Should You Pay Cash Or Get A Loan On Rental Properties?
Paying Cash For Rental Properties May Seem Like A Safe Bet, But It May Actually Be Costing You A Lot Of Money. Many People Feel Paying Cash Is The Best Option Because You Don’t Have To Pay Any Interest, But many have made More Money When Using Loans. It allows you to Buy More Rentals, Which Means you Have More Tax Advantages, More Equity, More Cash Flow, And More Appreciation. So Should You Pay Cash Or Get A Loan On Rental Properties?
The Key To A Great Strategy And Obtaining Great Returns Is Being Able To Leverage your Money. Leveraging Is Using Other People’s Money For Investments So You Use Less Of Your Own Money. By Using Other People’s Money, You Can Buy More Properties And Increase Your Returns On The Total Cash Invested. If You Pay Cash Your Returns Decrease Dramatically, And All The Benefits Of Owning Rental Properties Decrease As Well.
How can debt be a good thing?
Many people assume all debt is bad but debt can be an amazing tool if used correctly. Some of the largest companies in the world have used debt to grow faster and bigger as have some of the richest people in the world. If you have an investment or business that makes more money than the interest rate costs you on the debt, it might make sense to get a loan to multiply your returns.
If you have too much cash and nothing to invest in, debt will not do you any good. If you want to make a lot of money very quickly, debt can help you. With real estate, you can control an asset that is worth hundreds of thousands of dollars (or more) with 20 percent down or less as an owner occupant. If you have a house worth $100,000 and it increases in value 10 percent it is now worth $110,000. You made a 10 percent return paying cash or a 100 percent return if you put 10 percent down and only has $10,000 invested into the property.
Now, real estate is not that simple and there are many more costs than just the down payment, but I wanted to start with a straight forward example to show how debt can make you money.
Is it riskier to pay cash or get a loan and go into debt?
Many people shy away from debt because it is risky. I tend to think that using all cash to buy rentals can be risky as well. The problem with real estate is that it is not very liquid. If you need to take money out of a property you can get a loan against it (refinance or line of credit) or you can sell it. It can take 30 days to get a loan if all your finances are in order. If you have a high debt to income ratio, don’t have an income, or have bad credit you may not be able to get a loan at all even if you have a property completely paid for.
If you need to sell a property it can take 30 days under the best of circumstances when you price it very well. If you want top dollar it may take months to sell. If you sink all of your money into a property so that you can pay cash it is very hard to get that cash out. If you have an emergency or lose your job, you will be in trouble will all your money tied up in real estate.
I would rather use a loan to buy a property so that I have cash in reserves and readily available than spend all my money to buy with cash. I also believe that is is better to have more cash flow with multiple rentals than less cash flow with one paid off property.
Do you make more money from cash flow with loans?
I am going to use some basic figures to outline the benefits of leveraging your money. If you buy a $100,000 house with cash that makes $500 a month in cash flow, you are making about a 6 percent return from the cash flow alone. Cash flow is the profit you make after paying all expenses on a rental property.
If you buy a $100,000 house and put 20 percent down, you will have a mortgage payment, but the return on your money increases. If you are paying a 4 percent interest rate, your principal and interest payment will be about $382. You are only making $118 a month cash flow after subtracting the mortgage payment, but you are making a 7 percent return on your money due to the lower cash investment.
Even though the cash on cash return is 7 percent, you are actually making much more than a 7 percent total return in the above scenario. You are also paying down the principal on the loan by an average of $118 each month. That $118 equals another 7 percent return on your money that you would not have on a cash purchase! You have more than doubled your return by getting a mortgage instead of paying cash.
The exciting part about using leverage is when you get a higher cash flow, the returns increase even more. If you can make $800 a month cash flow without a mortgage, you will be making 9.6 percent cash on cash return. With 20 percent down on the same property, you would cash flow $418 a month after the mortgage payments and make over 25 percent cash on cash return just from cash flow! The way to make big money in rental properties is finding properties that will give you big cash flows and buying as many as possible while leveraging your money.
How does debt allow you to buy more rentals?
The best part about leveraging your money is it allows you to buy more properties. You can buy three or four homes with $100,000 instead of just one home paid for with all cash. Using the cash flow figures from above and buying three properties instead of one, you are now making $1,254 a month cash flow instead of just $800 a month. Not only does your cash flow increase by purchasing more properties, but the equity pay down increases, the tax benefits increase and the appreciation increases. If you can purchase homes below market, then every time you buy a home, your net worth increases as well!
