What should we do? Pay off or refinance?

**jpg7n16** · 08-11-2010, 08:27 AM

What's the rate on the mortage for your personal residence?

What is your income? (to see if you qualify for the student interest deduction or not, and also to estimate your tax bracket)

Once I know those, I would see which of all your loans is the highest interest rate after adjusting for any offsetting tax benefits. Then I would pay extra towards whatever debt makes the top of that list (highest tax-adjusted interest rate).

Saving the most interest puts the most money in your pocket, although it may not always feel like it.

**jIM_Ohio** · 08-11-2010, 08:28 AM

Originally posted by azcassie View Post

My wife and I have saved up some money and we're wondering how we should pay off some of our debt. I have $40,000 in student loans with an interest rate of 5.25% monthly payment of $253.89, and my wife has $23,000 with an interest rate of 6.50% and monthly payment of $193.56. My wife will soon be going back to school (medical school). Also, we have a rental property with a mortgage of $87,000 and an interest rate of 6.75% and a monlthy payment of $736.87. Both of our vehicles are paid off and we contribute the max to our Roth IRA's every year. We also contribute to our 401K's and a separate stock investment account. We have no credit card debt. We are trying to decide if we should pay off some of the student loans or if we should put money towards the principal on the rental property and refinance it. We figured if we paid down the mortgage and refinanced then we could pocket more of the rental income every month. Our personal residence is so far upside down that we figured its not worth putting more money into. Also, we have about $500 per month that we could use towards paying down debt, plus our savings. We already have 1 year's worht of an emergency fund. Thanks for the help.

I would look into the tax implications of paying down the rental.

Generally, look on your tax return, and verify you are claiming depreciation against the rental income, and also see if mortgage interest paid on the rental is being claimed against the rental income. All those numbers should be on same schedule.

If you pay down the principal of the rental, more of the rental income will get taxed. That is not a bad thing (maybe it is, maybe it isn't), but you need to know those details. Who does your taxes? Contact that person for more info.

I see debts as
40k SL 5.25% payment $253
23k SL 6.5% payment $194
87k rental $737

I would like to clarify the following questions

1) Do you have 6 months expenses in bank as an emergency fund?
1a) is the rental covered as part of the emergency fund?
2) Do you save 20% of gross pay every month/ every year? Some can go to debt repayment and some can go to retirement accounts, but in general if you gross $X, you want to see 20% of $X being applied to improve finances. The $500/mo extra you mention here is part of the 20%

Also, we have about $500 per month that we could use towards paying down debt, plus our savings.

3) What are your goals?
a) retirement- how soon?
b) debt free?
c) high net worth?
d) get thru week without really hurting someone (LOL)

If you want to retire earlier in life, I would probably invest the savings in stocks
If you want to have a high net worth, I would probably pay down the current mortgage (not the rental) or the 6.5% student loans. Just because you are upside down on house should not disclude you from paying it off.

My initial guess is
a) pay off 6.5% student loan
b) pay down on 5.25% student loan (add in the $194 payment and the $500 excess you have each month and this loan is gone within 5 years and probably much sooner)
c) pay down your current house to where you have 20% equity
d) then invest a portion of the money and keep working on the mortgage of the primary residence.

I would not pay down the rental at all, unless you make a case (numbers wise) to where it makes sense.

**azcassie** · 08-11-2010, 08:38 AM

The mortgage on our personal residence is $145,000 we just refinanced at 5.3% earlier this year. Our income last year was $130,000 so we don't qualify for a lot of breaks. Also, we do depreciate the rental and deduct the interest on our taxes. As for the emergency fund, it is 6 months of expenses and the rental payment is included in it. We like to be on the safe side. And yes we save 20% each year gross. Usually we pick something and pay it down. Earlier this year we paid off my truck with what we saved up last year. Our goals are to be debt free within 5 years even though we'll be adding new student loans to the mix. Also, I would like to tetire at 40 (my wife will be a doctor so she doesn't want to retire that soon). As for net worth we like being worth something but its not our main concern.

