Help a Reader: Paying Off Properties

Here's an email I recently received from a reader:

I own 2 rental properties.  Both were purchased between 2005-2006 and I have lost equity in the properties since the recession/housing bubble.  I am in the military, so these were purchased as homes for us to live in while we were stationed at those respective locations with the possibility of turning them into future rentals. 

My intent is to now keep both of these properties until I pay them off and have them as income producing assets into retirement (even though they arguably aren’t good investments as I am not making any money currently on the homes). I outline the facts of each property below. 

Property 1:

• Originally purchased at $245,000 in 2005.
• Currently owe about $197,000.
• Likely current value around $192,000.
• Loan is a 30-year, but I currently pay ONLY interest for first ten years of this loan.  After the first 10 years it switches to principal and interest.  Interest rate is 6.75%.
• No PMI payment.
• Currently a loss of about $150/mo between rent and property monthly expenses (mostly due to a 2nd loan already paid off).
• Currently managed by a professional property manager for $130/mo.

Property 2:

• Originally purchased at $255,000 in 2006.
• Currently owe about $240,000.
• Likely current value around $205,000.
• Loan is a 30-year fixed with interest rate of 5%.
• Payment of PMI (private mortgage insurance) of around $100/mo included in the monthly payment.
• Currently a loss of about $360/mo between rent and property monthly expenses.
• Currently manage this one myself but will hire a property manager when I move to my next military duty station.

My question is what type of strategy would you use to pay these properties off to get the most bang for my buck? 

Even though my credit score is over 730 I am not able to refinance either property currently even if that was my plan, as both are still underwater and both are now rental properties (meaning higher interest rates if I do refi).  My intent is to have them both paid off within 15-20 years from now if possible.  The question really is do I pay property 1 off completely first, then start throwing extra money at principal on property 2 or do I use a different strategy? 

Just “walking away” from either property is not an option so please don’t even bother suggesting it.  I am currently paying about $1,000/mo extra to the principal of property 1.  This is within our budget to do.

Side notes: 

I am 31 years old and plan on retiring out of the military.  I am currently at year 8 of 20 years (or more) of service.  My wife and I have about $65,000 in ROTH IRA’s in Vanguard accounts, a small emergency fund, and no credit card debt.  We have 1 child (2 years old).  Thanks for your comments.
 

What's your advice for him?

Comments

[Jonathan]

Given that your primary goal is to pay off the two mortgages, it definitely makes sense to focus on a single property first before moving to the next. If you pay off one property, that frees up a lot of cash flow away from mandatory minimum payments. On the other hand, if you paid half the extra to each house, you have the same minimum combined payment for a much longer period, and you lose payment flexibility in the case of some financial hardship.

Typically, I'd say go straight after Property 1 with its higher interest rate; however, you are paying $100 a month in PMI on Property 2, which is a total loss. I don't know how much you have to pay it down before the PMI goes away, but it might make sense to pay that down to that point first, then focus on Property 1 until it's paid off, then focus on Property 2 again.

Also, if the two properties are located in the same area (and local enough to you), consider managing both yourself - that would save $130 (which you could apply to the debt). Otherwise, if you're dead set on getting them both under management, see if you can get a multiple property discount from the management company.

[DJ Wetzel]

I would throw all of my money at the property with the PMI. This is a money out the window. Once you get below the 80% LTV, then switch back to putting all extra payments on the higher interest loan. Once you have paid down this loan below the 80% LTV, you can refinance to a lower rate. I would continue to put all of your money to the loan with the highest rate until paid off, then snowball that into a nice extra payment on the remaining mortgage. Best of luck, and thank you for your service!

[Adam]

You're best option is to build equity by paying down the principle as fast as possible. Thank you for hanging with this rather than walking away; shows real character on your part. Hang in there.

