Should I Pay Off This Mortgage Loan?

I just heard a personal finance expert recommend paying off a mortgage that has 14 years remaining. Here are the parameters of the 30-year fixed rate loan:

Debt Present Value:   229,880
Remaining Term:           168  (16 years paid, 14 years left)
Annual Interest Rate:     6.6% (fixed over 30 years)
Monthly Debt Service:  -2,100  (principal + interest)
Annual Debt Service:  -25,200

From these parameters, I can work backwards to find the original loan amount of 328,814. There was no mention of the original Equity to Value (ETV), so we’ll guess that it was 20%. Therefore, the original property value is 411018=328814÷80%. Thus, the current Loan to Value (LTV) ratio is 55.93%=229880÷411018, assuming no change in the current property value.

The owner has enough cash in a savings account to pay off this mortgage loan. The savings account has an annual interest rate of about 1% (practically nothing). The “expert” recommends paying off the mortgage loan, because that effectively “earns” 6.6% on their money by diverting the 2,100 monthly payment into a retirement account that is invested in a mutual fund to earn a higher yield. Most mutual funds have not yielded more than 6% in recent years, and some of them have lost principal.

Paying off the mortgage loan saves 2,100 per month and gives peace of mind that the owner has greatly reduced the risk of foreclosure in event of income loss. The owner must still pay property tax and insurance to protect the investment. Investing 2,100 per month into a retirement account (mutual fund) is probably a low yield choice and has the risk of loss in a down stock market.

I would recommend seriously considering not paying off the mortgage loan, and instead investing the 229,880 as a leveraged investment in income property. The cost and structure of the financing parameters are:

1st position debt:

Annual Interest Rate: 5.00%
Loan to Value Ratio: 70.00%
Amortization Term:     300

2nd position preferred equity:

Annual Yield:         9.00%
Loan to Value Ratio: 20.00%
Amortization Term:     300

3rd position common equity:

Annual Yield:          60.00%
Equity to Value Ratio: 10.00%

The Debt Coverage Ratio (DCR) on the senior tranches is 1.8665. The blended Annual Debt Constant (ADC) is 7.6940%. The blended Loan to Value (LTV) ratio is 90.00%. The Capitalization Rate (CAP) is 12.9246%. The Gross Return on Equity (ROE) is 60.00%.

I ran the numbers three ways:

1. An equity member of a syndication on a stabilized income property.

Investing the 229,880 as a common equity member with an annual yield of 20% will earn about 45,976 per year or 3,831 per month.

2. A private lender for the common equity of a syndication project.

Investing the 229,880 as a junior loan with an annual interest rate of 15.8540% fully amortized over 120 periodic payments (10 years) will return a total of 459,760, including original principal.

3. A common equity investment on a stabilized income property.

Investing the 229,880 as a common equity investment of 178,796 plus other costs of 51,084 will earn 107,278 per year. This generates the highest return and requires the buyer to manage the income property, or to hire a professional management company. The investor must also find the property, negotiate the contract, conduct due diligence, and obtain financing for the senior tranches.

In the scenarios 1 and 2, the investor merely provides the financing and the syndicator handles all of the project management, including finding the property, negotiating the contract, due diligence, and obtaining the senior tranche financing.

Any of the above scenarios provides a much higher return on the investment than just paying off the residential mortgage loan. The return at 20.00% yield is enough to cover the residential mortgage loan with over 1,000 extra income. In scenarios 1 and 3, the investor also benefits from principal amortization (paid by the tenants).

Considering the current low LTV on the residential mortgage loan, I would also suggest refinancing the loan. As of this writing, 15-year fixed rate owner-occupied loans at under 3.50% annual interest, but get an interest-only loan and pay it at the 15-year amortization level. That would lower the monthly payment and when combined with the cash flow from the income property, the investor has increased the overall return on investment.

Check my information product, “Introduction to Income Valuation and Syndication” to learn more about leveraging your money or Other People’s Money (OPM) to buy income property.