**jIM_Ohio** · 08-11-2010, 09:04 AM

Originally posted by azcassie View Post

The mortgage on our personal residence is $145,000 we just refinanced at 5.3% earlier this year. Our income last year was $130,000 so we don't qualify for a lot of breaks. Also, we do depreciate the rental and deduct the interest on our taxes. As for the emergency fund, it is 6 months of expenses and the rental payment is included in it. We like to be on the safe side. And yes we save 20% each year gross. Usually we pick something and pay it down. Earlier this year we paid off my truck with what we saved up last year. Our goals are to be debt free within 5 years even though we'll be adding new student loans to the mix. Also, I would like to tetire at 40 (my wife will be a doctor so she doesn't want to retire that soon). As for net worth we like being worth something but its not our main concern.

If retiring early is your PRIMARY goal, then its probably better to invest more (now=earlier) and let the debt pay itself off over time. Try not to incur new debt either (except on the rentals).

If debt free in 5 years is your primary goal, reverse what I said above- pay off the debt now, then invest more once debt free in 5 years.

The 5 years of debt reduction will probably delay retirement 5-10 years. If you invested now, the debts would probably be paid off in about 10 years (some would be gone sooner, all should be gone in 10-15 years).

**jpg7n16** · 08-11-2010, 09:08 AM

Well you actually do qualify for the deduction: Publication 970 (2009), Tax Benefits for Education

As long as your AGI (which means after 401k deductions, etc) is less than $150k, you can claim up to $2500 of interest. It's phased out from 120-150, so your AGI would need to be below 120k for the full deduction.

Meaning if you contribute a combined $10k or more to your 401k, you qualify for the full $2500 deduction. If not, you can still deduct up to $1,667 (based on a 130k income)

So doing a bit of calculations - and using a 25% tax bracket:

5.25% student loan (40k charges 2100 interest, fully deductible) - net rate 3.94%
6.5% student loan (23k charges 1495 interest, partially deductible -1st $400 only) - net rate 6.07%

6.75% rental mortgage (fully deductible) -net rate 5.06%
5.3% primary mortgage (fully deductible) -net rate 3.98%

So under current tax law, it is in your best interest to pay down debt in this order:

6.5% Student Loan
6.75% Rental
5.3% Primary
5.25% Student Loan

**littleroc02us** · 08-12-2010, 06:57 AM

Well, the nice part is you have quite a shovel to use for such large amount of debt. Also, your principle residence is quite reasonable for your high income level. The problem I see here is that you have $150000 in student loans and a rental house. Plus you plan on adding to that when your wife goes to medical school. Personally I think you need to stop contributing to your retirement until you get this mess cleared up. You have the ability to clean this up quickly if you apply all your means towards the end of this debt. Your Net salary is 91k approximately, which is $7583 a month. That is the best part. I calculated your mortgage payment to be around $956 which includes property taxes and insurance. That leaves around $6627 for additional expenses. If you were to pay $4166 on your school loans and rental you would have them finished off in 3 years. That leaves you $2461 each month for food, gas, entertainment, etc... Unless I'm missing something, with your income your totally capable of this. Start with the smallest loan and pay that one off first, because when you do this you will have more money quicker to apply to the next largest loan. Good luck.

**jIM_Ohio** · 08-12-2010, 07:06 AM

Originally posted by jpg7n16 View Post

So under current tax law, it is in your best interest to pay down debt in this order:

6.5% Student Loan
6.75% Rental
5.3% Primary
5.25% Student Loan

Make sure you factor in the rental tax schedule before paying it down. Interest paid on the rental can offset income from the rental, and that does not matter what the interest rate is. The decision is not as simple, IMO, as looking to see what the after tax interest rate on the rental is.

Paying down the rental could also lower the ROI on the property, so a separate ROI calculation, a separate tax benefit calculation, and separate decision on the rental is in order.

In addition the risks of the rental are different. If you have financial problems, let the bank take control of the rental before you let them take control of the house you live in, so its OK to have debt on the rental (from a risk standpoint) and pay off the other debts (including primary residence first).

**jpg7n16** · 08-12-2010, 07:34 AM

Originally posted by jIM_Ohio View Post

Make sure you factor in the rental tax schedule before paying it down. Interest paid on the rental can offset income from the rental, and that does not matter what the interest rate is. The decision is not as simple, IMO, as looking to see what the after tax interest rate on the rental is.

I accounted for being able to completely discount all the interest against income (saving a full 25%). It can't possibly save more than that on taxes - so I think my number was the most conservative.

Paying down the rental could also lower the ROI on the property, so a separate ROI calculation, a separate tax benefit calculation, and separate decision on the rental is in order.

If you pay $2 in interest on your personal home, or $2 in interest on your rental property, what difference does it make to your net worth which home caused the interest?