[Ginger]

In four years property one's costs are going to rocket up when you have to pay the principle down ($1500/month), however, your costs for property #2 will increase when you move ($130/month). It looks like paying PMI off would almost cause you $100/month which is almost as much as you are paying the property manager at property #1. To get rid of PMI, paying the extra $1000/month, it would take you over 3 years to do so assuming you do not move. Given the amount of time it would take to pay off PMI and the short amount of time until you need to pay down the principle down I would continue paying the $1000 to property #1. The only way I would change my advise is if you could get rid of PMI much fast, in about a year.

[uff the fluff]

Not to sound harsh, but unless I am mistaken, this person is asking how they can make money off of two investment properties that are cash-flow negative? The obvious answer is that one cannot make money buying high and selling low. These properties were overpriced relative to the rents that they can bring in. Sorry.

[retirebyforty]

I also think you should get rid of the PMI on #2 as fast as you can.

You should check with the bank if you can refinance property #1. I am refinancing our rental to get a lower rate. Even with the extra .5% rate you should still be able to get around 5.25% for a 30 years fixed rate loan.

Good luck.

[Travis_D]

I am the original poster.

@ Johnathan - the properties are not located together so property management will be with two different companies unfortunately.

@ Ginger - You make some great points and this is a lot of what I am wrestling with. I'd like to get rid of the PMI but know that it would take at least 4-5 years or more and this is right about when the other property will fully reset to principal and interest. After it resets there is no possibility of having a smaller mortgage payment. If I continue to pay property 1 down further then when it does reset it will be a smaller mortgage payment which will at least give me a bit more flexibility.

@ the fluff - not trying to make money on the houses in the current environment. After the mortgage is paid off, obviously the house will cash flow then (quite a long ways away I know). As I mentioned we purchased the properties to live in, and had to move. This was pre-bubble when military folks had no problem buying and selling when they had to move 3-5 years later. Obviously things changed, and now we are "forced" landlords which is fine. I live with the decisions we made and take responsibility for them. The question is how to pay down the debt in the most efficient manner to pay both properties off in the long term (retirement).

Thanks for the comments & feedback.

[Joe]

Call Dave Ramsey. Seriously.

[Kimberly]

The question wasn't how to make money off them, but rather how to get the best bang for the buck: "My question is what type of strategy would you use to pay these properties off to get the most bang for my buck?"

The reader said that he was going to keep both properties and the current financing. So with that in mind, I think he is really asking is whether he should apply the extra $1,000 to property #1 or #2.

It comes down to paying the higher interest rate first (#1) or paying down the mortgage to get rid of the PMI (#2). Assuming that you can get rid of the PMI when you pay down 20% of the original mortgage, that would be when it goes below $204,000. That's approx. $36,000 from now, or at $1,000 a month, 36 months. As you pay it down, more of the original payment amount will go towards principal, so it would probably be a few months less than that. But for simplicities sake, I am going to use the 36 months. And that only gets it to current market value and knocks $100 off the monthly payment.

During that 36 months, if you are only paying interest on mortgage #1, you will pay approximately $40,000. With no further reduction in the principal.

Even with the PMI, I would pay down mortgage on property #1 - you are closer to having that mortgage right-side up (huge emotional burden lifted) and it is a smaller balance and has the higher interest rate. I think all signs point to paying down #1.

Of course, I would also try to get higher rents in both, as well as reducing expenses (management fees, property taxes, maintenance costs, etc). Also, make sure you are taking full advantage of tax benefits to help offset some of the costs. It may be a good idea to speak with a CPA.

[Apex]

Many readers here are getting a little hung up on the PMI. I hate PMI as much as the next person but I hate interest too. It is true that PMI is money down the drain, but that is also true of interest. When thinking about costs of a house, every single dollar spent other than principle pay down is money down the drain and it doesn't really matter if its interest, insurance, property taxes or PMI. So the correct answer here is to focus on the area that can have the biggest savings for you.

