Mortgage at 7% interest rate for investment property; pay down earlier?

Question

Hi everyone - I currently have an investment property with a 150K+ mortgage of 7% interest. It is cash flowing a couple hundred bucks every month (so rent > mortgage).

I have a lot of cash saved up in a 5% HYSA currently and am wondering if it would be a good idea to prepay the principal by $60,000 (I would be financially fine even if I did pay this) - which would lower the amount of interest I owe. I feel in this market it is difficult to get outsized returns (S&P seems very hot and might be hard to sustain 7%+ returns in long term.. but even if so, I’m risk adverse so would probably keep it my HYSA)

I did run the numbers if I were to prepay $60,000 now and it appears the IRRs are lower (because of the higher cost basis). Does this mean I shouldn’t pay down mortgage with such high interest? One other thing is that I paid a lot in points to buy down my rate which made the mortgage initially expensive… It will also take a while to refinance (a couple years) so I don't want to wait fully for that option either

If my tax rate is 30%, is it right for me to think that the cost of paying interest is ~5% instead of 7%? (7%*(1-.3)

Patrick Roberts · Answer

Sounds like you've checked most of the boxes, so at this point, it boils down to your investment philosophy and preferences. Me personally - I expect inflation to remain higher than market expectations for the foreseeable future, and I feel that I can always find investments that yield more than 7%, so I probably wouldn't pay the balance down if it were me. Before I paid this cash toward the balance, I'd probably find a fixed income asset yielding 8-9% with monthly pmts to buy with the $60k and then would use the interest earned to cover part of the mortgage pmt. When I analyze decisions like this, I also weigh the cap rate on the property as it relates to the cost of debt (including the tax shield), the expected appreciation, and the total net cashflow to determine the appropriate amount of leverage. The larger the spread between the cap rate and the cost of debt, the more leverage I'd use while keeping an eye on overall risk balance.

If you could pay down the mortgage with the cash and recast, and simultaneously put a line of credit on the new equity, that could be more beneficial as it would still preserve liquidity while reducing the overall interest load. Food for thought if you prefer liquidity and dont like debt. Now you just have to find a lender willing to do this.

Adam Michael Andrews · Answer

You're being mislead by your model IRRs unless you also incorporate the HYSA balance you'll need to carry to keep the deal leveraged.You're also being mislead by the points you originally paid. That irreversible decision is made already, so it isn't relevant information to your next move. This is referred to as a sunk cost.Your revenue and expenses are going to be what they are, your question really translates to whether you think a 7% pretax fixed and *guaranteed* return is good relative to your opportunity set. What a lot of people miss is sure, you *can* earn more with that money, but it comes with higher risk. You mentioned that 7% is a large portion of long term market return, and I would agree with you. It's true you get a tax deduction for your mortgage, but you also pay taxes on whatever else you decide to do with that money.I would list all of your known investment opportunities, what you think the after tax returns would be, and a risk level 1-5.If paying the mortgage is a clear standout on that list on a risk/reward basis, I would spread out the $60k over a period of time and apply it to principal.You might have other goals like cashflow or reducing risk which might weight towards paydown also. Remember, if you find some generational opportunity, and it makes sense, you can refi and take the cash back out. It is just a bit of a hassle.

Kyle Z. · Answer

Thank you all - I will not be able to deduct passive losses against earned income, so I won't have that benefit. Timeline for IRRs I sensitized around 5,10,15, and 20 years (and at 2% appreciation). I am already maxing out retirement contributions.

Let me ask in this case; in what scenario would you want to pay down your principal with a high interest rate??

Jaron Walling · Answer

You answered your own question. Do not pay down the mortgage if you're happy with the status-quo. You said cash-flow is a couple hundred dollars per month, but don't forget to factor in maintenance, vacancy, CapX, and any costs outside the monthly loan. How much of the $60k is reserves? You need thousands of dollars in reserves, per property, to make it with rentals. You can get creative with recasting mortgages, refinancing, etc. but at the end of the day these things cost you money.

The goal with rentals is leverage. You're leveraging the ability to find/screen/properly manage people and properties. If you're doing that correctly injecting $60k of your own $$$ into the property makes no sense financially. That's the tenants job, not yours. My wife and I are in the same boat right now, dabbling at listings or off market whole sale "deals", or paying down RE debt. Paying down debt destroys our ability to scale. We're not rocking the boat when all the debt is good debt.

Ariel K. · Answer

I’m not a mortgage professional and I won’t give you any advice about paying down your loan, but if you do choose to go that route, I think you can recast your loan. Your interest rate and time left on the loan will stay the same, but your payment will go down.

Ray Hage · Answer

You can definitely make a lot more than 7% in other ways through the stock market, buying another rental or private money lending. I'd tell you to not put it into your current mortgage and look for a better way. Personally, I put my money into stocks and also I lend money for flips mainly in the central Florida area. Also, considering getting into my own flips when I have more time to manage them. I think those are far better options to consider.

Adam Michael Andrews · Answer

One more thought on this too. The 7% pretax return is also zero-work and accrues month 1 and lowers your portfolio risk (by increasing your cashflow). Most other investments are going to increase your risk on a net basis and require a degree of work on your part.

Joseph Chiofalo · Answer

Hi Kyle,

How long have you been in your current loan and is there a pre-payment?

You could entertain refinancing to a shorter term loan.

What state is the property in?

John Morgan · Answer

Never pay down mortgages until you’ve completely reached your financial goals. Once you have more $ than you need, then pay it all off. Game over. But if you want to create more generational wealth and more monthly cash flow, then invest your cash and put it to use. That’s what I do and I’m ok with 7 or 8% interest rates.

Mortgage at 7% interest rate for investment property; pay down earlier?

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