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I just purchased a new home (owe about 310,000) at a rate of 5%. I kept my previous house as a rental (owe about 104,000) which has a rate of 4.35%.

I have a bit more cash I can put down on a mortgage monthly (and no other debt at this point).

My first thought is that I should put that on the new house. Does that make the most sense? Is there any advantage to paying off the mortgage on the rental?

Alternatively I could just not put that money on either house and look for other investments.

Any thoughts? Or advice?

F

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  • Can you add the country tag where you are located. The tax treatment on second house varies from country to country and would be required to make good advice – Dheer May 20 '11 at 6:17
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You're in the same situation I'm in (bought new house, didn't sell old house, now renting out old house).

Assuming that everything is stable, right now I'd do something besides pay down your new mortgage.

If you pay down the mortgage at your old house, that mortgage payment will go away faster than if you paid down the one on the new house. Then, things start to get fun. You then have a lot more free cash flow available to do whatever you like.

I'd tend to do that before searching for other investments. Then, once you have the free cash flow, you can look for other investments (probably a wise risk) or retire the mortgage on your residence earlier.

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  • 1
    +1 Also, in the US mortgage interest on a primary residence is tax-free, while interest on an investment property is not. – Gabe Moothart May 20 '11 at 20:24
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    Gabe - what? All rental expenses are tax favored. The mortgage interest is part of one's Schedule E expenses, and offsets any gains (the rent) effectively being a deduction. If one can't take a loss on their own taxes, that loss carries forward to the next year until taken or the property is sold. – JTP - Apologise to Monica♦ May 20 '11 at 22:10
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I'll assume you live in the US for the start of my answer - Do you maximize your retirement savings at work, at least getting your employer's match in full, if they do this. Do you have any other debt that's at a higher rate? Is your emergency account funded to your satisfaction? If you lost your job and tenant on the same day, how long before you were in trouble?

The "pay early" question seems to hit an emotional nerve with most people. While I start with the above and then segue to "would you be happy with a long term 5% return?" there's one major point not to miss - money paid to either mortgage isn't liquid. The idea of owing out no money at all is great, but paying anything less than "paid in full" leaves you still owing that monthly payment. You can send $400K against your $500K mortgage, and still owe $3K per month until paid. And if you lose your job, you may not so easily refinance the remaining $100K to a lower payment so easily.

If your goal is to continue with real estate, you don't prepay, you save cash for the next deal. Don't know if that was your intent at some point.

Disclosure - my situation - Maxing out retirement accounts was my priority, then saving for college. Over the years, I had multiple refinances, each of which was a no-cost deal. The first refi saved with a lower rate. The second, was in early 2000s when back interest was so low I took a chunk of cash, paid principal down and went to a 20yr from the original 30. The kid starts college, and we target retirement in 6 years. I am paying the mortgage (now 2 years into a 10yr) to be done the month before the kid flies out. If I were younger, I'd be at the start of a new 30 yr at the recent 4.5% bottom. I think that a cost of near 3% after tax, and inflation soon to near/exceed 3% makes borrowing free, and I can invest conservatively in stocks that will have a dividend yield above this. Jane and I discussed the plan, and agree to retire mortgage free.

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A lot depends on whether your mortgage payments are interest only or 'repayment' and what the remaining term is on each of the mortgages. Either way I suspect that the best value for the money you put in will be had by making payments to the larger, newer mortgage. This is because the quicker you reduce the capital owed the less interest you will pay over the whole term of the mortgage and you've already had the older mortgage for sometime (unless you remortgaged) so the benefit you can get from an arbitrary reduction in the capital is inevitably less than you will get from the same reduction in the capital of the newer mortgage. Even if the two mortgages are the same age then the benefit of putting money into the one on the new house is greater due to the greater interest charged on it.

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Pay down the lower balance on the rental property. Generally speaking, you are more likely to need/want to sell the rental house as business conditions change or if you need the money for some other purpose.

If you pay down your primary residence first, you are building equity, but that equity isn't as liquid as equity in the rental. Also, in the US, you cannot deduct the interest on a rental property, so the net interest after taxes that you're paying on the rental narrows the gap between the 4.35% loan and the 5% loan.

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  • you can deduct interest on a rental property as it's a business expense. In fact primary residence interest wasn't deductable till 80-ies i believe and they are talking about taking that away. But for rentals i doubt they can do it. – Vitalik May 21 '11 at 15:25
  • Vitalik is correct: "Income-producing rental or royalty interest. Deduct interest on a loan for income-producing rental or royalty property that is not used in your business in Part I of Schedule E (Form 1040)." – Peter K. May 21 '11 at 16:11
  • @Vitalik Sure, provided that you're producing income in excess of the loan payment. – duffbeer703 May 22 '11 at 4:07
  • I disagree with the logic in general. I have rental properties and i'd rather sell my own home if i need the money. Because investment properties are income generating (if they are good investment) but your own house is not. – Vitalik May 22 '11 at 14:49
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One advantage of paying down your primary residence is that you can refinance it later for 10-15 years when the balance is low. Refinancing a rental is much harder and interest rates are often higher for investors. This also assumes that you can refinance for a lower rate in the nearest future.

The question is really which would you rather sell if you suddenly need the money? I have rental properties and i'd rather move myself, than sell the investments (because they are income generating unlike my own home). So in your case i'd pay off primary residence especially since the interest is already higher on it (would be a harder decision if it was lower)

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