Should you pay off your rental properties early?

rental-propertyWhen I started buying rental property a few years ago I financed them all with 30 year mortgages.  I wanted to create the most cash flow possible so that I could continue to buy more rental property. If I financed the property with a 15 year mortgage it would eat up the cash flow and wouldn’t give me the money I wanted to buy the next deal. Buying properties in Denver four years ago, using the Hard Money and Refinance Strategy, I was buying property that cash flowed $700 a month with 30 year notes; in most cases with less than $5,000 out of pocket. So that meant I could buy another property using the cash flow every few months. Prices were low, finding tenants was easy and my cash flow increased with every purchase, life was good! While preparing for taxes this year, I was reviewing mortgage statements on rental properties, seeing my monthly average principal pay down is about $125 a door. I currently have 10 properties so the pay down is slow. When I bought properties with 100% financing on 30 year mortgages I wasn’t expecting that I would have principal pay down over night, I also wasn’t expecting to be paying the same mortgages at 60 years old.

When a property cash flows so well, I start thinking about what things would be like if I started plowing all of the cash flow into the rental mortgages, and if that would be a good investment strategy. Keeping in mind that all of these mortgages are between 3-5.5% interest, the immediate thought from most investors is, “why would I invest my money at 5.5%?”

Everyone’s answer to this question is different, depending on your personal situation.  Let’s look at a typical investor with four properties; details are below as well as a few questions that might provoke some thought.

Here is an example landlord’s situation.

  •  4 rental properties; all balances at $100,000
  • Mortgage payments ($100,000, 30yr, 5%, $125 per month for taxes and insurance) $625 per month
  • All rented for $1,250 per month
  • Gross monthly cash flow: $625
  • Expenses at 25%, $315 per month, per property
  • TOTAL NET CASH FLOW: $1,240 

What are your goals?

Create cash flow for income today.  In the example provided, the net rents would add $1,240 to your monthly bottom line. This might pay your mortgage payment, fund a couple nice vacations a year or send a child to college.

Use the cash flow now to create more cash flow in the future. Pay down the mortgages and have one free and clear rental in just 6 years. Add the payment you were making on that property, $500 per month, creating $1,740 per month and the next one is paid off in 4 years and the next two in just 6 years. Accelerating the pay down delivers 4 free and clear rental properties in just 16 years, with a monthly cash flow of $3,240 (not including rent increases).

Other Investment Opportunities:  If you are looking for more deals, it makes sense to save that cash flow to invest in another deal. In the example of $1,240 net per month it is about $15,000 a year or $30,000 in two years to purchase another deal or two. In the Denver market the deals are more difficult to find now than ever before, so you may need to work harder to put that money to work. Some of our Minnesota clients are buying houses for $30,000, making it pretty easy to put the cash flow to work in your next deal.

Tolerance to Debt:  Your personal tolerance to debt could be your deciding factor. Some buy and hold investors only buy property with cash while others prefer financing. Each has their own benefits.  When paying cash, a change in the market or increased vacancies likely won’t cause lost sleep. Financing allows an investor to purchase more property with less cash. It could be uneasy for an investor to look at their balance sheet and see $400,000 in mortgage debt, for others is just a part of the business.

Time Horizon:  In my opinion, this is the second most important decision to make when considering paying down rental mortgages. Your time horizon could be crucial to your decision. If an investor is 30 years old, they may not be in a hurry to pay off the rentals as more opportunities could be in sight to continue acquiring property. Although based on the example in “what are your goals?” this investor could be 46 with a nice monthly rental income.

At 45 years old, an investor may or may not be comfortable with carrying that debt until 75 years old. This investor wouldn’t have as much time to enjoy the cash flow they created.  However, if the intent was to use it as retirement, it would be a great choice.

Required income:  How much do you require living on? This is the most important question to ask yourself. Some investors use rental income as a supplement or all of their income. Obviously if you use your cash flow to pay your bills, using it to pay down mortgages isn’t an option. Although, if you don’t need the cash flow; it could be easy to use the additional to pay down rental properties.

What makes sense for you? While acquiring rental properties have you ever stopped to think about 30 years from now? Will you pass your fortune on to your family, donate it to you Alma mater or liquidate it all and live on the profits? Sometimes as Real Estate Investors we spend so much time looking for the next deal and not why we are actually chasing these deals.

Send me a quick email; I would love to hear your thoughts!