pay off the rental mortgage or refinance and invest the difference?

[WM]

I know there are ongoing debates here about whether or not to pay off the mortgage on one's primary residence, but what about for rental property?

DH and I own a house north of San Diego that we lived in 5 years before moving to CO. After some debate, we decided to keep it and rent it out rather than sell, partly in case we ever want to move back there. We currently have 11 years left on a 15-yr fixed 4.5% loan.

Right now, the cash flow is negative. We are subsidizing it about $3000 per year, and I'm not counting on it breaking even for a number of years. However, the house is a little more than a mile from the beach, so we're hoping that in the long term the appreciation will make up for the initial losses.

Points in favor of keeping our current loan:
- less interest paid overall
- quicker payoff would provide great cash flow starting a few years into ER when the mortgage is done
- our current cash flow situation is manageable, and we have not had to reduce other retirement investments to subsidize the rental

Points in favor of refinancing for a lower monthly payment:
- lower payments would mean more $ to invest in something earning more than 4.5%
- instant positive cash flow, or at least break even
- more flexibility in the long term to invest or spend money as we want or need to, since it won't be tied up in the house

Thoughts on this? Things I've overlooked? Is this really any different than making the same decision about a primary residence?

Edit: I just realized that my title may have been misleading in that I don't mean pay it off in a lump sum, it's just a question of keeping the 15-year loan or moving to something like a 30-yr fixed with a lower monthly payment.

 

[haha]

Thoughts on this? Things I've overlooked? Is this really any different than making the same decision about a primary residence?

There is a difference, but it may not apply since you are planning to finance with a mortgage, you are just unsure about the best terms.

One difference is that your rental interest is a schedule E expense, and therefore deductible even if you take the standard deduction on your 1040. Only your net profit winds up in your AGI.

Ha

 

[Nords]

One difference is that your rental interest is a schedule E expense, and therefore deductible even if you take the standard deduction on your 1040. Only your net profit winds up in your AGI.

Yep. Do you have any other investments that are earning less than the interest rate on this mortgage? If so then it's worth paying it off. But if all your other investments are making more money than the mortgage is costing, then the odds are in your favor that you'll end up ahead of the game.

As long as you can sleep at night.

 

[WM]

One difference is that your rental interest is a schedule E expense, and therefore deductible even if you take the standard deduction on your 1040. Only your net profit winds up in your AGI.

Yes, that is nice. I ended up with a small profit on paper when I did a quick run-through, so I need to re-check that, but either way I think it's not going to affect us much tax-wise for quite a while, until the rent rises substantially.

Yep. Do you have any other investments that are earning less than the interest rate on this mortgage? If so then it's worth paying it off. But if all your other investments are making more money than the mortgage is costing, then the odds are in your favor that you'll end up ahead of the game.

Sorry, I'm confused. The only place our money is earning less than the 4.5% is in my checking account So are you suggesting it's better to keep the 15-year note and pay it off sooner rather than later?

 

[sgeeeee]

It sounds like you are contemplating keeping exactly the same asset allocation you currently have but increase the time-frame on the mortgage. It changes your current risk/reward position in a positive way but moves the horizon where you have to deal with that risk further into the future. My guess (without running detailed simulations) is that the long-term financial impact isn't much different.

It's about your risk comfort level. Would you rather reduce your current risk a little bit while facing the risk for a longer period of time?

 

[Martha]

Yes, that is nice. I ended up with a small profit on paper when I did a quick run-through, so I need to re-check that, but either way I think it's not going to affect us much tax-wise for quite a while, until the rent rises substantially.

I would recheck. With depreciation I would think that there is a good chance you have a tax loss.

Sorry, I'm confused. The only place our money is earning less than the 4.5% is in my checking account So are you suggesting it's better to keep the 15-year note and pay it off sooner rather than later?

The rate on the loan is mighty fine, I would not refinance unless I could get cheaper money.

 

[honobob]

Points in favor of refinancing for a lower monthly payment:
- lower payments would mean more $ to invest in something earning more than 4.5%
- instant positive cash flow, or at least break even
- more flexibility in the long term to invest or spend money as we want or need to, since it won't be tied up in the house

You should check the 15 vs. 30 year mortgage calculator on dinkytown.net

You're giving up $300K at 4.5% to get a 6.5-7.5% investor mortgage and trading a 11 year payoff for 30 years.

You say you're comfortable with the negative cash flow(positive on paper). Sounds like you're trying to fix something that's not broke.

You'd probably be better off on paper to keep the 4.5% and utilize a 2nd to "subsidize" the negative if that is the real worry. The small amount that you're talking about to free up for investment doesn't seem to warrant giving up the 4.5% mortgage.

Now if you were going to pull out enough to invest in another property my answer would change.

 

[WM]

Thanks for the quick replies!

Psychologically, DH and I would probably both prefer to keep our current loan and get it paid off faster rather than string it out. But if there were solid financial reasons to get a longer-term loan, we'd seriously consider it.

I posed the question mainly because we got this financing before I learned about the philosophy that keeping a mortgage might sometimes be to your advantage, which made me second-guess myself as to whether having the shorter-term loan is really the good deal that it seems.

I would recheck. With depreciation I would think that there is a good chance you have a tax loss.

Unfortunately, the land is worth a lot more than the house (900sqft 1970's 1/2 duplex) so we don't get as much depreciation. But I will definitely re-check the numbers.

 

[Nords]

Sorry, I'm confused. The only place our money is earning less than the 4.5% is in my checking account So are you suggesting it's better to keep the 15-year note and pay it off sooner rather than later?

