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See four strategies for determining how to pay down mortgage debt

How To Decide What Order To Pay Off Mortgage Debt

– Posted in: Real Estate

With 12 properties in our portfolio and a tendency to be risk-averse, I think a lot about how quickly and in what order we should pay off mortgage debt.

We own three of our rentals free and clear – i.e., zero debt – but that leaves nine mortgages, including our primary residence. Our loans have different balances, different interest rates and different maturities.

I rank ordered our mortgage debt based on four pay-off strategies and then took an average ranking to see which ones we should focus on paying off first.

See below for the analysis we used to rank how we should pay off mortgage debt, but first…

Why pay off mortgage debt early

why should you pay off mortgage debt earlyWhen you obtain a mortgage loan to purchase a property, you agree to pay a certain amount each month for the full duration of the loan. There are many different types of mortgage loans, but generally you will pay a monthly amount back to the issuer of the loan, a portion of which is for interest and the other portion is for reducing the principal balance.

Typically mortgages do not penalize you for paying off the loan early, and you are also allowed to make a payment that is greater than the typical monthly payment. Any access payment in a given month is applied to the remaining principal balance. Therefore, if you make extra payments or pay more than the minimum, you’ll lower the balance of your loan, reduce the interest owed, and the loan will be paid off faster.

To see the how this works, you can check out an online mortgage payoff calculator and plug in your own numbers. An example I used is for a 30 year loan of $100,000 at 5% interest. By making an extra $200 payment each month, the term of the loan is reduced from 30 years to 16 years and 9 months (almost in half!), and the total interest paid will be $47,708.25 compared to $93,255.78 (reduced also by almost half!) if only regular payments are made.

With that background out of the way, here are the four strategies we looked at to determine what order to pay them down.

Pay off mortgage debt with the highest interest rate

This strategy appeals to my value conscious side because it pays off the most expensive debt first. If I use this strategy we would definitely need to pay off House FOR because it has an expensive private loan attached.

Property Amount Interest Rate
FOR  $225,000 7.00%
PAL  $40,000 5.75%
FOU  $100,000 5.50%
FLA  $55,000 4.75%
OLD  $101,000 4.63%
LAM  $110,000 4.63%
PLA  $55,000 4.25%
ALS  $55,000 4.25%
NET  $114,375 3.00%

 

One downside of prioritizing House FOR is that the balance is so big, it will take time to see that balance go down. On the flip side, since the balance is so high, that interest in dollars is significant – almost $16,000 per year, or over $1,300 per month!

Pay off mortgage debt using the snowball method

The snowball effect is one method of paying down mortgage debtThe snowball method is advocated by Dave Ramsey, and it focuses on getting rid of the smallest debt first and then applying that monthly payment to the next smallest debt till it’s paid off and then applying that monthly payment to the next debt, and sure enough you have a snowball effect where smaller debt payoffs lead to bigger and bigger debt payoffs.

If we used that strategy, we would pay off House PAL first and then apply its monthly payment to House PLA and then House ALS, etc.

Property Amount
PAL  $40,000
PLA  $55,000
ALS  $55,000
FLA  $55,000
FOU  $100,000
OLD  $101,000
LAM  $110,000
NET  $114,375
FOR  $225,000

 

The issue I have with this strategy is that the earlier loans are so much smaller than expensive House FOR and their interest rates are much lower, so while it might feel good to see the balances dwindling, I know that I’m throwing money away by not knocking down the House FOR mortgage.

I would only pay off those smaller loans if I could quickly pay them in full and then re-title those properties into an LLC. We like the LLC for extra asset protection and privacy, but at this point, my disdain for the expensive debt of House FOR is more of a priority than re-titling the other Houses.

Pay off mortgage debt based on the interest dollars paid out (rather than simply interest rate)

A hybrid strategy of the above two approaches is to pay off mortgage debt based on the interest dollars paid out, rather than just the interest rate. This takes into account both the interest rate and the size of the balance.

House FOR still takes the top priority here because it has the highest interest rate AND the highest balance. But House FOU takes over second priority now because while its interest rate isn’t the second highest (House PAL takes that booby prize), its balance is so big the dollars out of our pocket are more significant.

Property Amount Interest Rate Annual Interest
FOR  $225,000 7.00%  $15,750
FOU  $100,000 5.50%  $5,500
LAM  $110,000 4.63%  $5,088
OLD  $101,000 4.63%  $4,671
NET  $114,375 3.00%  $3,431
FLA  $55,000 4.75%  $2,613
ALS  $55,000 4.25%  $2,338
PLA  $55,000 4.25%  $2,338
PAL  $40,000 5.75%  $2,300

 

Unlike the snowball method, I feel better about this approach even if a higher interest rate gets de-prioritized, because it still saves us more dollars now. House PAL’s interest rate looks less scary when I see it in absolute dollars.

Pay off mortgage debt based on the % of principal remaining on the loan

When you make a mortgage payment, a portion goes to interest and a portion goes to principal. In the beginning, almost all of the payment goes to interest, but over time, more and more of the monthly payment goes to principal.

If the majority of a loan payment is going to principal, don’t pay it back early! You already paid the bulk of the interest so prepaying that kind of debt doesn’t save you that much.

When I looked at the % of each payment going to principal, it became even more clear that the mortgage on House FOR has got to go. House FOR is a private loan and interest-only, so if we only make the minimum payment we will never pay down the loan. House FOU again comes in second here too. House PAL, which has the second highest interest rate, is actually the last priority here because most of the monthly payment is already going to principal.

Property % Principal
FOR 0.00%
FOU 16.67%
FLA 27.43%
OLD 29.22%
LAM 29.34%
ALS 35.07%
PLA 35.07%
NET 59.15%
PAL 60.00%

 


 

The rankings change slightly as you look at each strategy, but House FOR came out on top 3 of 4 times, so it clearly needs to be prioritized when we pay off debt. In fact, the balance is so high and the rate so high that I may take on consulting work specifically to make extra payments against that particular mortgage.

Do you agree that we should pay off mortgage debt on House FOR first? How do you prioritize your debts?

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