Which Should You Pay Off First: Your Rental Property or Primary Residence?

Investing in rental property is an excellent way to earn passive income. It can provide a steady cash flow to pay for the property itself and make a little bit of monthly profit for savings and other wants. After renting out property for years, you might even have enough to pay off the mortgage of either your rental property or primary residence.

On paper, paying off your rental property looks like a good move. Instead of directing your rental income back into the mortgage, you’ll increase your monthly cash flow by a significant amount. However, if both your investment property and the home you live in are mortgaged, the real question you’ll have to decide is whether to pay off your rental property or primary residence first.

Choosing between either paying off a primary home or rental property will depend on which you value most. Paying off your rental can increase your cash flow and equity, but paying off your primary residence secures a roof on your head. Another key factor to consider is the respective interest rates. There are many complex factors to weigh up when making an individual decision in these circumstances.

If you have a clear destination in mind for the additional cash, it can be easier to weigh up whether paying off your investment property is worth it. Some people might even use the freed-up cash flow to invest in a new rental property, but it all boils down to the current market and your unique financial situation. There are times when it is better to pay off an investment property before paying off your primary residence and vice versa. Let’s explore which is better—paying off your home mortgage or rental property.

When Should You Pay off an Investment Property Before Your Primary Residence?

There are times when paying off your investment property first makes a lot of sense. By maximising your rental cash flow, paying off an investment property first can help you save money to pay off your primary residence when the time comes.

When the Investment Has a Negative Cash Flow

Another reason to pay off your investment property is when you have negative cash flow. In some cases, the size of your monthly mortgage payments will mean you lose money on the property—even if you effectively subsidise your tenant’s residency. However, paying off the rest of your debt can instantly turn it into an investment with positive cash flow.

When You’re Approaching Retirement

You can also pay off your investment property if you’re planning to retire from work. Retiring at the right age may get you access to your super, but unless you’ve been extremely diligent with your super, your retirement income probably won’t match up to your working income.

If you are thinking about retiring, paying off your rental property mortgage will increase your monthly cash flow, helping to bridge that gap and provide a higher standard of living. If you plan to retire early, pocketing the full amount of your rental income each week may be crucial.

If you’re retiring and have downsized your primary residence, the amount of interest you’re paying on your primary residence may also be much lower than on your investment property.

When the Return Is Lower Than the Interest Rate

With a steady incoming cash flow, people often don’t notice that the interest rates on their mortgage are higher than the average annual return. Paying off your debt will definitely decrease the money you are directing solely to interest. Suppose your rate on the investment property is significantly higher than the interest rate you are paying for your residential property. In that case, you should definitely consider paying the rental property off as a priority.

Remember that having no debt is a more secure financial position than having debt. When making an investment, there is no guarantee that the cash investment will grow in the future. When paying off debt, you are reliably decreasing your liabilities—you can always think about how to invest your gains after some of your debt is taken care of.

Of course, investment always involves some degree of risk, and that’s what leads to financial reward. The bottom line is that managing your debt portfolio effectively is just as important as deciding where to invest, and these are decisions that should always be made in tandem.

Similarly, holding onto cash rather than paying off debt offers a very limited benefit in return. Consider the prospect of keeping your money in a savings account to appreciate 2% annually, while continuing to pay a 5% or 6% interest rate on your mortgage.

Advantages of Paying off Investment Property

There are many advantages to paying off your investment property. The fact that you are turning a liability into a cash-generating asset is obviously a strong incentive to pay off your rental property’s mortgage. Here are some of the other advantages of paying off your investment property:

Equity

One of the advantages of paying off investment property, or paying off debt in general, is the added equity it will provide you with. Having equity allows you to sell your appreciating property, but if you are not ready to sell and enjoy the cash flow, having equity will also give you the opportunity to refinance your investment.

Suppose you refinance your rental property to pay off our primary residence. In that case, you’ll still benefit from an improved cash flow, because the interest rate will be significantly lower than the first time it was financed.

