Pay off rental mortgage early, or keep making payments?

Question

Hi guys, I'm admittedly a bit math-challenged, so I'm having a difficult time running numbers on which option will serve me better in 10 years, 15 years, and 20 years.   I tried making spreadsheets but I'm more confused now than when I started.

I'm 32 and own a single-family house which we originally lived in for a couple of years but now rent out. We bought it 7 years ago for $340,000 with a 30-year mortgage at 4%. Our current cash payoff is $240,000 if we were to pay off now. We've already paid about $100,000 in mortgage payments, and if we keep making payments on it instead of paying it off now, we will pay another $360,000 total over the next 23 years. Mortgage payments are $1200, and escrow for tax/insurance is another $1100, for a total of $2300/month.

Rental income from the house pays for ALL expenses - for round numbers, figure $2400/month - so overall the house doesn't cost us anything, but it also doesn't make us anything. I'm basically trying to figure out if it's a better idea to:

a) pay off the mortgage now for $240,000, and take the extra $1300/month for income (or invest in something like Vanguard for 5% each month), or

b) keep paying the mortgage for the next 23 years, get no income from the property, but invest that $240,000 lump sum elsewhere (probably another rental property at 8-10% in this area).

What's the way to calculate which is the better option over the course of the next 5, 10, 15, 20 years?

Thomas S. · Answer

As a inexperienced investor your comprehension of the numbers, and in particular the value of cash, is as you state challenged. Options a and b are both terrible options.

You state several times the place is not costing you anything as the rent is covering debt but the fact is as a investment income property you are seriously deep into negative cash flow. Explaining that statement is irrelevant at this point.

You need to sell the property yesterday and take what you can before you pi** away all the remaining equity you have. The property is a black hole sucking up money you obviously do not see.

Pari Thiagasundaram · Answer

If you can sell it for a profit, then that is the route to go. This is what @Michael Swan has been talking about in another thread today. https://www.biggerpockets.com/forums/62/topics/394...

There are other places where you can get a better return on your investment.

Sam LLoyd · Answer

There should be a poll on bigger pockets.  "Who here rents out their first SFR, and doesn't really make that much money on it?"

My first SFR is a little better situated... after refinancing down to 4.5, and after taking into account maintenance reserves, it makes a couple hundred/month... on a good day.  I know I should sell it, but... the money's already invested.  However, everything these people have said is true.  Here's a simple way I look at the numbers.

You have 40k in the house.  You know Vanguard could give you 5%... minimum, you need to make $160/month, since that is your opportunity cost of not having it in Vanguard.  We already heard from everyone else how you probably have a negative cash flow.... so you're not even close with this investement.... so sell, pay off, or refinance.

Refinance.... You can't get rates lower, and you'll have to figure out loan costs, etc... I probably shouldn't have refinanced mine.

Pay off:  $240k with a $1,300/month return?  That's a 6.5% return.... paying off would be better than Vanguard.... if you really had a $1,300/month return.  If, instead, you needed  to put %7 or %8 away each month for a maintenance reserve... and you paid yourself 10% to manage it, plus a 4% vacancy rate (that's a bare minimum in my book.)  This would all drop your income down to $850/month, which is only 4.2%, and makes Vanguard a better investment.

There are benfits to real estate other than cash flow, such as interest deduction, principal paydown, depreciation, inflation proofing... but many of these go away or are minimized when the property is paid off.

So yeah... sell it if you can.  If it were me, I'd use the $240k as a down payment for a 26plex I'm looking at with management in place.  It should throw off between 2k and 3k/month... which is in the 10% range... and it would have significant leverage to take advantage of rent increases or appreciation in the future.

Aaron K. · Answer

Thanks guys - exactly the responses I was looking for!   You're right, a roof or other major repair would be detrimental.   The area is not appreciating or gentrifying so the values will not move significantly within the next 10 years.  You're right, makes sense to sell now.

Jeff Rabinowitz · Answer

You have 20 years left on the mortgage. Do you think you will have to replace the roof in that time? The water heater? Furnace? Do you expect you will have any vacancies during that period? Will you collect rent during the vacant periods? Will you have to paint, clean up, make repairs, between tenants? Will you have to pay for utilities during the vacancies? Maintenance and vacancy are real expenses. They will come out of your pocket. You are not breaking even--this property is costing you money.

Zach Quick · Answer

@Aaron K. Is there any reason that you think the price of the house will increase in the near future? Development/gentrification/etc... If yes, my vote would be to hold on a little longer, but if not, I think you could make your dead equity work for you a little better elsewhere.

Patsy Waldron · Answer

If the property is breaking even without taking into account any maintenance, then it could actually cost you in the future. You need to think about the major potential repairs- roof, HVAC, water heater, etc. How old are these components, and might they need to be repaired or replaced in the next few years? That may be a reason to consider selling now, while the market is strong (even though you would be selling for less than what you bought for).

On the other hand.... Your tenant is paying down that mortgage and building equity for you. 4% is pretty low as far as interest rates go, and you won't be getting that anymore.

The $240,000 can be invested much more profitably than paying off the house (talk about dead equity!)- you could buy a small multi-family building that would cash flow very nicely with this amount of money. Then you'd end up with cash flow AND two properties instead of one!

Aaron K. · Answer

We definitely don't make money on this property, but we don't really spend anything on it either.  Selling is an option.  Market value is right around 300k (market dropped after we bought the house), so we'd walk away with $40,000 in cash if we're lucky after paying off the mortgage and realtor fees.   But that doesn't take into account our overall loss on the property (even though we bought it as a primary home when we were young and dumb, not as a rental)

Pay off rental mortgage early, or keep making payments?

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