Given the roller coaster ride that stock market investors have experienced and the negligible rates offered by banks on savings, it’s easy to see why someone might want to use their cash to pay off their mortgage.
Being debt free is not only noble but can provide a buffer in tough times since you’ll have one less cash outflow each month.
For every dollar you pay off in a mortgage, your rate of return is equal to the amount of interest that you’re saving. This is measured by the interest rate (net of the amount that is deductible of course).
So in this example, you could be “earning” 6.125% (less the deductibility of the mortgage interest based on your tax bracket).
Compared to other savings alternatives, that’s a great return. And compared to other equity investments it can seem a lot less volatile.
But before you drain the cash reserve, let’s look at this more closely.
- Tying up a lump sum of cash in a property can be risky. You may come up short on emergency reserves by using the bulk of it to pay off the loan. Will you have enough cash to cover 12 months of your living expenses? Will you have enough to cover operating expenses for the properties if they were vacant or you lose your job?
- Considering that in this case you have three other investment properties and your primary residence, there is always the likelihood that you might need cash for an emergency repair or the cost of compliance with any changes in building codes or prepping a vacant unit for a new tenant or even to cover the carrying costs while a unit is vacant.
- Real estate is an illiquid investment. Once you send in the check to the bank you no longer have the cash readily available for use either to pay for ongoing expenses, cover emergencies or for other investment alternatives that may come along.
- What if a really good deal on another investment property came along? Depending on your market, you could find a very inexpensive property to buy that could more easily cash flow now but without the cash you’re out of luck. Sure, you’ll have more equity but to tap into it will require a bank to agree to give it to you which is more difficult on investment properties and your primary residence may not have enough equity to allow you to get a home equity line of credit (HELOC) or home equity loan to recoup the cash you may need.
- Property prices are still in flux.While savings bank rates are abysmal, losing money is even less appealing. By investing more in your property, you could actually see a negative return. In some markets, real estate prices are still going down so it is conceivable that you could turn each $1 paid in principal into 90 cents.
What Are the Alternatives?
Consider a non-bank financial firm that is offering one of those ultra-high yield money markets for a good portion of this reserve fund. It’s accessible and won’t cost you anything to hold and they tend to offer higher rates than most brick-and-mortar banks.
You could also split off a portion of the funds and find a ultra-short term bond mutual fund. Average yields are about 2%.
For a small portion (starting at around $2,500) you could even use a convertible bond fund. These are hybrid investments combining the fixed income of a bond with the potential capital appreciation of a stock. These types of investments have held up well when interest rates rise because of Fed action or inflation.
For more information on these, you could check out my article posted on www.ezinearticles.com here.
Likewise, you could also consider other types of short-term bond investments like mutual funds that target floating rate notes. These types of commercial loans are regularly reset and are a good way to hedge against inflation. Since there is credit risk, you don’t want to put a whole lot of eggs in this one basket but 5% to 10% of your funds is prudent for you to consider.
As in all things, read the prospectus and speak with your adviser to determine if these are right for you in your situation.