I'm a little late but you're getting the good advice-- run the numbers and decide whether you can get anywhere near that interest rate at a longer term. It may be easier for the stock market to beat the snot out of 4.5% over 15 years than to beat 6% over 30 years. Hey, you can beat it with just about any credit union's CDs! So yeah, it's hard to let go of a mortgage like that.

You say you want lower monthly payments to free up more money to invest. But just by getting the mortgage in the first place you kept that much money invested at a higher return than the interest rate of the mortgage. And over the next decade your rents will hopefully rise at roughly the rate of inflation while the mortgage payments will stay constant. You're already winning the game, now we're just trying to figure out how to run up the score. I'd sit tight and wait for some credit union to absolutely lose their minds and offer a 30-year fixed-rate loan below 5.75%.

Coming out of the 2000-2002 market it wasn't unusual to see people with low-paying I & EE bonds or even CDs paying less than 3%. But if you're beating the mortgage with all your other investments then there's no urgency.

 

[tryan]

I wouldn't mess with 4.5% $$$ .... might never see a rate like that again.

Hopefully the rental market will accomodate a few rent INCREASES ... then you be above water for the long term.

And forget about tapping the equity at todays rates .... not worth it (prime +1.5% on rental property).

 

[WM]

Ok, thanks, this all makes sense. I think in the future I might not be so quick to go for the shorter loan, since a 30-year loan (for example) gives a little more flexibility financially (lower payments that you can add extra to when/if you want to). And better cash flow if it's a rental.

For now, the 15-year loan seems manageable so I think we'll hang onto it as planned for this one.

 

[raysk]

One other concern may be that you will be an absentee landlord.
That will put you at the mercy of whoever may have to do repairs
or collect rent.You will not know if the property is being kept up or trashed.

 

[spideyrdpd]

Hmm
If you lived in it for 2 of the past 5 yrs it may pay to sell and tax the money tax free.
You could then buy additional properties in Co.

The only reason I could see to refinance is if you couldnt pay the loss.
As mentioned though after all the tax breaks its probaly not a big deal.
You could up your w2 deductions and get that money monthly. Rather than lend uncle sam that money interest free.
Rob

 

[scrinch]

As you know...the reason your 15 year mortgage has a higher payment is because you are repaying principal faster. So as far as your cash-flow-negative situation goes, you are just taking the cash from one pocket and putting in the other (admittedly less liquid equity) one. It may seem like less of an issue if you look at it this way. Admittedly, aggressive real estate investors don't look at it that way, but more conservative types like me do. With a 4.5% rate, you can't go wrong keeping the loan.

 

[Craig]

If I had a 4.5% fixed rate loan on one of our rentals, and especially recognizing we can use that small interest expense to offset our other rental income ... I definitely would not touch that loan. Wouldn't refi, and wouldn't even pay it off early ... just take what you would have sunk into the loan, and invest in other liquid assets. (Once you pay that loan down / off, it is expensive to get that money back.)

If I did anything, and if I had a challenge in deducting passive losses, I'd look at generating passive income somewhere else ... buying another rental property, etc. But this is a relatively minor tax issue.


YMMV, but I think you're in a wonderful position. Rents will rise, and from your description, I'll bet you love the value of that home in 10 years. Congratulations.

 

[WM]

Thanks for all the good advice. I think it makes sense to keep the loan we've got.

you are just taking the cash from one pocket and putting in the other (admittedly less liquid equity) one.

I think this is a good way to look at it, but the liquidity issue is what was making me think twice, given the negative cash flow.

We do have the issue of being absentee landlords, so we did our best to hire a competent property manager and are checking in with the neighbors occasionally. And keeping our fingers crossed

We definitely want to keep the property, at least for now, since we may want to move back there and couldn't begin to afford to buy a place at today's prices. We weren't looking to get into real estate rentals as part of our portfolio really, but it's worked out this way so we're trying to take advantage of the situation. Buying other places with the intention of making them rentals is a little more than we want to get involved with at this point.

So, it looks like we'll stick with what we've got and see what happens.

 

[tryan]

If you lived in it for 2 of the past 5 yrs it may pay to sell and tax the money tax free.

This would be a real reason to consider selling ... especially since you're eating a small negative cash flow on the place every month.

Point being, it'll take a VERY LONG time to get a better return on the place than selling TAX FREE within 5 years of moving out.

More food for thought ...

 

[WM]

Yes, we did consider that aspect.

I've heard rumors that because DH is in the military and we moved because he got re-assigned, that we actually have 10 years instead of 5. Need to check into that.

In the meantime, we figured we'd wait and see how the appreciation goes in the next couple years, think some more about whether we'd like to move back there, etc., and generally use the 5-year exemption time to make a decision. As long as the cash flow remains manageable and things go ok with tenants, property manager, etc.

Essentially, I guess we'd like to keep it if we can, so we're trying it out (just started renting it 6 mos ago). It's true that we're relying rather heavily on continued appreciation, but coastal San Diego is as good a bet for that as any, I think.

 

[tryan]

have 10 years instead of 5

Not aware of any extension to 10 years. Do know that you can have stayed in the home LESS than 2 years if the move was for employment.

 

[WM]

Not aware of any extension to 10 years. Do know that you can have stayed in the home LESS than 2 years if the move was for employment.

No, didn't realize that. We were there for all 5 years in this case, but good to know for the future.

I looked quickly at the irs website and there is some kind of "suspension" of the 5-year period allowable for military and foreign services when you're on active duty away from your "main home." In the "Excluding the Gain" section:

http://www.irs.gov/publications/p523/ar02.html#d0e1939

It's not clear what would qualify it as your "main home," though. But a great deal if you qualify - it looks like you basically get 10 extra years that you don't have to count if you were stationed elsewhere.