It turns out the extra interest on property 1 is a bigger problem than the PMI, if you could get property 1 refinanced. It also turns out that property 1 payments are going to increase a lot in a few years so that's another problem you would like to address and you can address both by a pay down of property 1 followed by a refi. You can currently get a 30 year loan for about 5.25% which would be savings of 1.25% on the interest of that property which would save you about 2500 per year on that loan versus the 1200 per year in PMI on property 2.

Thus for both the interest expense reason and the coming drastic increase in payments on property 1. You should do everything possible to get property 1 paid down to a level at which they will let you refinance it. When you do, go ahead and refinance it.

(Keep in mind that the negative cash flow on your properties will affect your debt to income ratio so you should check now to make sure that is at a level where they will give you a refi loan. If it's not you will have to work on improving that too which may not be possible. I just want you to be aware of the requirements to get a refi so you should check with someone about that in advance to ensure they would give you one after getting the mortgage paid down enough on property 1).

There will be closing costs but it will be saving you 2000-2500 per year in interest after the refinance. It will also prevent a huge increase in payment on that loan which will make your negative cash flow much worse.

Once you have done that then pay down property 2 until you can get rid of the PMI. After that pick the highest interest rate property (which will probably be property 1 by a little bit) and pay that off in full, then go to the remaining property. This plan will save you the most money and have the properties paid off the quickest.

Good luck!

[Travis_D]

@ Apex - I was hoping that I would see a comment here from you and sure enough it seems like great advice. This guidance makes sense and I will attempt to execute to the best of my abilities. Thanks for the insight.

[Steve]

Check with the mortgage company to see if you can refinance property 1. Refis have been made much easier to qualify for as part of the federal loan modification program. I was able to refi my rental even though I owe more than the property is worth. If you plan on holding the properties for the long haul (like me), this is likely your best option to make the best of of the situation. If the lender doesn't allow, then work through other suggestions. Best of luck.

[Goner]

If possible - 1) try to get extra income - extra assignments, freelancing, moonlighting, whatever you can do for a few hours a week
2) raise the rent a little. 3) look at other areas of your budget that can can trim - like the cable TV or your cell phone plan. Kids are expensive - what about saving on toys/clothes? Good luck.

[Dan Martin]

I agree with @Apex there paying down the higher interest makes sense. Another factor to consider is the possible increase in home value allowing for earlier re-fi on number 1, and quicker end to PMI. If home #2 raises so fast that a small extra principle payment will eliminate the PMI, then you should revisit the interest savings.

The difference between money down the drain for PMI and money down the drain for interest is the tax implications can be different. If you were living in the home, with few exceptions PMI is not deductible. Since these are income producing rentals, although not net income, you can deduct interest paid on a rental home, however there are some special rules for deducting PMI. You may want to check on the special rules.

[Apex]

@Dan,

There IRS doesn't indicate there are any special rules for deducting PMI on income producing property:

http://www.irs.gov/faqs/faq/0,,id=199625,00.html

Since this is a rental property the PMI should be fully deductible just like the interest. It's simply a business expense like any other.

For a primary residence as a result of the Tax Relief and Health Care Act of 2006 any mortgage taken out after Dec 31 2006, you can deduct the full PMI on your itemized deductions as if it was mortgage interest as long as your AGI is under $100,000. This is currently good through the end of 2011 and if not extended then PMI will no longer be deductible for a primary residence.

[Bankruptcy Ben]

Can't you claim for depreciation on the properties? You should be able to get your tax right down with an appropriate depreciation schedule

[Travis_D]

This is one of a few up sides of these investment properties - the tax benefit of the interest and the rental income losses. They offset other income and thereby reduce my overall tax burden. Obviously not a reason to have a negative cash flow but at least it is a silver lining right? Also, I do claim the depreciation.