Your personal ROI will be higher by paying down the highest interest rate - in this case, the rental.

In addition the risks of the rental are different. If you have financial problems, let the bank take control of the rental before you let them take control of the house you live in, so its OK to have debt on the rental (from a risk standpoint) and pay off the other debts (including primary residence first).

If I got into financial problems, I'd rather sell the rental than sell my personal property. That would cash out the equity from the rental, which would be higher cause I'd have been paying it down. Then I'd have a better cashflow position, and extra cash on hand.

**jIM_Ohio** · 08-12-2010, 08:21 AM

Originally posted by jpg7n16 View Post

I accounted for being able to completely discount all the interest against income (saving a full 25%). It can't possibly save more than that on taxes - so I think my number was the most conservative.

If you pay $2 in interest on your personal home, or $2 in interest on your rental property, what difference does it make to your net worth which home caused the interest?

Your personal ROI will be higher by paying down the highest interest rate - in this case, the rental.

If I got into financial problems, I'd rather sell the rental than sell my personal property. That would cash out the equity from the rental, which would be higher cause I'd have been paying it down. Then I'd have a better cashflow position, and extra cash on hand.

For whatever reason I cannot open pdfs right now, but I can remember some basics from my HR block tax course...

If someone has rental income (passive income) that income can be offset dollar for dollar with depreciation and rental costs- not percentages, but a straight reduction in taxes. I am not convinced 25% is best case (as you pointed out above)- this might still be a 25% reduction in taxes with dollar for dollar reduction, but it could also be a loss, which can then write off other income to a small degree (there is the passive loss which cannot offset to much of earned income exception which I wanted to look up, but could not)

So if a person has 12k of rental income ($1000/mo) and $7000 of depreciation (paper loss) and $5000 of mortgage interest (real loss) that $12k is not taxed "at all" (not taxed at all is better than saving 25% in my head, but would need to see numbers carried through to validate this).

Correct me if I am wrong on any of that. The biggest issue is does depreciation cover most of the income (or not). Another issue is less interest is paid every year on the rental, so that number goes down.

Once you pay down the principal, ROI changes and this was discussed in another thread.
Some details- see post #6 in this thread

Saving Advice Forums

http://www.savingadvice.com/forums/personal-finance/54539-pay-off-rental-property-mortgage.html

ROI on a rental to me is this:

My benefit/My cost

My benefit is three fold:
1) the income from the rental
2) the depreciation of the property on tax return
3) the writeoffs on tax return (if they exist- which includes mortgage interest)

My cost is
1) the money I put down on the property
2) any additional money I put into property (repairs, paying down mortgage)
3) Mortgage principal payments/ property taxes

If a person adds to the cost (pays DOWN a mortgage) but does not increase the benefit, their ROI goes down.

I agree some of that is recovered when sold (as you pointed out, more principal was paid down), but the ROI before property is sold actually goes down.

So if I put 10k down a property which gives me $1k in monthly rental income; and $100 of that income is profit (my PITI is $900/mo), my ROI is

100/10k per month
or 1200k/10k per year

either way, that looks good to me, plus the depreciation benefit would be a bonus, as would the mortgage interest offsetting the income from a tax standpoint.

If I paid down the mortgage on the rental (not paid it off, but just paid it down) with another 40k, my equation is

100 per month income/50k money into property. I don't see any immediate benefit because the cash flow did not change and the ROI number actually went down.

If that 40k paid OFF the property, then ROI does change (because costs decreased)

so ROI is now

1000 (monthly rent) /50,000 (my costs)
or
12,000/50,000

If you pay off the rental that looks good, but paying it down does not show an immediate ROI on the pay down, plus paying it down hurts the tax return on the rental.

If net worth is the goal, then paying down the houses should be done before paying down the debt
If paying less interest is the goal, your list is correct
If something else is the goal, another option might be better.

**jpg7n16** · 08-12-2010, 09:12 AM

Originally posted by jIM_Ohio View Post

For whatever reason I cannot open pdfs right now, but I can remember some basics from my HR block tax course...

