Buying Rental Property: Should you Pay Cash or Get a Loan?

Categories Rental Properties

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Paying cash for rental properties may seem like the safe bet, but it may actually be costing you a lot of money. I am trying to buy as many rental properties as I can because I feel they are one of the best investments available. Many people feel paying cash is the best option because you don’t have to pay any interest, but I make more money when I use loans. I can buy more rentals, which means I have more tax advantages, more equity, more cash flow, and more appreciation.

The key to my strategy and obtaining great returns is being able to leverage my 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 t0 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 debt riskier than paying cash?

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 (check out the bank rate mortgage calculator for calculating mortgage payments). 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 principle 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.

Below is a video that goes over this topic as well:

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. I never count on rents to go up or appreciation, but it is a nice bonus. I live and invest in Colorado 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. I can buy a house for $100,000 that is worth $120,000 or even $150,000 today. I did 26 flips last year and I used the same concept. There are many ways to get great deals but it is not easy. If I buy one house with cash I would gain $30,000 in equity if I bought it $30,000 below market (this assumes it needs no repairs). If I buy 3 houses with a loan, I 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 roof. With leverage, I can buy three properties for every one property with cash. I am 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 we have 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. I will continue to get as many loans as I can and to buy as many rental properties as I can because of the incredible benefits rental properties offer.

38 thoughts on “Buying Rental Property: Should you Pay Cash or Get a Loan?”

  1. Hi Mark,

    Thank you for the great article! I really appreciate your method. I am looking to get started buying properties and renting them as long term investments. I find it hard to do so in the location that I am, currently (Burlington, VT) due to high prices of properties. I was wondering if you wouldn’t mind sharing a bit of where you are buying these rentals.

    Thanks,
    Manny

    • I am in Northern Colorado. The market has gone up a lot here in the last year. The deals are definitely harder to come by, but out there if you look hard enough.

      • Thanks Mark!

    • Some investors are concerned about the leverage model, especially in light of the real estate meltdown of 2007 and beyond. Many people simply couldn’t deleverage fast enough. Since 1973 when i first became a Realtor, buying sfr’s as rentals was generally a wise move depending on the deal, of course. My investor clients, all high net worth folks pay cash up to $750,000 for a well-located and good home, content with as little as 3% cash-on-cash return knowing that some of these properties will likely sell for double the current price (about was they cost at the highest part of our market. Frankly, I was surprised by this approach but see a good bit of solid wisdom.

      • Hi Tom, How are you!
        Thank you for the comment. I would agree for some high net worth individuals that do not have other outlets for their money, paying cash for property makes sense. For those looking to build wealth quickly I think leverage is the way to go, as long as you follow your guidelines and buy for cash flow.

        • Cash flow should be roughly irrelevant though. I realize some assumptions behind the Modigliani-Miller theorem aren’t quite true, but it’s still a useful result in economic theory because it forces you to question your assumptions.

          Modern economics takes this theorem to be an important result, and I’ve yet to get a clear explanation on which deviations from the theorem’s assumptions should prevent it from even *approximately* applying in real estate.

          • Cash flow is what you make every month from your investment. If you are only investing for appreciation you are basically speculating that prices will go up. Are you saying you think 20 percent return on my investment is irrelevant? That doesn’t make much sense.

            The model you discuss says the difference between bank financing and say a stock sale should be irrelevant to the value of a company. Not that bank financing is not relevant versus an all cash strategy. Almost all companies use stock sales or bank financing to increase returns.

  2. Mark,

    I’ve purchased properties both ways – cash and financing (FHA and conventional), and I think there are two potential benefits of paying cash for properties not mentioned above. 1) for certain distressed properties, I believe you gain an advantage in the bidding process by being a cash buyer. I’ve witnessed this in both a short sale situation and an REO, where I was able to purchase properties for $5K-$10K below other offers. 2) some properties that require a sizable amount of rehab may not be eligible for financing. In Texas, many distressed homes have foundation problems, and require $3K-$7K in repairs. I’ve found lenders shy away from properties that require this kind of major repair.

    My workaround is – pay cash, and then do a cash out refinance six months down the road, after the property is rehabbed and rented out. I’ve done this twice and was able to borrow 70% of APPRAISED value (not 70% of my basis), which in my case allowed me to borrow 100%+ of my investment in the property. One caveat though – you can’t do this if you’ve placed the property in an LLC.

    My $0.02. I still agree that – in most situations – borrow as much money as you can at these rates and allow leverage to work in your favor.

    Jason

    • Thank you for the comment Jason! Great information. Cash can sometimes get you a better deal on an REO. My lender does not care about repairs and I make sure I let the other agents involved know that. All my lender wants is an appraisal if the purchase price is over 100k.
      My lender does not care about the properties being in LLCs either as I just did a cash out refi this year. I have heard from many other people, that most lenders do not like properties being in LLCs.
      That is great that you can refi with a new basis after 6 months. My lender makes me wait a year, like most.

      • I’m in Az, have properties in llc. Would love to talk with your lender!

    • Jason,

      I thought cash out refinance is not allowed in Texas. A lender told me that when I did a refinance with them. The closing cost can be included in the loan, but they are not allowed to write me a large check at the end. I had about 50% LTV when I refinanced.
      I also googled on the topic of how to get a loan when a house is already paid off. The only choice seemed to be home equity loans.
      How did you refinance?

      John

      • This sounds like a question for Bigger Pockets.

  3. I am using the same approach and like it. Leverage is key as long as you have enough cash flow not to have a alligator
    that eats you.

