Are you considering buying a new rental property and wondering whether to finance it or buy it in cash? The decision can be tough, and each choice has a considerable amount of pros and cons.
In this blog post, we will walk you through the advantages of both options.
The Pros of Financing Your Rental Property
While paying for an investment property has obvious benefits, there are many perks that come with financing your rental property over time.
Spread Out Your Investments
One benefit of financing your rental properties is that you can diversify your investments. But what exactly does that entail?
Let’s say you have $100,000 to invest in real estate, and you are able to get rental property loans with a downpayment of 20%. Here, you will have a choice: you can either purchase an investment property with $100,000 in cash, or you can buy five rental properties that are worth $100,000 with a 20% downpayment ($20k) on each.
By spreading your capital across five different investment properties, you will be able to reduce some risk, as you will be placing all of your eggs in five baskets instead of one.
The fact is, even when an investor does everything in their power to avoid making a bad investment, there are many things that can still go wrong. For example, six months after purchasing a property, the city could choose to put a construction site right beside your property.
Or, you could end up with a problem tenant who causes damage to the home. The list can go on and on, so it is important to avoid relying on a single investment property if you can help it.
Faster Scaling
You will also be able to buy a larger number of properties at a faster rate if you use financing options rather than trying to buy them all in cash. When you purchase a rental property using a loan, that means you will be able to scale your real estate business at five times the speed than if you were to buy in cash.
Regardless of whether or not you take out a loan, you will get the same benefits of owning a rental property. This includes tax benefits, appreciation, and the income that is generated over time from the home. These advantages will only grow as you fill out your real estate portfolio.
Higher Liquid Assets
One drawback to investing in real estate is that it can be difficult at times to convert your assets into liquid cash. For example, if you purchase a $100,000 property, your cash will essentially be locked in one single property.
If you ever wanted to access the cash, you would only have two options to do so: take on some debt or sell the property entirely. Both of these options will cost you time and money.
Alternatively, let’s say you only invest $20,000 in the property, financing the other $80,000. You will still own the investment property, but you will only have $20,000 of your own cash locked up in it.
This leaves you the rest of your $80,000 to do with as you please, whether that means covering other life expenses, saving for emergencies, or investing in other properties.
The more liquid assets you have built up, the easier it will be to access your money, offering you more options in the long run.
Inflation Is on Your Side
While inflation tends to make some people’s lives more complicated, it will only work in your favor if you finance your next rental property. But how?
Let’s say you have a 30-year property loan with a monthly mortgage payment of $500. By the time 20 years have passed, that mortgage will still be $500 a month, which will be far less than the average mortgage payment.
Further, the average cost of rent will be significantly higher than $500 a month. This will allow you to raise the cost of your rent each year, keeping up with inflation. This means that as each year goes by, you will only generate a higher and higher return on your investment.
Amplify Your Returns
If you are able to get a good deal on your next rental property, then leveraging money that isn’t yours to cover the cost can increase the return on your investment.
Once again, let’s say that you have purchased a $100,000 rental property. Your monthly expenses (besides your mortgage) come to $450, and you charge $1,100 a month for rent. If you were to purchase this rental property in cash, you would generate a monthly cash flow of $650 every month or $7,800 a year.
With a $100,000 property, that would amount to a 7.8% return on your investment. This is a pretty good return that many investors would love. However, it can be higher.
Let’s say you take out a 30-year mortgage loan for your property at 5% interest with a $20k downpayment. That would make your monthly mortgage payment (including the principal and interest) at $429.46, dropping your monthly cash flow to around $220, and your annual cash flow to $2,646.48.
However, since you only invested $20,000 of your own money, you would be earning an approximately 13% return on your property.
However, this idea works both to your advantage and disadvantage. If you purchase a property and end up with a negative cash flow, adding leverage will only make it worse.
Take Advantage of Tax Benefits
As you may know, mortgages come with some added tax benefits for real estate investors. Property owners will be able to deduct the interest of their mortgage on any loans they have taken out for rental homes. Beyond this, you can also deduct a variety of other fees that can pop up when you purchase a new property, such as lender fees.
The Pros of Buying Your Rental Property in Cash
While there are benefits to financing your rental property, there are also advantages to buying a property in cash.
Reduce the Risk of the Deal Falling Through
If you are relying on a loan to purchase an investment property and the deal doesn’t work out, you risk losing the property altogether. With a cash investment, you won’t have to worry about this happening as you will be in complete control of all the money involved.
Better Negotiation
Paying in cash gives you a competitive edge in the negotiation process. As you may know, sellers love a “cash offer”, and they are hard to compete with in the offer process.
In fact, if you offer an all-cash deal to a seller, they are more likely to accept it at a lower cost. This is for a couple of reasons. First, a cash deal will be wrapped up quicker, which is always a plus.
Second, an all-cash deal removes any risk of a financing deal falling through on the seller’s end as well. Offering to pay for the property in all cash is a more secure deal for the seller, and they will usually favor this over a financed offer.
Avoid Lender Fees
When it comes to financing a property, lender fees can add up quickly. By paying for a property in cash, you will be avoiding these often arbitrary costs and potentially saving thousands of dollars.
Avoid Interest Costs
As you know, interest costs can really add up over the lifespan of a loan. For example, if you purchase a $100,000 property with a $80,000 loan and a 6% interest rate, you will end up paying more in interest than the loan itself, as the interest alone would add up to $92,670. Avoiding this cost leaves a lot more income for you to enjoy.
Higher Cash Flow, Less Work
Of course, avoiding a monthly mortgage payment allows you to have a much higher cash flow every month. This means that it will ultimately take less work each month to generate a positive cash flow, allowing you to enjoy your income without the stress.
Let’s say you are preparing to enter your retirement and you have 10 financed properties that each generate $3,000 in cash flow each month. While you could keep managing these properties as you retire, you could also sell seven of the properties, using the money to pay off the remaining mortgage left on the other three.
This can allow you to earn the same amount of money, except instead of managing 10 properties, you will only have to handle three.
No Risk of Falling Behind on Payments
An “underwater” rental property refers to when the mortgage becomes higher than the value of the property itself. When you finance a property, the more money you borrow, the more you risk this outcome. Without a mortgage to worry about, you won’t have this risk at all.
Investment Property Financing: Bottom Line
So, should you finance your next investment property or pay for it in cash? At the end of the day, this is a decision that must be made based on your own personal and unique situation. Consider where you are at in your life, how much risk you are able to handle, and what your ultimate real estate goals are.
However, while this decision can be different for any investor, it is important to be aware of the advantages and disadvantages that can come along with each one. If you have any further questions about buying your next investment property, contact Blanket today.