Increased Cash Flow

One of the most apparent reasons for paying off your investment property is increasing your cash flow. Without having to pay a monthly mortgage from the money you get from renting it out, you can definitely save more to pay off your residential property next or invest in another property—whichever works for you! Of course, you will still have to pay your monthly or annual taxes and insurance fees, but that is nothing compared to your mortgage and interest.

Funds to Hire a Property Manager

Having the extra cash flow can enable you to hire someone to take care of your property for you. You can always do it yourself, but it can be a lot of work, particularly if you have multiple investment properties. Particularly if you’re approaching retirement, the extra financial freedom can give you more time to relax and enjoy everything you’ve worked hard for.

Rental Flexibility

Renting out a property you haven’t paid off in full comes with some rules and regulations that you need to follow, and this can sometimes make finding a suitable tenant challenging. With your debt paid off, you can run your rental property in any way you like, without other parties having a stake in your decisions as a landlord. You can stick with a good tenant that treats the place like their own, giving you income security for years to come, even if it means charging them less per week. It is always better to have a good tenant that cares about the property than to switch from tenant to tenant, chasing higher returns due to the demands of other stakeholders.

Eviction Protection

You will never miss a mortgage payment if your tenant is unable to pay rent. In the current financial climate, there’s definitely a heightened chance your tenant may run into financial difficulties, and it’s not always as simple as finding a new tenant. With a global pandemic at play, a freeze on evictions for cash-strapped tenants is always a possibility.

If your rental property is still under finance, it can put you in a very tight spot if your tenant is late paying their weekly rent. In the best-case scenario, you’d have to pay the mortgage from your own funds just to save your credit score—and if you’re also under financial duress, the situation can quickly spiral out of control.

Once you’ve paid off the mortgage on your rental property, your liabilities are far more limited. This means that any disruption to your rental returns isn’t such a crisis, and paying down your debt can help better prepare you for any future financial storms.

Disadvantages of Paying off Investment Property

Of course, paying off your investment property also comes with a few disadvantages that you should consider before shelling out a big chunk of your cash. Here are some of the drawbacks of paying off your rental property debt:

You Will Lose Access to a Large Amount of Money

Here’s the bottom line: to pay off your debt, you will need a lot of money. Let’s say the remaining debt you have on your rental property is around $300,000. That is still a significant amount of money you could otherwise use as a down payment on a few new investments.

If your sole rental property is giving you a positive cash flow, then paying it off immediately might not be a high priority. You can use that extra money as capital to buy a second rental property or invest it in another business. While that business is growing, you will be getting closer and closer to paying off your first rental property without spending too much money all at once.

Of course, many people would still choose to pay it off ASAP if it means having less debt and monthly dues to pay—which is totally alright! You can still save up for your next venture quicker with the higher monthly cash flow you will enjoy once the debt is paid down.

Before paying off your rental property, you must be sure that you won’t need the money for something else. You should also think about how long it will be before you retire. Suppose you are still enjoying a generous positive cash flow even without paying the debt. In that case, you may prefer to use the money as your retirement fund, for emergencies, for enjoyment, or capital for investing in other businesses.

Lower Liquidity

You may prefer not to pay off your investment property mortgage in the short term, and instead focus on your personal account balance. Your unique financial equilibrium will feature different obligations (i.e. your mortgage) and multiple assets (i.e. your cash). If you reduce your liquidity by reducing your debt, you also lessen your ability to deal with unforeseen expenses or take advantage of opportunities for investment.

Higher Borrowing Costs

Borrowing against your property that has been repaid in the future—for example, taking out a new mortgage—could potentially be more costly. Interest rates may rise in the future, and if you do need to refinance your investment property, there’s no guarantee you’ll be able to get a lower interest rate.

Of course, this scenario can easily be reversed, and you may be able to remortgage at a much lower interest rate in 10 years time. That’s the risk you need to consider if you decide to pay off your investment property in the short term.