    • Haha, thanks for the comment kevin

  4. If you feel that leveraging your money is the way to go then why pay off the loans so quickly? (waterfall effect)

    • For a number of reasons.
      1. when you have more than 10 mortgages it gets much harder to leverage and finance properties.
      2. My loans are ARMs and the rates can adjust after 5 years to a higher rate
      3. Having paid off properties gives me more financing options like lines of credit.

      If I could get as many 30 year fixed rate loans as I wanted and I knew that would never change, I wouldn’t pay them off.

  5. I recently sold a company and have plenty of cash flow. Purchased a one family for $55,000 cash and renting it for $750. Like my return but now thinking I could have an even better return if I had financed it. Looking for other similiar properties and wondering if I should be financing even though I have plenty of cash? You have given me a lot to think about.

    • I personally would finance them, but it all depends on your level of comfort with debt.

  6. Hello, I am in the process in buying an investment property in Florida and am using funds from a line of credit on my primary residence as a down payment. I like the leverage method for all of the reasons that you mentioned before but also for the tax deduction/ expense that you get to take at the end of the year. If you pay cash then your entire rent roll becomes profit,therefore 100% taxable. If you have a mortgage you get to deduct the interest that you are paying on the loan.

  7. Nice article. How does the guideline some lenders follow with not lending where you have more than 4 mortgaged properties. It would seem that to these lenders, once you have 4 mortgaged properties, you cannot obtain any more financed properties, thereby limiting future investment purchases to cash purchases. What do you recommend?

    • There are many ways to get more than four mortgages. Find a portfolio lender or some conventional lenders will lend on more than four. Don’t believe the lender that says you can’t get anymore than four mortgages.

      • Fennie Mae guidelines allow upto 10 loans on each individual names. After 10 it becomes little difficult. Once you have 10, then you have to find the portfolio lender, also known as private lenders. The major problem is….. with portfolio lenders, the interest rates are 6% – 9%

        • Hi Parry, Portfolio lenders are different than private lenders. Banks that lend their own money and do not sell loans on the secondary market are known as portfolilo lenders. Private lenders are anyone with money that will lend it to you. You can also get lower rates with the right portfolio lender.

  8. Hi Mark, I have 100K to invest on rental property and was thinking to put all for one property. but after reading I think i shouldn’t put all my 100k in one property. My job is to move to other place every one or two year. What you advice me here. Thanks Ashok

    • If it were me I would use the money to buy more houses.

  9. Hey Mark, I think I will have enough money to put 20% down on my first house, but it will be awhile before I can save up enough to put 20% down on another home. I am in a very good location for renting and project to get between $1,100-1,500 on a 100-130k property. after accounting 10-15% for maintenance, and 10-15% for vacancies, I should still see about $400-500 monthly cash flow. My question is if I should move forward getting a second house when I can only put down 10% on the home? I will have a PMI payment of about $80-100 per month if I do so. This would still leave me with a positive cash flow, but the margin is definitely slimmer.
    I’d just like to know your thoughts.

    Thanks

    • I think that depends on how long it takes to save up for a down payment, if you can get the PMI removed and many factors.

  10. Mark,
    Why would you focus on paying the mortgages off with the cash flow versus using that cash flow towards the next property. If you’re trying to maximize your rate of return and your growth, you’d want to maximize your leverage. While obviously you want to make sure you’re making smart choices and not over extending yourself, paying the mortgages off faster just means eliminating the leverage that you’re benefiting from. If you pay a mortgage off within a year, that’s nearly the same thing as paying cash for it. To my mind, the only time you should pay extra on your mortgages is when you’re shifting focus from growth to cash flow, ie. “retirement”.

    • I agree, I don’t pay them off anymore./

  11. “You are also paying down the principle on the loan by an average of $118 each month. That $118 equals another 7% return on your money that you would not have on a cash purchase! ”

    Paying off debt (be it the interest or the principal) is never a “return”.

    • It is a return, but what kind of return it would be could be argued. It is not a cash on cash return, but it could be included in ROI. It is definitely money that is reducing the loan amount that you would not have if you paid cash.

  12. What is the time frame you are looking at in paying off all those loans? Or

    • My loans are 30 year amortizations, but they are also ARMs. My strategies keep changing. I was thinking of paying them off as fast as possible, but now I may be selling some houses and buying more or refinancing some.

  13. Like most investors that have partial knowledge, you neglect the very important principle of Time-Value of Money. You will not be able to access the principle that is being paid down with your mortgage until you sell or refinance. If you actually analyzed your investment using Internal Rate of Returns (IRR), you likely aren’t doing as well as you think.

    If you pay cash for a property, the full net income of your annual cash flow can be invested elsewhere, capturing additional value versus equity that you cannot immediately access.

    • I agree with that, but if you pay cash for a property you are tying up 80 percent of the value of the investment which cannot be reinvested either. Sure you get all of your income, but what is that $400 to $500 extra a month on a $100,000 deal? It would take over 13 years to get the full $80,000 back that could have been financed and reinvested right away.

  14. I see the there is a subtle message here. Buy under valued property, this strategy reduces the risk of not being able to meet your dept repayments eg can sell the property later at a profit.

    I have no doubt the leverage model can work but make no mistake many people have destroyed their lives though speculation funded by debt. i personally know a guy who has been a millionaire made and broke 3 times, he just has the guts to get in there and go for it. The stress on him and his family is enormous, he is also on his third wife and has just been diagnosed with cancer.

    My personal message to all is if you must buy a speculative investment with leverage it is a good idea to have access to the funds to pay out the debt should the need should arise.

    • I do not believe in buying real estate for speculation. I buy for cash flow and hope for it to go up in value.

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