What mortgage term should I have for my rental house? Seek out a mortgage length that you can afford the monthly payment when the house is vacant, but not so long that it takes a half of a lifetime to pay off. If you can’t do that, than you are buying too expensive of a house. Start smaller. Read on for the benefits of shorter terms.
My approach was to have other people pay off the mortgage as quickly as possible. To do this I had as short of mortgages as possible. But I was only making $25,000 a year with my day job.
So what is as short of a mortgage term as possible?
To know this you need to know your expenses, income, and factor in a buffer for when things do not go as expected. Rent and expenses are unpredictable, right? Well no. On a short time line, such as month to month the expenses and income are unpredictable. But landlording is not a short time line.
I stepped back and looked at my income and expenses from an annual view. Annually your income and expenses should be much smoother and easier to predict than monthly. As you have more years under your belt this gets even more precise.
Divide your annual income and expenses by 12 and you have your monthly net income.
If you own one rental house, have your mortgage be short enough to where you barely have any net income for that house. But be sure you can cover the mortgage when the house is vacant. This is why it’s important to save the small amount of net income you receive when the house is rented. Expect vacancies. Read my post on my McDonald’s Principal to knowing how much you can afford to pay for real estate.
Debate over lower mortgage vs paying extra
Now is a good time to address a debate. Many experts and fake gurus will argue that it makes more sense to have longer mortgages so you have lower monthly payments. By having lower monthly payments you can just pay extra towards principal when you want.
I dismiss this argument. It makes the assumption that we are all logical robots. We aren’t. We are people. People are rarely disciplined enough to see extra money in their account and use it to pay down principal every time there is extra money in their account.
Instead, I wanted to force myself to figure things out in hard times. I was committed to having other people pay off my rental house mortgages as quickly as possible. So I made it hurt. But I left a buffer.
Interest savings from shorter term mortgages
This is real math (see for yourself). Assuming you are comparing a $100,000 mortgage with zero down and a 3% interest rate
|Term||Monthly Payment||Interest Paid over life of mortgage||Savings vs 30 year mortgage|
It will be very tough to turn a profit on a $100,000 mortgage if the monthly payment (not including taxes, insurance, expenses) is $965. But it’d doable at $554 or even $690.
If your net income is $150, then I would take out a mortgage that would get that down to say $75. Then if the house is vacant 10% of the time (assuming your mortgage is $800ish) then you can save $75 for 11 months each year. When the house is vacant, you’ll have one month to cover the mortgage because you would have saved $75 x 11 = $825
If you are more conservative then save a little more, if you are more aggressive then save a little less. But plan for vacancies.
Diversify your income streams
As you add more houses re-evaluate the model. By the time I had 7 houses I structured my mortgages to where my break even was 2.5 vacancies. This means that when I had 2 vacancies, then the net income from the other 5 houses would cover the 2 vacancies mortgage expense. 3 vacancies meant I had to hustle and figure out what to do case by case. 3 vacancies was hard. I also knew that it would be very rare for me to have 3 vacancies at once. Landlords have a rule of thumb that we expect a 10% vacancy rate. I owned 7 houses, so 3 vacancies is a 42% vacancy rate. Dire and rare but I planned for it by saving extra in the months I had one or no vacancies.
Consider the length of your Mortgage Term to be the worst case scenario
If your goal is to retire early using my approach, then the length of your mortgage is the worst case scenario. You want to attack those mortgages. I treated my houses separate from my salary. Until all of the houses were paid off I was careful not to take any profit all from my rental houses. Instead I would continually use profit to pay down debt. I paid down debt as aggressively as I could. But, I didn’t use my salary from my day job to pay down debt related to the rental houses. Instead I maxed out my 401k, and anything left over I used to pay down the mortgage on the house I was living in.
Refinance and shorten the lengths of your mortgages
As I became more experienced, I continued to refinance my mortgages to shorter and shorter lengths. I could have just paid more towards principal, but that’s hard to commit to. So I started off with 20 year mortgages, then I would drop them to 15 year mortgages or 10 year mortgages. As houses would pay off, and leave me with higher net income I refinanced remaining mortgages down to 7 year terms. I even dropped one to a 3 year term. Note I am not referring to adjustable rate or adjustable. I mean fixed and amortized over 3 years. Get those mortgages paid off!
Bottom line when deciding your Mortgage Term
If your goal is to retire early, take out as short of mortgages as possible. Your goal is to have these houses paid off. You took out a lot of debt, now rush to get rid of it. But don’t have it be so short that you can’t afford to pay the mortgage when the home is vacant.