Limited Leverage and Velocity

You cannot generate money out of money that is trapped in property equity. When you opt to refinance and take equity out of your property, you can divert profits rapidly (ie. velocity), allowing you to acquire more property with more leverage. Leverage and velocity are crucial in creating wealth. And with higher leverage, you can enjoy a leveraged appreciation.

For example, if you’re shelling out $20,000 equity on a $100,000 property and the property appreciates to $200,000, your returns are going to be much higher. Compare that to paying off an $80,000 mortgage and having $100,000 equity in that same property.

As you can see, it’s really not a good idea to pay off a rental property mortgage to build wealth.

You Don’t Allow Inflation to Reduce Debt

In a nutshell, inflation erodes debt by decreasing debt’s value – there’s no guarantee that every dollar of present-day debt will be worth the same amount in five or ten years’ time. Thus, if there’s a good chance inflation will reduce how much your debt is really worth, that’s one potential reason not to jump the gun and pay off your mortgage right away. Under the right circumstances, the debt can be significantly ‘washed away’ by inflation – but of course, the opposite is always possible as well.

What are the Tax Implications of Paying Off a Rental Property in Australia?

The money you receive from renting out a property is taxable income according to the Australia Taxation Office. Therefore, you always need to declare the income you receive from renting out your investment property. However, you can still deduct your expenses, such as utilities and other maintenance costs—meaning the only taxable income is the net income after expenses.

But what are the tax implications if you pay off your rental property? Since you will be making more money without any mortgage payment, you will need to pay more taxes on your rental income. Typically, this is still a lower value than having to pay an ongoing monthly mortgage. However, you will want to consider your specific tax bracket and individual circumstances when weighing up the tax implications of paying off your mortgage.

If negative gearing is a key part of your investment strategy right now, paying off the mortgage is immediately going to flip the script. The ins and outs of negative gearing are a bit too complex to delve into here, but this should be a major consideration when it comes to managing your debt.

However, you shouldn’t be discouraged from paying off an investment property just to avoid paying more in tax, as long as it works with your overall investment strategy. Here are some deductions that could save you money on tax with an investment property:

  • Cleaning fees and council rates
  • Landlord insurance
  • Legal expenses and land tax
  • Property management fees
  • Land tax
  • Repairs and maintenance
  • Travel expenses for collection and inspections
  • Advertising fees for finding new tenants
  • Costs of inspection
  • Home contents

Just make sure you record all the expenses associated with your investment property, even after paying off, to make sure you include all the tax deductions that can maximise your return.

Is it Smart to Pay Off a Rental Property at All?

Should you pay off your primary home or rental property? It really depends on your circumstances.

It is wise to pay off any debt at all if you want equity. However, it is also wise to use the money to invest in a second investment property, especially if you’re going to generate more wealth in the long run.

However, it is a smart move to pay off your investment property if you are not too close to retiring or if the interest rate is high. Essentially, you want to pay off the debt that has the highest interest rate.

However, paying down your debt, especially if it is a tremendous amount of money, needs a lot of consideration. Make sure you weigh the pros and cons, thinking about your age, the money you will have left, and how much you have to gain from paying off your rental property’s mortgage.

Should I Refinance My Rental Property to Pay Off My Primary Residence?

Refinancing your rental property to pay off your primary residence at the right time could be a smart move. There are some benefits to refinancing your rental property, enabling you to pay off your primary residence or take advantage of other opportunities for generating wealth.

Refinancing your rental property can lower your interest rates—which is always good. It could also reduce your monthly payments and improve your loan terms to maximise your cash flow. However, when is the right time to refinance your rental property?

The best time to refinance your property is when it appreciates. At this point, the property’s value is now higher than when you initially bought the place, and the interest rates would be at their all-time low.

Why Should I Refinance My Rental Property?

