Paying off a rental property is a much more complicated question than it might seem. On the one hand, cash flow will increase and worries may decrease. But on the other hand, cash-on-cash return will go down and opportunities could be lost.
Let’s take a look at when and if it might be a good idea to pay off a rental property, along with three important things to think about first.
- Before paying off a rental property, investors may want to make sure they have money for an emergency, get rid of high-interest debt, and fully fund retirement accounts.
- Potential advantages to paying off a rental property loan include increased cash flow, less worry, and eliminating debt.
- Drawbacks to consider include potentially having fewer liquid assets, less diversification, and lower potential returns.
- Investors looking for less risk or nearing retirement may choose to pay off a rental property, while other investors may decide that using the cash to purchase more rental property makes better financial sense.
Is it a good idea to pay off a rental property loan?
Another way of thinking about this question is to ask, “What is the best use for the extra cash that an investor has?”
Of course, the word “best” means different things to different people. Granted, the idea of not having to worry about making another mortgage payment each month can be a tempting reason to pay off a loan.
But before pulling out the checkbook, many investors make sure to take care of themselves first. Here are three important things to think about before paying off a rental property loan.
1. Are there sufficient funds on hand for a personal emergency?
Life is full of ups and downs, and bad things usually happen at the worst possible time. To help plan for the unexpected, many people set up an emergency fund to make sure they have the cash on hand to pay for disasters like a car accident or medical expense.
When you think about it, having money on hand for a personal emergency is similar to what real estate investors do when they set up and fund a CapEx account to pay for major repairs.
2. Is there other current debt with a higher interest rate?
Total credit card debt in the U.S. is $807 billion this year, and the average debt per American family stands at $6,270. Nearly half of families in the country have some sort of credit card debt, and surprising as it may seem, people with college degrees carry the highest credit card balances
Before even thinking about paying off a rental property loan, many investors focus on getting rid of high-interest debt such as credit cards, car loans, and personal loans. Even if the loans are unsecured, having high interest rate debt can have a negative impact on credit scores.
3. Are retirement accounts fully funded?
Paying off a rental property before retirement accounts are fully funded is similar to leaving money on the table, especially if your employer offers a 401(k) match.
There are also a wide variety of retirement plan options available for self-employed people. Before using extra money to pay off a rental property mortgage, investors may consider funding IRAs, solo 401(k)s, SEP IRAs, or defined benefit plans for high income earners with no employees who want to save as much as possible for retirement on an ongoing basis.
Advantages to paying off a rental property
Here are five potential advantages to consider to help decide if paying off a rental makes financial sense.
Increase cash flow
The monthly mortgage rate on a $125,000 loan is about $600 per month, principal and interest, based on an interest rate of 4% for an investment property loan. Not having to pay the bank each month adds a significant amount of money to the bottom line, especially if the home isn’t cash flowing as well as expected.
Offer aggressive rents
Not having a monthly mortgage payment also gives an investor the option of offering an attractive rent to keep occupancy as high as possible. An investor who doesn’t have a rental property loan can also take more time to find the most qualified tenant possible, instead of jumping at the first prospect who comes along.
Even with a great tenant and an outstanding property management company, there is still the risk that something will go wrong. For example, the tenant could have a life-changing event and need to be evicted at a significant out-of-pocket expense. Not having debt on the property allows an investor to increase cash reserves to ensure funds are on hand for unexpected events.
Income more important than write offs
One of the advantages of owning a rental property is being able to write off expenses like interest to reduce pre-tax income. However, some investors may decide it makes more financial sense to increase cash flow instead of paying a lender hundreds of dollars in interest every month.
Living debt free
For many people, the idea of living debt free and not being beholden to anyone is an attractive proposition. Equity in a rental property owned free and clear may be protected from creditor claims in some states, and retirement planning can be easier without an extra mortgage expense.
Disadvantages to paying off a loan on a rental property
While there are some pluses to not having a rental property loan, there are also some potential drawbacks to consider as well.
Not having leverage on a rental property can lower cash-on-cash returns.
To illustrate, assume an investor has a $150,000 single-family rental home originally purchased using a down payment of 25% ($37,500). The annual rental income is $18,000, operating expenses are $7,200, and the annual mortgage payment is $6,500.
Currently the mortgage balance is $90,000, so if the investor pays off the loan balance, the total cash invested will be $127,500 ($37,500 down payment + $90,000 mortgage payoff).
Here’s how the cash-on-cash return would change if the investor paid off the loan:
- Cash-on-Cash Return = Annual Before-Tax Cash Flow / Total Cash Invested
Return with a rental property loan
- Annual before-tax cash flow = $4,300
- Total cash invested = $37,500
- Cash-on-cash return = $4,300 / $37,500 = 11.5%
Return without a rental property loan
- Annual before-tax cash flow = $10,800
- Total cash invested = $127,500
- Cash-on-cash return = $10,800 / $127,500 = 8.5%
Fewer liquid assets
Using available cash to pay off a rental property loan means an investor has fewer liquid assets. While it’s true that the home could be sold or refinanced, it could easily take one month or more to pull the money back out of the property. If an emergency arises, or an unbelievable investment opportunity comes along, not having sufficient liquid assets could create unnecessary stress.
Loss of tax write off
Compared to high-interest loans, mortgage interest on a rental property loan is fully tax deductible. For some investors in upper income brackets, the tax benefit of writing off the interest expense to reduce taxable income may be more important than paying off a rental property loan.
Less of diversification
One reason people invest in real estate is to diversify an investment portfolio. However, paying off a rental property loan could lead to an unbalanced portfolio. By using cash to pay off the mortgage, an investor is effectively putting more money into real estate. If the property value goes down, an investor’s net worth could be negatively affected because investment funds were not sufficiently diversified across different assets.
Should I pay off a rental property or buy another?
The answer to this question depends on the investor. Generally speaking, it may make financial sense to pay off a rental property loan if an investor is:
- Conservative or risk averse
- Nearing retirement and doesn’t want to deal with rental property
- In a low tax bracket without the need for tax deductions
- Has a high mortgage interest rate on the rental property
On the other hand, an investor who is seeking a more balanced blend of risk and reward, or who is years from retirement, may see more value in buying another rental property instead of paying off an existing mortgage.
Earlier in this article we discussed an investor who owns a single-family rental property with a current loan balance of $90,000. The home has an annual before-tax cash flow of $4,300 with a cash-on-cash return of 11.5%. If the investor paid off the rental property loan, the cash-on-cash return would decrease by several percentage points.
Instead of paying off the rental property loan, the investor may decide the $90,000 is put to better use by purchasing two more rental properties that offer the potential for double-digit cash-on-cash returns, while still having cash in reserve:
|Gross rental income
|Before-tax cash flow
(Cash-on-Cash Return = Annual Before-Tax Cash Flow / Total Cash Invested)
There are a variety of factors to think about before paying off a rental property, and the truth is that what’s right for one investor may not be the best choice for another. Investors who are less risk averse or nearing retirement may feel more comfortable by having less debt. On the other hand, people just beginning to invest in real estate may decide that it makes more financial sense to purchase another rental instead of paying off an existing mortgage.