[CoolMouseLuke]

Just one idea to add to the good advice above:

* If both these rental properties are titled in your personal name, an umbrella policy is a great investment. Adding a property or two to an umbrella is very inexpensive(I added a rental property in another state with a million dollar umbrella for $20/yr), and covers you against large liability claims at these rental properties you are not seeing very often if serving in other cities/states. You can't do this if they are titled in an LLC or any different entity, but since yours were purchased as primary residences I suspect they are in your personal name.

[CoolMouseLuke]

And before paying the $1000 to principal on an underwater property, I'd definitely consider using the $1000/mo to increase your emergency fund from "small" to at least six months, especially if you are going to deploy. Those are pretty big mortgage payments to handle without a good reserve. One vacancy or large repair bill could cause major issues, and I've seen this happen to spouses at home while the other spouse was deployed.

I've managed properties in other states for houses that I lived in for a few years and had connections for repair contractors, agents, insurance, etc... and had some form of direct deposit for rent like Section 8 type programs. The rent gets direct deposited from the state, if there is a repair I make one call to my known/proven contractors who take pictures before and after, and email to me. Then I pay them with online banking or Paypal. I wouldn't recommend this if you don't have these connections, or while deployed if your spouse is not comfortable with it. Or you could just use the property managers to find tenants, do the showings, applications, screening, but not for the ongoing monthly rental once the tenant is moved in and hopefully stays for years.

[Tim]

As a follow up to CoolMouseLuke, I would ask why you are pre-paying the mortgage at all. Take that $1000 and put it in a money market or even just a savings account. Earmark it for the mortgage.

When you prepay mortgage you lose access to that cash (especially on an upside down property). By putting it in savings the effect on net worth is the same but the liguidity and flexibility are vastly different.

A lot can happen in three years, the one you are prepaying now may not be the one you want to refi at that point.

While I completely get paying off a mortgage early, I have never understood why I should do that by prepaying monthly.

[Crystal]

I seem to agree with several of the commenters above, pay off as much as you can on the house with PMI until you get that knocked off. Then tackle the house with the highest interest. Good luck!

[KMI]

Paying down house #1 at least until you are not upside down in the loan and can look at a refi sounds like the best bet - and if you are right about the current value that shouldn't take too long. I'd agree with Apex on this one - you want to get a lower interest rate as soon as you can since you are going to face a big jump in interest and payments within just a few years with your current loan.

Good luck!

[Travis_D]

Thanks for all the insights from everyone. This definitely gives some perspective and will help in my future planning of the homes.

[RS]

@Tim - It's a tradeoff between the "return" you get on your prepayment by avoiding interest and the liquidity you get from having cash savings earning almost nothing.

Correct me if I'm wrong, but won't paying down the mortgage on #1 also reduce the interest payments you make each month, as the balance that the interest is calculated on is shrinking? Then you can take the additional savings from reduced principle (should probably be around $800/year after the first year of $1000/month) and add that to the principal paydown. Like Kimberly said above, you'd likely have it paid down enough in 4 years to refinance to a lower rate. Things only get better if rents and housing values appreciate at all in the meantime.

It's great to hear you say you're not planning on walking away from either property. Keep at it, and thank you for your service to our country!

[Tim]

@RS - I agree about the tradeoff. It is a personal decision.

I ran some numbers on 150K @ 6% (30 yr). With a $1000/month prepay, after three years one would have "saved" about $3250 in interest (it increases significantly every year). That is a lot of money, but zero of it is in your pocket. Plus you will have locked up $36,000 in real estate and reduced the bank's risk.

$1000/month in the bank would give you $36,000 ($36,000.50 with interest). Maybe in three years one of the markets would have recovered enough so as to allow you to refi both with that amount of money. Cash gives you the choice.

Given the economy, the real estate market and my crystal ball not working right now, I'll take the cash and the flexibility.

Of course, one could do a hybrid ($500 prepay and $500 saving or $12000 prepay at year end) which would offer some flexibilty and some interest savings.

Good Luck.

