When does it make sense to pre-pay mortgage?

Question

I currently own an investment property and have been considering pre-paying the mortgage down to increase equity but not sure if this is the right approach.  My mind tends to focus on the increased monthly cash flow from the property assuming a paid-off mortgage - but I know I could also consider buying additional properties.

Is there an alternative that is better than the other?  Any info would be appreciated.  I've included some details below:

Purchase Price:  $280K

Down Payment:  25%

Interest Rate:  4.75% (30-yr fixed)

Net Monthly Cash Flow:  Average of +$500 per month (after mortgage, taxes, ins, repair, vacancy)

Est. Current Property Value:  ~$310K

Thanks!

Steve Vaughan · Answer

To me it makes sense

1) If you are in a commercial loan and the nuances of annual reporting and facing a call/adjust every few years aren't worth the risk and headaches anymore.

2) In an adjustable or negative am or balloon mortgage that poses more risk than a conventional or normal mortgage.

3) In an older mortgage like some of mine that are 6%+.  Good risk-free and tax-free use of $ if the rate is high enough and opportunities don't abound in your market today.

4) Close to being rid of PMI, ie getting to a 80%- LTV.  PMI runs about $75/mo per $100k borrowed and does nothing for you.  A $200k loan costs about $150/mo extra with PMI.

5) Getting rid of an expensive 2nd or HML or any loan from family, etc.

6) If it's in a protective blanket of an entity or trust already. I'm comfortable with high equity positions in my commercial assets that are inside entities. I don't slowly pay down assets in my personal name.  With those, I leave a high LTV or swoop in and pay it all off before getting it more protected.  Good discussion!

Stan K. · Answer

@Sean Golin it all really depends on your circumstances and goals. As @Kevin Siedlecki mentioned, there are multiple reasons you might want to repay your mortgage

• You don't want to expand and buy more investments (real estate, stocks, etc.)
• You are happy with cash flows after you pay down your mortgage and don't need any additional investments
• You want to reduce your risk and lower your expenses in case tenants move out and you can't fill the vacancy
• You don't think that you can find other investments that will return better than 4.75%

Buying additional properties definitely has the potential of increasing your income. However, it comes with higher risk. For example, if you lose both tenants, your total expenses will be much higher. Can you afford that?

There are a few alternative strategies you might want to consider:

• You can refinance your current mortgage to lower your monthly payments. However, I don't think you can find anything much better now after the rates hiked.
• You can pay down a portion of your mortgage to the level where you feel comfortable you can afford another property and expand slowly
• Buy another property but put down more than the regular 25%

From the timing perspective, we now switched to a rising interest rate environment. If you believe wall street investors then it might make sense to hold on to this mortgage. Here's an interesting article on this subject from one of the more respectful financial bloggers - http://www.financialsamurai.com/mortgage-pay-down-strategy-in-a-rising-interest-rate-environment/

In the end, the real answer depends on your current situation, your expectations of the future and the level of risk you are willing to take.

Kevin Siedlecki · Answer

@Sean Golin

Whether it makes sense to pay loans off is a huge debate here. Some people will say it never makes sense, but it really depends on your strategies and goals. If you want to grow your portfolio, then put that money away towards your next down payment.

To me, it makes sense to pay off the loan early only in a very specific situation:

You don't want to grow your business any more, because you recognize that paying off your current loans will give you enough cash flow to meet your goals, and you can get there quicker by paying down the loans rather than using the profit to buy more property. Or you just don't want to do the work of finding and managing more properties. Paying down the loan can get you to your desired cash flow with much less work than finding additional properties.

For example, say you want $5000 a month in cash flow. In your price range, that means you can either buy 10 properties that cash flow $500 each, or 3 that cash flow $1650 each with no loans. That means fewer houses to look after, same income. If your plan is to retire on your rental income, then you could either keep working to get to 10 properties, or start paying down the loans on 3. It's as close as you can come to literally buying time. Every extra payment brings that date of being able to retire closer.

I'm guessing that's not the situation you are in, since you are even having the debate with yourself, so I would recommend holding on to the cash and using it to buy another place once you've saved enough.

Jeff B. · Answer

Compare & Contrast the use of $X dollars:

• pay down a mortgage to increase cash flow from the rents (only works for an ARM, never for a fixed rate loan btw)
• put the same $X elsewhere  to gain some other return

When the amount in question ($X) is small (ie can't buy something substantial like another property) and the existing mortgage is an ARM, the paydown will return better that a savings account and is a safe bet.

When $X is quite large, you have the dilemma of Opportunity Costs:  Whatever you choose, there's a cost for NOT doing something else.

We usually jump at Cash-out-Refi and apply this and other cash to acquire another property.  HOWEVER,  owning SFRs will keep you subject to your DTI and you soon get boxed in; can't move up and can't cash-out.  Recommend trading SFRs via 1031 Exchange to get into MFU 5+.  These properties will get you into a Commercial Loan where the DTI is not important but rather the performance of the units (NOI and DSCR) is what the underwriters are looking for.

Summary: Extra equity in an existing property is a safe investment in yourself and allows you to prepare for trading up when the right deal presents itself.

Mark Holencik · Answer

If you put the $500 on the principal, that would apply $6,000 a year to the principal. You will also save 30 years of interest on that $6,000 which is about $5,000.  In the first year you would save on interest and pay down the principal for a total of about $11,000. This is above what your regular payments will apply to the principal - $3240. The savings will only increase every year after.

Another benefit is that every time you pay on the principal, the regular mortgage payment also applies more to the principal.This adds to your savings.

Thomas S. · Answer

When does it make sense to pre-pay mortgage?

If you are truly a investor it never makes financial scenes to have equity lying dead in a income property.

With your interest rates at 4.75% and the opportunity value of cash at a minimum of 10% when does it make scenes to lose (10 - 4.75) = 5.25%

Equity in a property creates a separate income stream from the property itself which at a minimum value of 10% will only reduce your "property" cash flow not increase it.

IN my opinion you already have too much equity lying dead in your property resulting in monthly losses. You have $100,000 in equity in the property costing you $833/month in lost income, you do not want to lose any more.

Michael Lee · Answer

Hello and welcome to this website!  Your statements are really right and put well.  There is not much I can add to it but I would say to pay off your current mortgage depends on your goals.  If you are paying a higher rate mortgage you might want do that to lower your payments.  You might use it to use any cash made to reinvest in another property or two while the rates are low.  Having more debt that has positive cash flow is good debt and usually not taxable.  Another reason would be to do a home improvment loan that includes that payoff of your loan for the other property.  It is all taking advantage of the lower rates and your belief in where they will go.  Nobody can see all that the future holds and know you do not have anything/or control over it so you have to make decisions based on the present and the way you think about where the future will go.

Good luck to you!

Lynn McGeein · Answer

I agree with @Kevin Siedlecki   Think about your main goals as they are different for everyone, and it will make decisions going forward much easier for you.  If it gets you to your main goal faster, pay the property down.  If buying another one gets you there faster, save it up for the next one.  Our main goal is to have x amount in passive income 10 years from now, so our decisions are made based on that.    We're now mostly in the pay-down stage as we'd like to be debt free going into retirement, and actually finding good cash-flowing buy and holds is much harder in our target areas right now, so easier for us to concentrate on paying off the good deals we already have as that gets us to our goal.

Aaron Howell · Answer

Would that $500/month be better served investing in something else ?

You're not losing $500/month if you pay the principle down, you're just moving it into one asset vs. another asset but if you can get a better return of something else I wouldn't pay it down.

When does it make sense to pre-pay mortgage?

Most Popular Reply