The question often asked by homeowners is, Should you pay off your mortgage? That question is more poignant than ever with the current environment of very low-interest rates.
Let’s take a look at the pros and cons of owning a property mortgage-free. There are differences between personal residence and investment property. We shall first begin with a personal residence.
The biggest benefit of owning your personal residence mortgage-free is lower monthly costs. That much is obvious. However, even if your mortgage is paid off, there are expenses that you cannot avoid such as property taxes and insurance.
If you own your home outright, you have a greater risk of equity loss. This can result from a fire, lawsuits, or acts of God. Sometimes insurance is not sufficient to cover the loss.
If you do not or cannot pay your property taxes, the government will take your property and you could lose all your equity. It seems better to have less equity for the government to take.
Should you happen to become a defendant in a lawsuit, and judgment is rendered against you, you could lose your home to settle the judgment. In some jurisdictions such as Florida, homeowners are protected from judgments. However, should you decide to sell your home, the net proceeds can be confiscated to settle the judgment.
In some countries, especially the USA, the interest you pay on your mortgage is deductible from your income. Should you decide to pay off your mortgage, you no longer have that deduction and you could potentially land in a higher tax bracket.
The Biggest Myth
If you have not already done so, read my previous post, The Biggest Myth in Real Estate, The reality is that you only own your property for as long as the government says that you do. Does it make sense to have 100% equity in something that you really don’t own?
When dealing with an investment property, there are a few other factors that should be considered before deciding to pay off the mortgage.
Return on Investment (ROI)
As I discussed in a previous post, Return On Investment, ROI is calculated as Net Operating Income / Purchase Price. Let’s take a look at the following example.
An apartment building was purchased for $300,000. The Gross Rental Income is $60,000 per year and the operating expenses are $18,000 per year. In the first column, the property has a $240,000 mortgage at 4% with an annual interest expense of $9,600. In the second column, the property was purchased for cash.
To calculate the ROI on your investment property, go here.
With no financing costs, the ROI is 14% compared to 11% with 80% financing. It would appear that from an ROI perspective it is more profitable with no financing costs. However, is that really true?
Cash on Cash Return
My favorite metric for measuring ROI is the cash on cash return. In other words, what return am I earning on the actual cash that I have invested in the property? Let’s go back to our example.
In the first column, the property was purchased with a 20% down payment or $60,000. The net operating income including the interest expense is $32,400. That is a 54% return on my $60,000 investment!
As a reminder, the second column shows an ROI of 14% when the property is purchased for cash. Which option provides a greater return?
The rule of thumb is, the greater the percentage of equity, the lower the cash on cash return will be.
One of the major advantages of investment property is the ability to deduct depreciation from the net income. Only the improvements can be depreciated; the land is not depreciable.
In our example, the purchase price is $300,000. Usually, 30% of the purchase price is allocated to the land, so in this case, the amount that can be depreciated is $210,000 (70% of $300,000).
In both cases, the depreciation expense remains the same at $7,140 per year. However, with zero financing costs, the net income after depreciation is still significantly higher and as such, the effective tax is higher.
When you own an investment property, the liability risk increases substantially. Lawsuits are inevitable over a long enough time period. You need to purchase adequate insurance to protect yourself from liability risk.
If you have a mortgage, and only 20% equity in the investment property, you have a significantly lower risk of loss. In addition, you can lower your insurance coverage so that just your equity is protected.
You might think that you are better off mortgage-free, but in essence, what you save in interest expense, you might be paying a large part of the savings on insurance premiums.
What exactly is arbitrage? The dictionary defines arbitrage as “the simultaneous purchase and sale of the same securities, commodities, or foreign exchange in different markets to profit from unequal prices.”
In real estate, arbitrage is defined as the difference between the interest rate paid on a mortgage, and the rate of return on the mortgaged property. In our previous example, the ROI with a $240,000 mortgage was 11%, yet the interest rate on the mortgage is only 4 %.
Does it make sense to pay off a mortgage that is costing you 4% while you are earning an 11% return on the investment? The arbitrage in this example is +7%.
If you are able to pay off your mortgage, why not put that capital to better use and buy more real estate? Given the cash on cash returns, this makes the most amount of sense. However, be careful not to invest 100% of your cash. It is important to maintain adequate reserves.
For some people, anonymity is important. Perhaps you are recently divorced and you inherited a substantial sum of money that you want to keep hidden from the ex-spouse. You can shelter that cash in real estate by setting up an LLC and then paying cash for the investment.
WHAT IS THE ANSWER?
Given all the above considerations, should you pay off your mortgage? The answer with few exceptions is, NO! However, that does not suggest that you should finance your property 100%. The best structure is based upon the following elements:
1) Rate of Return
If you own real estate, regardless of whether it is a personal residence or investment property, you should compare the rate of return you can earn on your capital to the interest rate on your mortgage. If you can earn a higher rate than what you are paying on your mortgage, it would be wise to invest your capital elsewhere.
In the 1980’s the average rate for 30-year mortgages reached its all-time high of 18.63%. At that time, it was obvious that if you had the capital, you should have paid down your mortgage since it was highly unlikely to earn a higher return elsewhere.
2) Level of Risk
You certainly do not want to be 100% financed nor do you want a mortgage that is going to be difficult to pay every month. In the event of a financial emergency where you might be forced to sell your property, you want some flexibility so that you can price your property for a quick sale.
It, therefore, makes sense to have 30% equity in your property and to have at least 6 months’ worth of expenses in the bank.
This information is provided for educational purposes only and is not to be construed as professional advice. Please consult with a real estate attorney for any legal questions, or a tax accountant for any tax-related issues that you might have. If you are unfamiliar with other forms of investment, consult with a financial adviser. Every situation is unique and may require specialized advice.