[Tyler]

- the places are not cash flow positive. Not even including depreciation or other costs.
- you spend $510 per month to keep the properties. $6,120 per year.

- By your current value calculation you've lost 100k in value (21%). I bet its more/ you'd realize less value if you tried to sell the units today and you factored in the massive transaction fee.

- You've paid 63k over 5-6 years in mortgage principle. Lets say 12k per year or 1k per month.

- both of these properties are in different states and soon you wont even be near one so there are zero synergies.

Walking away isnt an option? How so? Why not? What are you going to do if the places go down in value by another 20%? Have you even considered that things might get worse? What if it doesnt get worse and it stays the exact same for 5 years? Every single investment should have a walk point.

You are limiting your decision options because of a sunk cost that is totally irrelevant. (look up sunk cost cognitive bias)

My advice isnt to walk away, its to seriously re evaluate your decision making framework. Continuing to throw good money after bad is a poor investment strategy.

[Ladam8518]

I crunched some numbers looking at 5 different cases:

1: Minimum payments only
2: Minimum payments only but snowball when PMI and Loan 1 are paid off
3: Focus all effort on Loan 1 with only minimum (and PMI) on loan 2
4: Focus all extra payments on Loan 2
5: Focus all efforts on paying off PMI and then Loan 1

In order to do this I had to make some assumptions on the loans. I assumed payments began in January of the year purchased, this made the interest only payment for Loan 1 $1,108.13 and the reset value $1,497.92 and the minimum payment for Loan 2 $1368.90. The loan one values are based on the current balance of $197k rather than the $245k.

My analysis shows that the most efficient means of paying off the loans is case 5. Put the extra towards the second loan until PMI is paid off, then focus on the first loan. Assuming that the loans entered repayment in January means that there are 43 months until the rate reset on the first loan and, with no extra payments, 84 months till PMI stops. If the second loan is focused on until PMI stops, this reduces PMI to 26 months (assuming 80% LTV cut-off).

In addition to reducing interest (and PMI) paid, option 5 (and option 3) will have both properties paid off in 15.5 years.

Taking into account depreciation and rental losses, there is tax savings of $506 per month at a cost of $510 per month. This is close to break even and doesn't include other items which may be claimed and are not mentioned in the question.

The best option, based on my opinion and analysis, is to focus on getting rid of PMI and then paying off the first loan. I can provide my analysis if desired, I just need an email address to send it to. It is a simple Excel spreadsheet.

[Travis_D]

@ Tyler - Yes I am limiting my decisions. I am familiar with sunk costs and cognitive biases but my reasons have nothing to do with that. If the properties go down in value by 20% in the near term how does that affect me if I plan on holding the properties for 20, 30 or 40 years? As long as rents don't go down 50% or something crazy (which is wildly unlikely) I will be able to make this work. Owning these houses is not the same as buying and selling stock - it obviously isn't very liquid. My rationale for not wanting to walk away is listed below.

1) Most importantly when I signed the loan documents I put my name on a contract and signed it with the full intent of holding up my end of the bargain. I was not hoodwinked by the loan officer. I was not swindled by the bank. I have the ability to pay the mortgages. I was fully aware of my decisions and my integrity, duty, and principle dictate that I am held accountable for my personal decisions. If I get to a break-even point and choose to sell a property then - so be it, but I am not just going to stop paying because it is no longer financially attractive.

2) If a majority of homeowners who were underwater decided to simply walk away and go rent somewhere because it is more economically convenient even though they can afford the mortgage - who ends up paying for this? The taxpayers do via bailouts of banks, etc. So the suggestion that I walk away from an investment when I am able to make the payment is akin to saying that other people should now pay for my poor decisions. This is irresponsible on many levels, and if compounded by many people choosing the same path will create even more economic turmoil for the country than we are already in. Personal responsibility is a seemingly lost art in this country for some reason.