  • To lower your monthly mortgage payments
  • To purchase new property
  • To upgrade your current investment via renovations and improvements
  • To pay off other loans such as your primary residence
  • To pay off your loan faster

With that being said, refinancing your property can lower your interest rates and help you pay off your loan faster—even without paying it off in full. You can now use the money you’ve saved to buy new investment properties or save it for retirement.

Should I Sell My Rental Property to Pay off My Primary Residence Mortgage?

Ultimately, this will depend on what stage of life you’re at and the relative costs involved in each option. Your choices before retirement, for instance, will differ from the best course of action early in your investment journey, with many years ahead to benefit from a steady investment property income.

The performance of the property market will also have an impact on your decision. It may be a good idea to sell your investment property to pay off your home’s mortgage, but that doesn’t mean it’s the best time to go ahead with it, either. On the other hand, if the value of your property is likely to fall in future, you might be better off reclaiming your investment. Whether it’s best to move onto another investment or pay off your home’s mortgage is another question that depends on your unique circumstances.

You’ll also have to consider that your rental property is a capital asset, meaning the sale would be subject to capital gains tax. This can have a significant impact on both the amount of tax you pay for the financial year and your tax bracket.

Should I Pay Off Investment Property Before I Retire?

In most cases, it might be a smart move to pay off your investment property before you retire. However, you will lose access to that large chunk of cash, which you might otherwise need for retirement.

There are some scenarios where it is not a very smart move to pay off the investment property in full right before you retire. You might be receiving your superannuation soon after you retire, but it will still not be enough to match what you were making while you were still at work. However, if you crunch the numbers, add up your new cash flow and your super, and see that there is not much difference to what you are usually making—paying off the property might be a good choice.

It is also a good idea to pay off your investment property if it does not seem to earn money. If you’re currently losing money on your property, it is a good idea to turn that liability into a cash-generating asset by paying it off in full before you retire.


Related Questions

How Much Profit Should You Make on a Rental Property?

A good ROI on rental property in Australia is 15% and above, considering factors like the property location, size, and your investment goal. However, 15% is a pretty high target to hit. A $400,000 property that you will rent out for $2,500 a month is only around 7% ROI annually. You can increase that by cutting some expenses, paying off the mortgage to increase profits or refinancing at a lower interest rate.

Can I Rent Out My House Without Telling My Mortgage Lender?

You will need to notify your mortgage lender if you plan on renting out your property. Rental income is also taxable income in Australia, and you will need to declare it.

Why Do Landlords Have Interest-Only Mortgages?

Interest-only mortgages allow you to pay for interest only each month, lowering your monthly payments, which equals more cash flow from a rental property. However, you will have to repay the amount of money you borrowed at the end of each term.

Landlords generally choose interest-only mortgages so they can increase their investment’s potential in the future. As such, they can enjoy a profit from the property’s increase in value after repaying the capital they owe. Interest-only mortgages also provide maximum flexibility and tax benefits.


Disclaimer:

This article is provided as general information only and does not consider your specific situation, objectives or needs. It does not represent financial advice upon which any person may act. Implementation and suitability requires a detailed analysis of your specific circumstances.

Matthew Rutter, Director/Head Financial Advisor of WVPC

Matthew has a wide ranging background in business, finance, taxation and accounting with over 25
years’ experience, firstly as an Accountant before becoming a Financial Planner. Matthew has been in
the Financial Planning Industry since March 1998 and has been the principal of his own financial
planning practice since 2003.

Matthew has studied a Bachelor of Commerce degree from Newcastle University majoring in Financial
Accounting and the Diploma of Financial Planning from Deakin University. Matthew is a Registered Tax
Agent and is a member of the National Tax & Accountants Association (NTAA).

Matthew has particular expertise in the areas of retirement planning, superannuation, investments and
insurance. His emphasis is on building a professional, integral and lasting relationship with clients with
the objective of assisting them to achieve their financial and lifestyle goals.

 

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