Pay cash or finance? This is an age-old question in the real estate industry that many people have different opinions on.
Some buyers prefer to pay for their homes in cash instead of taking out a loan because it allows them to avoid paying interest, having a monthly mortgage payment, and cuts out the middleman. Many people finance their investment properties because they either don’t have enough money to buy one outright or because they don’t want to tie up too much of their money in each property.
Investors who have the ability to pay cash should consider borrowing money for their investments, as they will get more value for their money. Let’s dig a little deeper into how that works.
- The age-old question in real estate: pay cash or finance?
- Good debt as a powerful real estate investing tool
- Financial leverage: using borrowed money to increase the potential return on investment
- Power of leverage: leveraged buyer can make significantly more than a cash buyer
- Risks of leveraging: reduced disposable income, property value decrease, delayed sales, vacancy issues, inability to make mortgage payments
- Mitigating risks: find a balance between financing and debt, use cash flow to pay down debt, make purchase decisions based on detailed analysis
- Financing options: hard money loans, business partners & investors, crowdfunding, credit card financing, refinance & cash out, HELOCs, house hacking & government-backed loans
The Power of Debt
No one wants to be in debt, especially when it comes with interest and offers no rewards. However, not all debt is bad. A home mortgage, for example, is a loan that has a low interest rate and provides the borrower with a place to live as well as tax benefits.
All debt isn’t necessarily bad, despite what many talking heads in personal finance will tell you. Debt can be good and not just bad.
Good debt is a powerful real estate investing tool that can turn your first home purchase into a real estate portfolio.
What Is Financial Leverage?
Archimedes very famously stated, “Give me a lever long enough and I can move the world.” That’s the same basic concept behind financial leverage.
Leveraging is when a buyer uses financial tools or borrowed money to try to increase their potential return on an investment. A common investment practice, leveraging, is using money that belongs to other people to acquire an asset that will generate revenue.
If you have the cash to purchase a home without help, you can still leverage good debt to supersize your returns.
The Power of Leverage
If you’re looking to invest $200,000 in a rental property, you may be wondering how much rent you could charge and how much profit you could make. After finding a home at the desired price, you would then go through with the transaction.
Single-family rental investors can earn income from four sources: rent, appreciation, tax benefits, and amortization. This home will net you $700 a month after expenses and reserves, and will appreciate 5% every year.
After one year, you sell the home. You will make a profit of $18,400, which is made up of $10,000 from the appreciation of the property and $8,400 from the accumulated rental income.
$18,400 is a good return, but you can make more money using other people’s money.
This time, let’s look at a scenario where we use good debt.
By buying five homes instead of one, you increase your purchasing power by $1 million.
This is how it works: You put down $40,000 on five different $200,000 rental homes and the rest is financed. Assuming that each house appreciates by 5% every year and that the monthly expenses are fixed, each house will clear $150 in net income every month.
If you sell your five properties one year later, they will have each appreciated by $10,000 and generated a total of $9,000 in rental income. The total profit would be $59,000 if all the factors are taken into account ($10,000 x 5 + $1,800 x 5).
For the same real estate investment of $200,000, the leveraged buyer made around 220% more than the cash buyer over the same timeframe.
Risks and Rewards
There are indeed many benefits of using financing to purchase a single-family rental property. Leveraging is a way for investors to get a larger market stake and subsequently a higher return.
No investment comes without risk, however. Here are a few to keep an eye on:
Taking out a mortgage to buy a property will mean that at least part of your monthly rental income will go towards your mortgage payment, leaving you with less disposable income each month. The downside of having more money tied up in your property is that you have less money available to spend.
If a property is worth less than the mortgage, this is known as being “underwater.” It often happens when the loan’s loan-to-value ratio is too high and the market value of the property decreases. This has not been a major issue for property investors in the past, but it is something that could happen.
There are other risks in addition to delayed property sales, vacancy issues and inability to make mortgage payments. These problems can be fixed by planning ahead, preparing well, and researching the market.
Experienced investors know how to find the perfect balance between using enough financing to increase returns and not using so much that they end up with more debt than the property is worth. One way to minimize risk is to use cash flow from the property to pay down debt, whether the debt is on the property itself or on another rental property.
Investors who take a calculated approach to buying houses find it easier than homeowners, because their purchase decision is based on detailed number-crunching rather than emotion.
How to Finance Your Investment Property
Now let’s down into the nitty gritty of this and get into 6 different ways to use other people’s money to finance your investment properties. Other People’s Money (or OPM) is one method to use financial leverage and grow your investment portfolio quicker.
OPM Option 1: Hard Money Loans
Hard money is a form of financing that is an alternative to more traditional means such as securing a 30-year mortgage from a bank. It is also an excellent way to use other people’s money. Furthermore, hard doesn’t mean challenging. This means that these lenders are only interested in the physical property and not the person who owns it.
Traditional lenders require minimum standards with the borrower’s non-financial assets. Hard money lenders don’t concern themselves with this. They don’t ask, “What was this property?” When taking on a new loan, these lenders look to see what the property will become rather than what it once was. They make their decision to lend based on the projected after-repair value of a property.
