I’m a huge believer in using real estate investments to build wealth and produce passive income. In fact, I believe investing in rental properties is one of the best ways to build wealth and produce passive income there is! Real estate investing is something anyone can do, but if you're not careful about how you finance your property, you can lose your shirt in a hurry.
In today’s article, I’ll tell you a little about my recent history with real estate investing. I’ll also run the numbers to show the differences between paying cash for your real estate vs. taking out a mortgage.
I’ll show you the risks involved and whether the rewards are worth it. You’ll see if there is a clear advantage to either strategy and discover which strategy is best for you.
Investment Advice is All Over the Place
There is a ton of advice out there about how to invest in real estate. Some of it’s good, some of it is misleading or downright wrong. A lot of that advice revolves around how to fund your real estate investments. Some say you should pay cash, some believe it's better to leverage yourself to the hilt for maximum returns.
I don't claim to know it all when it comes to investing in real estate, but I do have some valuable experience that I think you'll find helpful.
My Experience with Real Estate Investing
When I first got interested in real estate investing it was quite intimidating. Real estate investments involve a lot of money, and I wanted to make sure that I knew as much as possible before I took the plunge.
I read a ton of books and articles on the subject to see if it was something I really wanted to do. I also wanted to make sure I had all the information I could get so I didn’t make any mistakes that would cost me money.
My House Flip
In early 2012 I paid cash for a small house that needed a light rehab. My goal was to flip it for a profit. The rehab took about three months, then it took about six months for the house to sell. I made a nice profit on the sale, but in the end I decided house flipping involved more time and stress than I wanted to deal with.
I wrote a blog post series detailing every aspect of my house flip, which you can find here.
My Rental House Investment
After I flipped the first house for a profit, I decided I wanted to buy a rental house. I figured that investing in a rental would be much less stressful than flipping, especially if I hired a property manager to handle the details.
A few months after I sold the flip, I bought a nice little house that needed no repairs and had a long-term tenant already in place. As of this writing I’ve had an incredibly positive experience with my rental house investment and hope to buy more in the future!
You can read my blog series about my rental house investment here.
Want to Invest in Real Estate Without Debt or Becoming a Landlord? Check out RealtyShares.
I Like to Pay Cash for My Real Estate Investments
When I started investing in real estate, I made a conscious decision that I wanted to pay cash for my properties. I believe it greatly lowers the risk and maximizes the income from the property.
However, I didn’t have that kind of cash readily available.
But I did have a retirement account with enough money to purchase a house. So I converted my IRA account to a Self-Directed IRA, which can be used to purchase real estate and other alternate investments that you normally can’t buy using a retirement account.
Conflicting Advice About Real Estate Investing
There is a lot of conflicting advice out there when it comes to investing in rental properties. Real estate investors are mostly divided into two camps:
- Those that like to pay cash for properties.
- Those that like to use leverage (borrowed money) to purchase real estate.
Below, I’ll cover the advantages and disadvantages for why each camp operates the way they do. Then I’ll run the numbers for each one to see what they reveal.
Why Pay Cash for Real Estate?
Those of us that like to pay cash vs. financing our real estate investments do it for several different reasons:
- You don’t have to go to the trouble going to the bank for a mortgage.
- When you pay cash, you don’t pay interest to the bank.
- All the cash flow from the investment property goes to you instead of the bank.
- There is almost no chance that you will lose your entire investment.
- When you have cash, you can act more quickly when you find a good investment property.
- No risk of foreclosure.
- Vacancies don’t put you in a financial bind.
- The rent is almost all profit.
Risks of Paying Cash for an Investment Property
There are a few risks and disadvantages involved with paying cash for real estate, though overall the risks are minimal. Here are some of the risks involved:
- No tax deduction for mortgage interest.
- Less diversification- You can’t buy as many properties with the same amount of money.
Why Use a Mortgage for Real Estate Investments ?
For those that like to leverage their real estate investments, there are plenty of reasons why they believe using other people’s money is best:
- You can multiply your investment more quickly.
- Using leverage lets you buy more properties for the same amount of money.
- You can deduct mortgage interest from your taxes.
- Potential to make a higher rate of return on the money invested.
Manage all your investments (including Real Estate!) in one place with Personal Capital. Here's how to do it.
Risks for Using a Mortgage to Finance Rental Real Estate
Anytime you use leverage to buy real estate, there are real risks and disadvantages you have to consider. Anytime you involve a third party and use their money to finance your property, it puts you at a disadvantage that increases the chance that something could go wrong. Here are some of the pitfalls:
- Your property will be foreclosed if for some reason you can’t pay the mortgage.
- Vacancies put you in a financial hole.
- Your loan could be called by the bank, forcing you to pay in full or the property will be foreclosed.
- You pay interest to the bank every month, decreasing your profits.
- If the property goes down in value, you’ll have trouble covering the mortgage if you need to sell the property.
