I’ve been salivating over these insanely low mortgage rates out there right now. But I never even thought that another option might be to just pay off the rental property.
Today I want to tell you about how I went from unsuccessfully trying to refinance to considering that maybe I just pay off the rental property. It even involves a discussion with the one and only Clark Howard!
There’s always discussion in the real estate world about whether it makes sense to buy property out-of-state or other areas where the costs are lower and the rents are higher (in perspective to the costs).
Lucky for us, that was never an issue because northeastern Ohio is one of those good rental areas and we lived there at the time we started investing.
We bought our duplex back in 2015 during a quest for a second rental property. We were able to purchase it for $98,000 – less than $100k for a nice ready-to-rent two-unit property! It was built in 1967 and it’s located in an area where duplexes are the norm and solid renters are common.
I put down about $25k and was able to secure a loan for $73,500 at 4.75% for 30 years. The property is now worth around $150,000. I’m not in the game for the appreciation, but that’s always nice to see!
In the meantime, our tenants are paying $800 each in rent. That’s $1,600/month with a mortgage payment (including taxes and insurance) of only $750/month – and that’s with me adding some extra to pay it off a little faster.
Currently, we owe $63,739.63 on the duplex. So after 5 years of owning the place, the tenants have paid off just under $10k on it… not too shabby! In other words, not only am I making money every month on the place, but the tenants are also helping to build the appreciation on the property.
I’m not saying everything’s perfect. We’re in the process of evicting a tenant for not paying rent and we get the occasional repair headaches, but overall, we’re in good shape. And knowing that one side of the duplex can cover the whole mortgage payment each month keeps a lot of the stress down.
As a side note, this is the only rental property we still hold. We sold our first rental house in 2018, which was becoming a real pain in the butt. Unlike the duplex, the house is in a rough area (there was a shooting incident directly in front of the house!) and it’s over 100 years old. It was one problem after another… I really learned from my mistakes when we bought the duplex!
The refinance problem
The start of this entire rabbit hole was that I wanted to refinance the mortgage on the duplex. It’s hard to complain about a fixed rate of 4.75% but with rates as low as they are now, I could do a lot better.
On Thursday, August 06, 2020, according to Bankrate’s latest survey of the nation’s largest refinance lenders, the benchmark 30-year fixed refinance rate is 3.080% with an APR of 3.270%. The average 15-year fixed refinance rate is 2.650% with an APR of 2.860%. The 5/1 adjustable-rate refinance (ARM) rate is 3.300% with an APR of 3.990%.
While poking around, I’m seeing rates of 2.775% for a 20-year loan. Plugging in my current and proposed numbers into a calculator like this one on NerdWallet gives me these results:
That looks fantastic, right? I’d shave about 5 years off my loan and would drop my payment down a few bucks every month.
Unfortunately, that’s only half the story. If this was our personal residence, done deal. But with a rental property, you’re generally not going to get the same rates. More commonly, you can expect to pay one extra percentage point for that type of mortgage.
To put it simply, we could probably expect to find a loan for the property for around 3.775% instead of 2.775%. While not as exciting at that rate, the results still aren’t too bad:
Even though my loan payment would increase by $17/month, I’d still shave 5 years off my loan. Depending on the actual rate I could get, it may or may not be worth pulling the trigger on it.
Here’s the problem – getting a bank or mortgage broker to help me was going from one dead-end to another. First of all, refinances are hot right now. A lot of the institutions are struggling to even keep up with all the applicants. So who would want to deal with the measly $64k I still owe on the property? Not many.
But the other issue I’m running into is that I don’t have a regular job. I’m retired… happily retired. Yeah, I make a little money blogging, but not enough for them to want to give me a new mortgage.
Even though our net worth is currently over $1.3 million and we probably have a steadier paycheck than a lot of folks, that doesn’t mean much. You’d also think that our rental income being twice as much as our current mortgage payment (taxes and insurance included) would help green flag this for a loan.
I knew this going into it, but early retirement brings along some issues like trying to buy or refinance a property.
A whole different perspective from Clark Howard
I used to listen to a ton of personal finance podcasts all the time. But now, I’m a lot pickier. Even though I have my favorites, I’ll only listen to an episode here or there if it truly seems interesting.
However, there’s one that I listen to every single day… The Clark Howard Show. I’ve been listening to him for years and I usually learn something new in every episode. I find him entertaining and his advice is generally spot-on. Plus, he touches on other topics like technology that I enjoy as well.
So I decided to write to him about my refinance problem a few weeks ago. Would you believe that I got a reply later that same day asking if I wanted to be on a call with Clark Howard the next day? Of course, I would!
We were actually on our way to go camping at the time the call was scheduled for so we pulled off to a store parking lot and I did the call with him.