If someone has rental income (passive income) that income can be offset dollar for dollar with depreciation and rental costs- not percentages, but a straight reduction in taxes. I am not convinced 25% is best case (as you pointed out above)- this might still be a 25% reduction in taxes with dollar for dollar reduction, but it could also be a loss, which can then write off other income to a small degree (there is the passive loss which cannot offset to much of earned income exception which I wanted to look up, but could not)

So if a person has 12k of rental income ($1000/mo) and $7000 of depreciation (paper loss) and $5000 of mortgage interest (real loss) that $12k is not taxed "at all" (not taxed at all is better than saving 25% in my head, but would need to see numbers carried through to validate this).

Correct me if I am wrong on any of that. The biggest issue is does depreciation cover most of the income (or not). Another issue is less interest is paid every year on the rental, so that number goes down.

In the case you present, the $5000 of rental interest saved you from paying 25% tax on $5000. While the depreciation saved you from paying 25% on $7000. They reduce taxable income, not tax liability.

Therefore the tax savings from the interest charged would have been $1250. (Under normal circumstances, that $5k of income would have been taxed at your marginal rate, so it would have $5000*.25= $1250 tax liability)

Let's say that was charged on a 100k mortgage so 5000 would be 5%. So you pay $5k in interest, and save $1250 of taxes for a net cost of $3750. 3750/100k = 3.75%

The shorthand version is 5% * (1-.25) = 3.75%

Once you pay down the principal, ROI changes and this was discussed in another thread.
Some details- see post #6 in this thread
http://www.savingadvice.com/forums/p...-mortgage.html

I disagree with this viewpoint as it conflicts with the debt reduction goal of the OP in this thread.

If we were to truly adhere to maximizing ROI, we would suggest that the OP cash out his equity on his personal residence and use it to finance a 2nd rental, or to invest in the stock market. If he can borrow on his home at 5% in order to invest in real estate, stocks, or bonds that yield greater than 5%, he will increase his ROI through debt leverage.

But he will not acheieve his goal of reducing debt.

If the OP here is trying to pay down debt, in order to raise his net worth and not necessarily his ROI, then you would have to evaluate the rental as part of his overall financial situation. Evaluate all income from all investments over his net worth (Assets - Liabilites = Equity = Net Worth).

So if OP will be paying down debt either way - paying down a 6% debt will save OP more money than paying down a 5% debt, and calculations of ROI on the rental are misguided.

**jIM_Ohio** · 08-12-2010, 10:04 AM

Originally posted by jpg7n16 View Post

In the case you present, the $5000 of rental interest saved you from paying 25% tax on $5000. While the depreciation saved you from paying 25% on $7000. They reduce taxable income, not tax liability.

Therefore the tax savings from the interest charged would have been $1250. (Under normal circumstances, that $5k of income would have been taxed at your marginal rate, so it would have $5000*.25= $1250 tax liability)

Let's say that was charged on a 100k mortgage so 5000 would be 5%. So you pay $5k in interest, and save $1250 of taxes for a net cost of $3750. 3750/100k = 3.75%

The shorthand version is 5% * (1-.25) = 3.75%

I disagree with this viewpoint as it conflicts with the debt reduction goal of the OP in this thread.

If we were to truly adhere to maximizing ROI, we would suggest that the OP cash out his equity on his personal residence and use it to finance a 2nd rental, or to invest in the stock market. If he can borrow on his home at 5% in order to invest in real estate, stocks, or bonds that yield greater than 5%, he will increase his ROI through debt leverage.

But he will not acheieve his goal of reducing debt.

If the OP here is trying to pay down debt, in order to raise his net worth and not necessarily his ROI, then you would have to evaluate the rental as part of his overall financial situation. Evaluate all income from all investments over his net worth (Assets - Liabilites = Equity = Net Worth).

So if OP will be paying down debt either way - paying down a 6% debt will save OP more money than paying down a 5% debt, and calculations of ROI on the rental are misguided.

Our goals are to be debt free within 5 years even though we'll be adding new student loans to the mix. Also, I would like to tetire at 40 (my wife will be a doctor so she doesn't want to retire that soon). As for net worth we like being worth something but its not our main concern.

I agreed with most of what I read above, so points well taken...

Is debt free really the way to go on the rental if the income from the rental is going to help retirement?

It still might be...

but if OP has the cash to pay extra on the rental... it is shifting money from a liquid form (cash) to an illiquid form (house). If someone is retiring at 40 yo, and that is a stated goal, my advice would be to not pay down the rental.

It locks up assets in the house, when early retirement suggests he might need those assets in cash. Much of this depends on the retirement picture though (and not the pay off debt in 5 years picture).

What should we do? Pay off or refinance?