Cash vs. Financing Real Estate- A Look at the Numbers
So now let’s take a look at the numbers when it comes to purchasing a rental property. The first thing I’ll do is make a few assumptions to keep things as simple and clear as possible.
- You’ll be buying a single rental property that costs $100,000
- The property will appreciate at 3% per year.
- You are in the 28% tax bracket.
- Closing costs, fees, etc. will be the same no matter how you finance the property.
- You have a renter that pays $1,000 in rent.
- You will charge the same amount of rent whether you paid cash or used a mortgage.
- Property taxes, repairs, and other expenses will be the same every year no matter how you financed the property.
- You plan to hold the property as a long term investment (20 years) instead of holding it for a few short years.
- The rent stays the same over the 20 year investment period.
When You Pay Cash for Rental Property
So you found the property you want and you plunk down $100,000 cash for the property. You now have an asset worth $100k in your portfolio.
The property appreciates at 3% per year. After 20 years, your investment property will be worth $180,611, for a total appreciation of $80,611.
Over 20 years, you collected $240,000 in rent.
Overall, with property appreciation and rent collected, you gained $320,611 on your $100,000 investment over 20 years.
That’s a nice 320% gain on your investment!
When You Use a Mortgage to Finance a Rental Property
Instead of paying cash, you elected to finance your real estate investment with a mortgage. You find the same $100,000 house and purchase it with a 20% down payment. Closing costs and fees are the same as if you paid cash.
Now you have a house that’s worth $100,000. You have $20,000 equity and owe $80,000 to the bank.
The payment on your $80,000 mortgage is $485/month (using this mortgage calculator), which leaves you with a monthly profit of $515. Over 20 years that monthly profit adds up to $123,600.
The property appreciates at 3% per year. After 20 years, your rental house will be worth $180,611, for a total gain of $80,611.
Over the next 20 years your renter pays you $240,000 in rent.
Mortgage Interest Will Cost You
However, total payments on your $80,000 mortgage cost you $116,348 over the life of the loan. This means you paid $36,348 in interest ($116,348 – $80,000).
But wait! Since you took out a mortgage, you get a tax deduction on all that mortgage interest you paid over the years! Because you paid $36,348 in interest, you can deduct that much from your income every year over the 20 year mortgage. Since you’re in the 28% tax bracket, this works out to a savings of $10,177 over 20 years (I used this tax calculator to calculate results).
Now let’s add up the gains and losses:
$123,600 monthly rent profit
$10,177 income tax savings
TOTAL GAINS= $214,388
$26,171 in mortgage interest ($36,348 interest – $10,177 tax savings)
Total Gains Minus Total Losses
$214,388 – 26,171 = $188,217 total profit over 20 years
That’s an even better 941% return on your $20,000 investment!
Comparing Returns on Investment
Ok, so I’ve gone through all the calculations and we got some interesting results! First of all, I do realize we could introduce many more factors into the equation that would change the numbers above.
However, my goal was to keep the numbers as simple and straightforward as possible so we don’t go down a rabbit hole of “what if” scenarios.
Cash vs. Mortgage- Which is Better?
Now that we have the numbers, is paying cash better than financing a rental property? Well, it depends.
On a percentage basis, using a mortgage is the clear winner. However, even though you get a huge advantage on your return percentage, your real dollar return on the deal is 59% better when you use cash ($188,217 financed vs. 320,611 cash).
Other Factors to Consider When Buying Investment Property
Of course, when deciding whether to finance a property or pay cash, there are a few other things you’ll need to consider that are extremely important to the success or failure of your real estate investments.
Which is More Risky?
Financing a property is more risky. There are several factors that could cause you to have to default on the loan. For instance:
- What if your lender has a change in their business model and decides to suddenly call your loan?
- If you have trouble keeping good renters, you’ll have to pay the mortgage yourself.
- If property values go down, you could end up upside down on your loan. You could get stuck with a property you can’t easily get out of (think 2008).
When you pay cash for a rental property, you don’t have to worry about these risks.
- If you have a gap of a few months without a renter, you don’t have to come out of pocket to make mortgage payments.
- If property values start going down, you can hold on to the property and wait for valuations to come back up, or you can sell the property quickly and take a small loss. You won’t get trapped in an upside-down loan.
Paying Cash Takes a Lot More Money
Obviously, it takes much more money out of pocket to pay cash for a rental property than it does to finance. But overall, that money helps you make more profit on a real dollars basis, and it eliminates all of the risks that come with financing.
How I Finance My Rental Property
Personally, I paid cash for my rental property using money from my Self-Directed IRA. I’m extremely happy with the returns I’m getting and I can sleep well at night not having to stress about bank payments and whether my tenant can pay the rent.
I realize there are plenty of people out there who totally disagree with me about paying cash for real estate investments. In the end, you gotta do what’s right for you.
For me, I want to take on as little risk as possible while making good returns, and that’s what I’m doing with great results! I can sleep at night knowing I have no debt for my investments!
Question: Do you have any real estate investments? How did you pay for them? How is your investment working out for you?