I explained my situation to Clark about how I was struggling to find a loan provider because of my early retirement and the smaller loan amount. I was hoping to find an alternative avenue where I could make the refinance possible.
Here’s why I love the guy. He listened to what I was saying, took a step back, and said something along the lines of, “So, I’m thinking of something a little different. With you being an early retiree, you’re probably sitting on a lot of cash right now, right?”
When I replied “yes” with it being part of our withdrawal strategy to help protect against the sequence of returns risk, he mentioned that I’m probably not earning much in savings on it. That’s correct. My online savings account with Ally is only earning about 1% right now.
His thought… what about just paying off the property completely?
Hmm, that’s an interesting idea that I just hadn’t even thought of before. I had always just kept my blinders on with letting the tenant pay off the mortgage.
But this really was an eye-opening thought. If I’m earning a paltry 1% on my money in savings, wouldn’t it make more sense to put it toward a debt of 4.75%? That would be a much better return on my money. It would even be a better return on my money than a refinance, too!
There was more information and back and forth, but I found this to be considerably helpful – a fresh and valuable perspective.
And just so you know, I never heard my call on his show… I must be pretty boring to talk to on the air! Doesn’t he know that we were on an episode of House Hunters International?! Guess that isn’t very helpful either. 😉
UPDATE: What are the chances my appearance on The Clark Howard Show aired on the same day that my post came out?! If you’re interested, you can check it out on the Clark Howard Podcast page. It’s episode 8.10.20 and I’m on the air at about the 13:24 mark. Thanks for the heads up, Thomas!
Why we should pay off the rental property
Though the notion to pay off the rental property wasn’t something I had considered before, it sure was a reasonable idea.
Mathematically, it just makes sense. Paying off debt with a 4.75% interest rate using money only earning 1% is a much better return on my money. That’s about as simple as it can get.
Additionally, my net profit on rental income from the duplex would also go up substantially. That would be a nice check every month from the property management company after they take out their cut. The money we get could then either go toward our own monthly living expenses or be used to put back into our cash bucket for use a few years down the line.
And then there’s the psychological aspect. This mortgage is our only debt. I consider it to be good debt since our tenants are paying for it and we’re making extra money on it as well, but it’s still debt. And obviously, it’s much easier to sleep without a mortgage over our shoulders. I don’t have much stress since one tenant can cover the payment anyway, but it would still be nice not to have to think about it at all.
Why we shouldn’t pay off the rental property
Ok, so it seems like a no-brainer to pay off the rental, right? Not so fast! After thinking it over and talking with a friend who’s very much on top of this stuff, there were a few realizations.
First off, there’s a small nuance I didn’t realize. We get an interest deduction on our taxes for having the mortgage on our rental. I’m not an expert in taxes, but I thought that this went away for those filing a standard deduction which is what we’re now doing.
But that’s only true on a personal residence – we still get the deduction for a rental property on Schedule E. Last year, we had $1,309 in interest. With the Roth IRA conversions we’re doing every year now, that deduction gives us the breathing room to convert that amount at the target tax rate. But it’s not a ton of dough… we could just convert a little less each year to accommodate for that – not that big of a deal.
Another possible issue to remember is that if we pay off the rental property… well, that money’s gone. When you have money in the bank or the stock market, you can always move it around or take it out if needed. When you pay off a debt like this with a chunk of money, you can’t get it back. Sure, a way around that might be to get a home equity loan or line of credit but that’s a whole separate project.
Finally, the biggest obstacle is that the numbers aren’t as straightforward as they seem. Even if I could get a mortgage at the 3.775% I mentioned (or lower), I can’t just compare that to the 1% interest rate I’m getting from Ally for two reasons:
- That interest rate from Ally is going to change over the years… and it’s probably going to go up. Over 20 years, it could absolutely go higher – maybe even a lot higher. Will it go higher than the 4.75% I’m paying right now? I have no idea.
- The money we would be using to pay off the loan wouldn’t just be from Ally at the 1% rate. In fact, most of it would come from the latter money we have in our bucket strategy. And that means it would come from selling off some BulletShare bond ETFs to pay off the mortgage. When I checked, I was surprised to see that BSCO has returned 5.32% YTD and 8.06% over the past year… that’s a dramatically better return than the 4.75% I’m paying in interest on my loan. That said, interest rates are crazy low right now. As rates go up (which they will), the return will inevitably go down. When will that be? I have no idea.
After looking at the pros and cons, this is not that easy of a decision to make. It’d be nice to pay off the rental, but I don’t think it’s going to really make that much of a difference over the long haul.
So if that’s the case, I might be back to square one of just trying to refinance the property, which is probably pretty unlikely. Personal finance is fun, my friends… good times!
What do you guys think? Pay off the rental property, try harder to refinance it, or just leave it alone?
Thanks for reading!!
PS Shout-out to my friend for the great information on both sides of this equation – very much appreciated!