Last week I got a couple of emails from our readers asking some questions about mortgages.
…you have a mortgage in both your condo and rental property. I would like to know what your thinking process was. Why not payoff the condo? Also, why the investments in the market instead of paying off the real estate?
Another reader - Is the tax deduction high enough to justify the risk in the market?…Financing when the cash is available goes against my “sleep well at night” beliefs and everything I have read about the topic.
First of all, it’s confession time for me. I have been avoiding this topic because I like to say that we don’t have any consumer debt. That’s true because we don’t have any credit card debt, car loans, or other outstanding consumer loans, but we currently have 3 mortgages. They add up to about $600,000… Holy Crap! That’s a lot of money. And that’s why I don’t want to talk about it. In my defense, the properties all have positive equity. We could sell all of the properties and come out with over $400,000 after paying off all the mortgage debts.
Even if we forget about equity, we could pay off all the mortgages today. It would be very painful to do, though. I can sell all my after tax investments and pay off the 2 rental mortgages. Then I could cash out part of my IRA to pay off our primary residence (the condo). If we do that, our monthly cash flow would improve by a huge amount. We would have more rental income and less housing expense. However, I can sleep just fine while owing $600,000, so I don’t think I’m going to pay them off just yet. Well, I did have that bizarre dream a few weeks ago so maybe it is affecting my subconscious somewhat.
There are many reasons why I would rather have mortgages than paying them off right away. Let’s go over these reasons.
Here is the inflation data from the Bureau of Labor Statistics from 1996 (the year I started working) until now.
The average inflation over the past 17 years is between 2% and 3%. This means every year, your money is worth 2-3% less than the previous year. The same also applies to your debt. We owed $600,000 in 2012, but every year, that debt will be worth less and less due to inflation. 2-3% might seem insignificant, but over 17 years we saw the value of a dollar drop by nearly a third. If you had $600,000 in 1996, it would only be worth $400,000 today.
Let’s look at it from more practical terms. We purchased our old home in 2000 and got a $165,000 mortgage. The interest rate for a 30 year FRM (fix rate mortgage) was around 9% back then and we paid about $1,300 a month. This was a lot of money for us back then because we were in the early part of our careers. Fast forward to 2012, and $1,300 doesn’t seem like a lot of money at all. You can’t even rent a similar house for that much money. Inflation and the rise in income made $1,300 look much smaller 13 years from the initial purchase date. Also, we refinanced to a lower rate. Currently we are paying $900/month and the house is scheduled to be paid off in less than 10 years.
Rates are low
We refinanced all our mortgages in early 2012 before I left my job, but the rates have dropped even further since then. You can get a 30 year FRM for 3.5% these days with good credit. That’s not much higher than the inflation rate. If you take mortgage tax deduction into account, it’s almost the same as the inflation rate. Why is that important? If your mortgage rate is the same as the rate of inflation, the bank is basically letting you borrow the money for free.
It’s kind of hard to explain, so let’s look at an example. In 2012, I borrowed $100 from the bank at 3%. In 2013, I will have to pay back $103. In 2013, I got a 3% cost of living adjustment raise at my job. The $103 I will pay back to the bank is worth the same as the $100 from 2012.
My example is kind of convoluted, but I hope you get the idea. In 1996, it DID make sense to pay down mortgage debt quickly because the rate was 9% while the inflation rate was 3%. Now, the mortgage interest rate is 3.5% and the inflation is around 2%. I think it’s better to lock in the low rates now if you can.
This one is just for the primary residence. The mortgage tax deduction pushes the effective mortgage rate down even further. If you are in the higher tax bracket, then having a mortgage tax deduction is very helpful. The mortgage tax deduction alone isn’t a good reason to get a mortgage, but if you combine that with the low interest rate then you can get very close to the inflation rate. The 3.5% 30 years FRM rate effective become 2.6% if you can use the mortgage tax deduction and are in the 25% income tax bracket.
I like being able to access my money somewhat quickly if needed. If I paid off all the mortgages, then a very large percentage of our net worth will be tied up in the properties. It’s hard to get money out if you need it quickly. What happens if I stumble upon a great business opportunity? It could take a few months to get some cash out of the properties and the opportunity would be gone by then.
I guess I could get a home equity line of credit set up, but to me, that’s not much different than having a mortgage. The bank also could rescind the HELOC whenever they want, then you’d have to refinance, and that’s a whole another ball of wax with a paid off property. Lastly, the rate wouldn’t stay low forever. If you need a HELOC when the rate is high, then you will be paying more interest.
Older rental properties also require a lot of repair and maintenance. Over the last 18 months, we spent nearly $15,000 to fix up the 4plex. This property was a bit older and the previous owner put off quite a few maintenance items such as repairing the gutter and painting the exterior. I’d rather have more liquidity so I don’t have to worry about paying for these items. The good news is that we’re pretty much done with the big repairs so we should have some lower repair bills over the next few years.
We don’t want to put all our eggs in one basket. If we pay off the mortgages, then most of our net worth will be tied up in real estate. I don’t think I can handle another real estate crash like in 2008, if that’s the case. I’d rather spread out our net worth into stocks, bonds, real estate, peer to peer lending, precious metals, and business investment. $400,000 is already a lot of money to be tied up in local real estate.
Positive cash flow
This one is just for the rentals. If I have positive cash flow, why should I pay off the mortgage? The rent will keep rising every year (inflation) while the mortgage payment stays the same. Every year, I will generate more income and own more and more of the rental properties. I don’t see any advantage to paying off the mortgage early on a rental property.
Time mortgage payoff to retirement
As you can see, I like having a mortgage, but I do want to pay them off at some point, especially on the primary residence. Once we both fully retire, then I don’t want to deal with the mortgage payment anymore. That’s why we are paying down extra on our primary mortgage. It should be paid off before we both fully retire in 15 years or so. When we stop having earned income, the interest deduction won’t be useful anymore. It would also be nice to live in our home without having to worry about the bank at that point.
Mortgages are good
I don’t mind having mortgages at all and if the bank let me borrow more, I probably would. It’s up to you really. If you can’t sleep while owing a ton of money (albeit with positive equity), then it’s probably better to pay cash or pay off the mortgages early. If you don’t mind having some mortgages, then I think it’s still a great time to buy some properties. Home price is rising fast and I’m glad I’m done buying. Mrs. RB40 growled “don’t you dare” when I mentioned another mortgage…
Would you pay cash for a home if you could? I wouldn’t, but that’s just me.
Have you refinanced lately?
If you haven’t refinanced in a while, you should check with your bank to see the latest rates. Also check with Quicken Loans to see if they can give you a better rate. They were fast and pushed the refinance process through in less than 30 days when we refinanced our primary home. The interest rate is very low now and I think it’s worth locking that rate down with a refinance if you could.