Should I use the money to pay off the mortgage or invest?

[Wenqi Nelson]

Hi everyone,

Thanks for reading my first post. My husband and I own two properties in Grand Rapids, MI. We paid off the house that we live in several years ago. We bought another house that is 400k and we owe about 192k now on the property. We rent that house out and the rent just covered our mortgage. My parents sold their property and they are willing to give us 210k to help us pay off the property. Shall we use the 210k to pay off the house or shall we use the 210k to invest in other properties? Or maybe we could use 150k to pay the mortgage and save 50k to invest? Thank you very much!

Wen

[Mark Krier]

I get questions like this from my friends all the time, and I always explain it like this: 

The math is going to tell you to buy the rental properties instead of paying off the debt. However, there is a certain piece of mind when it comes to being debt free, and sometimes the psychological benefits of being debt free can far outweigh the mathematical benefits of buying assets. It's just a personal decision as to what you're comfortable with. 

Personally, I'm highly analytical and minimally emotional when it comes to money. I love debt/leverage, so no matter how much money I accumulate in my lifetime, I will probably always use other people's money (i.e. the bank's money) instead of my own to buy properties. So for someone like me, the answer is simple, "buy more properties instead of paying off the mortgage". 

However, I know other people who are much different than I am, the type of person who is very uncomfortable with debt in any form, and who might lose sleep asking themselves "what happens if..." types of questions. To those friends, I always tell them to pay off the mortgages. It's just not worth it to take advantage of the mathematical benefits at the expense of the emotional/psychological cost. 

FYI, in case you're wondering, here's a quick explanation as to my thinking when I say that the optimal choice from a mathematical standpoint is to NOT pay down the mortgage: 

To analyze this, you have to ask yourself a couple questions: 

First: What is your short-term and long-term downside to buying rental properties right now in Grand Rapids? To answer that, you have to ask if you can you find rental properties in Grand Rapids which are currently cash flow positive, and which even in market-downturn stress testing (using 2007-2010 data as a stress test) are highly likely to maintain relatively neutral cash flows? The answer is yes. That means there is a very little short-term and long-term risk for you to ever have to come out of pocket with any of your own money. FYI, that includes never having to come out of pocket for things like property management, cap-ex/maintenance, etc.. All that could be paid for and escrowed from the rental income. 

Next: What's the upside, and what type of returns can you achieve in the short-term and long-term? That question is one which would take a whole new thread to discuss, but plugging in simple and conservative numbers into the BP rental calculator will show you that 6-15% is VERY likely. You should play with rental calculator if you haven't already.

Lastly: Assuming the mortgage on your current primary home has an interest rate in the ballpark of 4.5%, does it make more sense to use $210k to pay off your loan charging 4.5% of interest (tax-deductible interest I might add) or to invest the $210k in rental properties that are very likely to earn you 6-15% interest with very little downside risk? 

Personally, I'll borrow $210k at 4.5% to earn 6-15% all day! (and I do!) But like I said earlier, it's a matter of personal preference on what makes you comfortable. At the end of the day, piece of mind is much more valuable than investment returns. 

Best of luck to you!