Better to pay off loans, or keep a permanent note?

Question

Hi everyone…

I see people on the boards here speaking about paying off mortgages on their rental units, as if that is a desirable goal. What do you think?

My first influence in pondering owning rentals was my best friend’s dad, back about 30 years ago. He always told me that keeping money owed on his property changed the way his income was defined at tax time. He said if he paid the property off completely, then rental income would be taxed at the normal rate on his 1040. But he said if he keeps a perpetual loan on the property, he annually deducts that interest, which lowers his tax burden. (on that rental income)

Also, I have a friend who opened a restaurant two decades ago. He has told me that every time he pays his loan off, his accountant tells him to renew that loan for financial benefit.

I just bought my first property for cash. I had intended to take a mortgage on it to leverage a second buy, but now I am wondering if I am missing something. Is it better to keep it “paid off” ?

(Big thanks to all of you on these boards. I love this site and how friendly everyone has been.)

Trevor Schumann · Answer

This is a debate that goes way back and has smart people on both side. In my opinion there are 2 kinds of debt. Good debt is debt where the cost of borrowing money (interest-tax savings) is less than the return received from that borrowed money. Bad debt is debt where the return received is equal to or less than the cost of borrowing (interest - tax savings). For example lets say you have a 30-yr fixed mortgage and your paying 4.5 % APR. Let's assume based on your tax bracket that your marginal tax rate is 35%. That means to calculate the cost of your money you need to multiply 4.5% X 35%. Your effective cost of borrowing is 2.925% per year. Therefore if your after tax capitalization rate exceeds 2.925% then you are making money essentially on arbitrage and the debt is good. Lets assume you make a (very realistic) cap rate after expenses of 13% annually. To qualify for mortgages you will typically need at least 20% down. Let's look at both scenarios assuming you have 100k to invest.

Scenario # 1 Cash purchase:

This one is simple. You purchase a home for 100k and that investment will yield a return of 13k per year

13% Cash on cash return.

Scenario # 2 Finance Purchase

You split your 100k investment into 5 down payments of 20k a piece and you purchase 5 homes. Each home yields the same 13% cap rate but you also need to deduct the cost of borrowing the money from your bottom line.

House # 1: Price: $100,000 Annual return after expenses: $13,000

House # 2: Price: $100,000 Annual return after expenses: $13,000

House # 3: Price: $100,000 Annual return after expenses: $13,000

House # 4: Price: $100,000 Annual return after expenses: $13,000

House # 5: Price: $100,000 Annual return after expenses: $13,000

Total Portfolio: Price $500,000 Total return ($13,000 X 5): $65,000

Total Interest: ($500,000 X 4.5%) $22,500

Total tax savings ($500,000 X (4.5% X 35%)) $7875

Effective Cost of interest ($22,500 - $7875) $14,625

Total Profit: (Total Property Return - Effective Cost of Interest) $50,375

50.375% Cash on cash return.

Notes: Of course there are a few factors not taken into account as well as other over-simplifications with this model but it is meant only to prove the point of how leverage impacts return. If you can leverage good debt you will achieve substantially more aggressive returns. You will however also consume much more time, take much more risk in exchange for that higher rate of return. You have to decide personally which meathod best aligns with your goals in rei.

Best of Luck.

Pat Martin · Answer

It sounds like your friends accountant is an idiot.  There is no reason to renew a loan just to have a loan.  If there is an opportunity in front of you to make a great return that out weights the risk of having a loan then go for it.  But to just go borrow money just for the sake of a deduction is bad advice.

CL Ziegler · Answer

Thanks everyone, for your thoughtful replies.

Andy Collins · Answer

look at the interest rate, currently rentals with conforming mortgages I'm paying roughly 5%,,now the question is, would I rather have cash and be paying the interest (less tax deduction, which reduces that to maybe 3 1/2%), or no have cash and save that interest cost.

I personally will take all the 5% money I can get, I won't do a deal with a cash of cash return of less than 25%,,,so yes, I want to make that and pay the 5% (as noted really 3.5%) in interest.

If the deals get to the point I'm could only make, say 15% cash on cash, and I was paying 10% on my money, I would re-evaluate that

Everyone's situation is different,,what's right for me might be wrong for someone else

Duncan Taylor · Answer

On the interest front, depending on your tax bracket, for every dollar in interest you pay, you only get back your marginal tax rate. So, if your marginal tax rate for federal, state and local taxes is 41%, you lose 59% of every dollar in interest you pay.

Better to pay off loans, or keep a permanent note?

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