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Should We Pay Off The Mortgage On Our Rental Property?

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Contributor:
Mary Holm
Mary Holm

Question:

We have kept an interest-only mortgage on our rental property on advice we received two years ago that it was better to keep the mortgage on a rental property to gain the tax breaks.

We have a sum coming off term deposit in January with which we could pay off the mortgage on the property.

Can you advise if, in the current situation of declining property values, it would be better to pay off the mortgage or to reinvest the money.

Answer:

Mary Holm: Paying off a mortgage on a rental isn't quite as good as paying off a mortgage on a home. More on that below. Nevertheless, not only would you probably be better off repaying your rental mortgage now, but you probably should have done it a while back.

Perhaps your adviser two years ago meant that it's good to fully pay down your home mortgage, on which the interest is not deductible, before repaying the rental mortgage, on which the interest IS deductible.

But once you've got rid of the home mortgage, there's usually little point in keeping the rental mortgage while also holding considerable term deposits - regardless of what house prices are doing.

The only time that would make sense is when term deposit interest is higher than your mortgage interest rate. That could happen occasionally, if you have a long-term fixed mortgage rate and market rates rise after that. But it's unlikely to be the case for long.

Generally, mortgage rates are higher than term deposit rates. How else would banks cover their costs and make a profit?

If your mortgage rate on your rental is 8 per cent, after tax it will cost you 4.88 per cent (in the top 39 per cent tax bracket) or 5.36 per cent (in the 33 per cent bracket). Meanwhile, if you are earning 6 per cent on a term deposit, after tax that comes to 3.66 or 4.02 per cent.

Avoiding paying an expense has exactly the same effect on your wealth as earning a return.

If you use the term deposit money to repay the mortgage instead, you avoid paying the mortgage interest - getting the equivalent of 4.88 or 5.36 per cent instead of 3.66 or 4.02 per cent. You'll retire richer.

What about other tax breaks on property? Tax deductions such as rates, insurance, maintenance and depreciation are not affected by whether you have a mortgage.

Why else might you stick with a mortgage and also hold term deposits?

If the mortgage is fixed and there's a penalty for repaying it early, it might pay to wait until the term ends to avoid the penalty.

If you set up your term deposits so that some mature every month or so, that might give you more accessibility to your funds in an emergency than if you have paid off the mortgage.

But there are counter-arguments:

Many lenders will let you keep a zero-balance mortgage, so you can borrow again later. Often, you could get money faster this way than waiting for a term deposit to mature.

Some people would be more tempted to spend money in term deposits than to re-borrow mortgage money.

While there's usually no real difference, in terms of security, between having a $100,000 mortgage plus $100,000 in term deposits and having neither, in tough times many people prefer to keep debt to a minimum.

In the vast majority of cases, repaying a mortgage wins hands down.

What about a mortgage on your home?

The above five points apply equally to a home mortgage. What's more, because interest on home mortgages is not tax-deductible, when comparing the return on term deposits with the equivalent "return" from repaying a home mortgage, you should look at the basic mortgage rate.

In our example above, you would be comparing earning 3.66 or 4.02 per cent on a term deposit with 8 per cent on repaying your mortgage. No contest.

 

Mary Holm is the author of bestselling books on KiwiSaver and personal finance. She is also a highly praised seminar presenter. Her written advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following that advice.       

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