@ Ladam8518 - thanks for the analysis, definitely worthwhile. If you email the spreadsheet to FMF I'm sure he would forward it to me. Thank you.

[Steve]

Travis - I know I said this already, but check with the mortgage company to see if you can refinance property 1 now, rather than in 4 years. They may allow you to do it now, and if they do it's your best option.

[Jim]

Couple points:

The PMI on #2 is $100/mo. or $1200/yr. That is like paying an extra 0.5% on the existing mortgage. So #1 is still higher carrying cost just for the mortgage.

Have you considered selling property #1? Its almost even so you wouldn't take a huge loss. If you hadn't thought of it, then look at it this way: Would you buy that property today with those terms? If not then its not a property you'd really find a good investment, may as well dump it now and cut your losses. Something to think about.

[sosa]

Travis,

I am also under on 3 properties and will not walk away,I agree with you,my name is on the line. If you are able to fullfill your obligations you should do so! Thanks for your service to our country.

[Taylor]

I am a landlord and have been for awhile now.

I recommend not prepaying either of them, but rather putting the money in the bank and putting both houses up for sale for the the best possible price. When one of them sells, take the money you have saved up with you to closing (since you are underwater). Do this for both of them. This is going to be a painful process, but I promise you will make more money in the long run.

Once your properties are sold (even for less than they are worth), save up. Once you are in a location where it is unlikely that you will be moved, then purchase a rental. DO NOT SPEND $200K on a rental. Regardless of the market, this is too much for a rental. Buy your properties low enough that they will cash flow, even after all expenses, emergencies, rental management fees (though you should manage them yourself as they will be in the same town where you are located). It is better to buy more of them for cheaper than a single expensive one - too many eggs in a basket, and vacancies affect you more with fewer properties.

Also, consult with other landlords - these are rental properties, you should be hitting up the Q&A billboard on mrlandlord.com and asking questions about how you can get rents raised and improvements to your property to get them rent for more or make them saleable. While the financial aspect is good, your question is fundamentally about the property, not the mortgage (also it may seem like it is about the mortgage).

Good luck!

[Kenny]

Here are my suggestions being in the same business with rental properties. This is from a owner/property manager who runs a very tight ship, and has $36K per year in net-net-income before taxes on total of 3 1/3 small (2 unit) properties. None of these are easy, but the sum-total of this is very creative:

1. Reduce expenses down of each of the properties.
2. Upgrade the property a bit and seek for more rent.
3. Change the Property Manager to someone reliable with lower cost per month.
4. Hire a handyman to handle any challenges/upgrades/repair to the property instead of paying the property manager to call a licensed plumber or electrician to change the 'proverbial bulb or faucet'.
5. Introduce more responsibilities for the tenants in the next iteration of the lease renewal, and hence your responsibilities go down.
6. Take the first $100 of expense item, and dump it on the tenant. Define $100 as what you would pay your guy.
7. Reduce the interest of the property loan by dipping into your own home if you have some equity in it.
8. Tap into your after-tax brokerage account where you might have some SOLID long term holdings and borrow on margin over there at a very low rate to save on monthly payment < VERY dangerous, but very lucrative if you run it correctly
9. Reduce your Emergency Fund holding to reduce the loan on your rental homes so that you cash flow positive
10. Reduce your expenses in your personal life to save more and therefore reduce the loan amount, and therefore get to positive cash flow.

I HAVE done ALL of the above, and have gotten myself to very positive numbers. I want to get to 10 properties and get a net-net-income of $100K before I let my professional job go by the way side. I need one more winter to make this happen.

Of course, some might have suggested to get out while you can. And, of course, if you do not like 'renting', then continue to rent, and silently put it on the MLS to sell the property (no signs outside is silent to me). And, see if you can stop the bleeding in one shot. But, then you are not building ANY equity in the home.

Hope this helps.

Kenny

[Wisenheimer]

Cpt 13 with investment property will "cram down" mortgage to current value..