Tax benefits
Rental properties have many tax benefits including depreciation. The IRS allows you to depreciate a percentage of your rental properties every year and write that off as an expense. You can depreciate a rental over 27.5 years, which means you can deduct 1/27.5 of the value of the structure every year from taxes. You can also deduct the interest paid on the loan and most expenses. If you have three houses instead of just one, you can get triple the tax deductions
Appreciation
If you have three properties instead of one and the market appreciates, you also have the benefit of triple the appreciation. It is the same situation if rents go up, the more properties you have, the more money you will make. Never count on rents to go up or appreciate, but plan for a nice bonus. In Arizona for instance where we have seen crazy appreciation. Some markets may not see any appreciation at all.
Equity pay down
With multiple rental properties, you are also paying down the loans on three properties, which increase your returns as well. Most of the payment will go to paying interest at the beginning of the loan, but as time passes a larger portion will go to the principal of the loan
Buying below market
One of the biggest advantages of real estate is being able to buy below market value. You can buy a house for $100,000 that is worth $120,000 or even $150,000 today. There are many ways to get great deals but it is not easy. If you buy one house with cash you would gain $30,000 in equity if you bought it $30,000 below market (this assumes it needs no repairs). If you buy 3 houses with a loan, you would gain $90,000 in equity!
When you think of the tax savings, possible appreciation, buying below market, and equity pay down the returns shoot through the roof. With leverage, you can buy three properties for every one property with cash. You are making more money per month, plus paying off loans, plus saving money on taxes and creating a ton of equity.
How can you be safe using a loan?
When you use leverage, do not blindly get a loan for as much money as you can. Make sure you have enough cash flow as already discussed. You also need to make sure you have reserves in place. Reserves are extra cash you have available in case a problem comes up. If you have an eviction, someone stops paying rent, or repairs to make you need cash available to cover those expenses. Most banks will want 6 months of reserves for every mortgage payment you have including a new purchase. If you have one or two mortgages I would suggest having even more cash ($10,000 would be ideal).
How can debt be bad?
There is a downside to more properties. You will have to pay more for repairs and improvements since each property will need repairs, not just one. You will also have three rental properties to manage instead of one. However, if you are able to cash flow $400 or more with a mortgage, you will still be way ahead of the game by leveraging your money. You will also have more total cash flow coming in, which can pay for a property manager. We accounted for the repairs and maintenance when we figured the cash flow, so it won’t be an added expense with more properties, but it will be more work if you manage the properties yourself.
Some people think it is less risky to buy with cash than with a loan, but I would also disagree. Here are some reasons why cash may be riskier than getting a loan.
Diversification
When you buy with cash you have fewer properties. The fewer properties you have, the fewer sources of income you will have, and the more a loss of an income will hurt. If you have 1 property paid for with cash, it really hurts when it goes vacant. But if you have three rentals that have loans on them, one may go vacant, but you have two more that are bringing in money. When you have multiple rentals, you also have more diversification. If you happen to have one rental, you are more susceptible to neighborhood changes, storm damage etc. With multiple rentals, you have less of a chance of all your properties being damaged or hurt by other factors.
Market Crash
You actually lose less money when prices go down with multiples properties. I know that may not make sense at first, but consider this. If you buy three houses below market value for $100,000 (they are worth $125,000 when you bought them) and the market goes down 20 percent. Your houses would be worth $100,000 so you are not losing any money if the market goes down since you bought below market value. If you bought one house with cash below market value you would be in the same position, no loss or gain.
If you are able to get better deals and bought the houses for $90,000 that were worth $125,000 you would be in good shape if the market goes down 20 percent. You would have three houses worth $100,000 that you bought for $90,000. You would have $30,000 in equity from buying below market value. If you only bought one house for $90,000 with cash and the market went down 20 percent, you would only have $10,000 in equity from buying below market value.
If the market went down even more or you bought with properties with less equity you would lose more money using loans. It can be riskier to use loans if the market crashes, but not always. The main thing to remember is that you don’t have to sell in a market downturn. If you have plenty of cash reserves in the bank, and the houses are rented, there is no reason to sell them. Ride out the bad market.
Over-leveraging
The riskiest move using loans is when you over-leverage. That means loan values are very high compared to the rents or the value of the property. When I buy a property with 20 percent down and below market value I have a lot of equity. On the example above the loan would be $80,000 and the value $125,000 when I buy a house for $100,000 that is worth $125,000.
If you have a loan of $100,000 on a house that is worth $110,000 you may be asking for trouble. You are asking for more trouble if you are only making $50 a month in cash flor or losing money every month. Almost all the horror stories from the last housing market crash came from investors who were breaking even or losing money on their rentals every month. Most of the investors who were making money every month made it through okay.
Conclusion
If you are wondering if it is smart to pay cash for a rental, consider the returns you may be giving up. In my opinion, it is better to use other people’s money and increase your returns versus paying cash. Some people are very averse to any risk and do not want any debt at all. If the idea of debt makes you sick to your stomach, maybe paying cash versus getting a loan is the best route for you.
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