming other expenses remain the same, your negative becomes a $13,000 positive cash flow.
Interest rates are another factor in whether investors consider paying off a rental property, because eliminating the mortgage debt also eliminates the extra you’ll pay over time with interest. Eliminating a 5% interest payment effectively equals saving 5% on the cost of the property, which can give your overall portfolio a boost -- especially if it’s not making the same returns overall.
Finally, it just feels good to not have debt, and that is especially important for people on the path to retirement.
When it’s probably not a good idea to pay off your rental property
While owning a property free and clear may seem like the right solution for investors, the reality is a little more complicated. Consider your endgame -- if it’s increasing your net worth vs. income, here are some reasons why it may be more beneficial to you to keep the mortgage.
One benefit to having a mortgage is tax savings. In fact, one of the big reasons people choose to invest in rental property is to take advantage of its numerous tax write-offs. Depreciation, for example, is an important deduction because it can help investors show a loss on paper for the year, leading to a lower tax bracket.
Mortgage interest is another tax deduction that would be lost if a mortgage is paid off. Put together with the loss of depreciation and a potential positive cash flow on the property, you could find yourself owing tax on income vs. showing a paper loss.
One way to determine the tax implications of paying off your rental property is to compare the money you’d save by paying off the interest to the tax savings you’d receive if you didn’t. If you’d actually save more on taxes by keeping the mortgage, it might be the best move.
Another big reason investors choose real estate is their opportunity to leverage up, which means using other people’s money (i.e., the bank’s) to grow your portfolio. If you use cash to pay off a mortgage balance, you lose your leverage -- and if you bought the property using leverage, it would be negated.
Here’s an example of why it may be better to leverage up vs. pay down:
What would happen if, instead of paying down that one property, you used that $200,000 to buy five more rental properties with a down payment of $40,000 each?
Also consider the current interest rate on your mortgage. If the rate is low (today’s are as low as 2-3%), and especially if the house has positive cash flow, why not let the tenants continue to pay down the mortgage for you? You’d be trading a small effective return for the chance to invest your $200,000 in assets that will earn even bigger returns, like your IRA or stock portfolio.
The Bottom Line
Consider paying off the mortgage on your rental property if:
● The property has a negative cash flow
● You’re in need of liquid income
● You’re considering retirement
● The mortgage interest rate is higher than the return on the rest of your portfolio
● You want to be debt-free
Consider leaving your rental property mortgage in place if:
● Losing tax deductions would significantly increase your taxable income
● The property has a positive cash flow
● You want to grow wealth
● You don’t want to lose your leverage
● The mortgage interest rate is lower than the return on the rest of your portfolio
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. The examples shown are for illustrative purposes only. Actual results may vary and be more or less favorable than shown.