This system provides real estate investors two key advantages. Even if you don’t have a great credit score, you can get a hard money loan. However, most lenders won’t work with you if you have bankruptcies or judgments in your credit history. Hard money loans can be used for distressed properties, which makes them a good option for investors who are looking to fix and flip a property.
So-called “hard money” lenders are willing to lend based on the expected future value of the property. Traditional lenders want to confirm that a property will cover the loan balance if foreclosed upon, while so-called “hard money” lenders are willing to lend based on the expected future value of the property. Hard money lenders assume more risk. They give loans based on what they think the property will be worth in the future. Do Hard Money offers loans of up to 70% of a property’s ARV. This means that if a borrower is unable to improve a property, hard money lenders will need to get back their outstanding loan through a sale of the property. The loan was based on the projected value of the property after repairs were made, so selling the property before the repairs are completed is not likely to cover the outstanding loan balance.
Hard money loans are more risky than traditional mortgages, so they have higher rates. The interest rate for this investment will be between 7.99% and 15%. However, investors can also close these loans extremely quickly. A traditional mortgage usually needs 45 days or more to be completed. A hard money loan can be closed in a shorter time frame than many other types of loans.
OPM Option 2: Business Partners & Investors
This option is represents borrowing money from others. This means that you can look for people who are willing to invest money in your real estate venture. A lot of individuals would like to put money into real estate but don’t have either the time or the experience required to do so. If someone has money to invest, you can ask them to invest in your business as a limited partner. The people who give money for this venture do not take part in the everyday activities and get money back for their contribution. This means that in order to have a successful investment, you will need to be willing to give up some of the money you make. If it means the difference between being able to fund a deal or not, partnering up can be a great option.
OPM Option 3: Crowdfunding
Crowdfunding is a method of raising money via the Internet to finance a variety of projects, according to the Securities and Exchange Commission (SEC). In order to make these investments, you must do so through an online platform that is operated by a middleman. Intermediaries that connect potential investors with companies seeking crowdfunding investments are playing an important role in funding new businesses.
Crowdfunding opens up the opportunity for real estate investing to a wider pool of people by making it possible to solicit small investments from a large number of people instead of relying on a few wealthy investors. Crowdfunding makes it easier for people to find investors for their projects by making it possible for anyone with a well-developed deal to post their deal on a crowdfunding platform.
OPM Option 4: Credit Card Financing
Credit card companies want your money. If you’re a responsible borrower, they’ll provide you with some pretty good personal loan options. If you limit yourself to only spending $2,000 of your $25,000 credit card limit each month and pay it off on time, you will be in good shape. The card company will most likely offer you a low-interest personal loan for the difference between your credit limit and the credit you regularly use. This is a one way to use other people’s money, namely the credit card company’s money.
Very famously, Robert Kiyosaki (aka Rich Dad) financed the down payment on his very first investment property with a credit card.
However, let me emphasize this particular strategy definitely is not recommended. I consider it far too risky to go this route, but it’s certainly one option.
OPM Option 5: Refinance & Cash Out
Over time, either your own house or your rental properties accumulate equity in them. Tapping into this equity is commonly referred to as a “refi-cash out”.
This type of loan allows you to use your home’s equity as collateral. More specifically, with a home equity loan you receive a one-time cash payment and then pay off the loan over an extended period of time, much like your original mortgage. This predictability is one of the main advantages of home equity loans. The interest rate on your loan will be fixed, meaning your monthly payments will stay the same. Here you are using the banks money and tapping into your own equity.
For us, this is how we accelerated our own financial freedom plan by getting a chunk of cash out of properties and buying rental real estate.
OPM Option 6: HELOCs
Rather than borrowing a lump sum all at once, with a HELOC you can withdraw as much money as you need, when you need it. A home equity line of credit is similar to a credit card in that you can borrow money up to a certain limit, as you need it. Typically, investors tap the equity in their primary residences. This means that you own your home outright, or owe very little on your mortgage. Assuming you have $50,000 in equity in your property means that you either own your home outright or only owe a small amount on your mortgage. If you are looking to take out a home equity line of credit (HELOC), the lender may not give you the full amount that you want. However, even if you are only able to get a $25,000 HELOC, this can still give you a lot of financial flexibility. This means that you only pay interest on the portion of the HELOC that you use, rather than the entire amount. If you pay off the money you owe, you will not have to pay any extra interest.
OPM Option 7: House Hacking & Government Backed Loans
It seems like there are shortcuts or easy ways to do everything these days, including finding housing. With house hacking, you can use part of your primary residence as an income-producing property. If you live in a single-family home and don’t have any kids, there is probably an extra bedroom that you aren’t using. You could turn this extra bedroom into a storage space, a guest room, or rent it out to earn some extra income.
If you have an extra bedroom, you can rent it out to generate income. You can either rent it to a friend or a screened applicant. The goal is to have the monthly rent from this tenant to equal your monthly mortgage payment. If someone else is paying your monthly mortgage payment on your primary residence, you now have extra money to save or invest in other properties.
How does this text relate to using other people’s money?
Generally, you need to make a down payment of at least 20% on a conventional mortgage for an investment property. loans from the government can help you get a loan for a house with a down payment of 0% to 3.5%. You can access between 16.5% and 20% extra financing by turning this home into a partial investment property.
Consider a Fixed-Rate Mortgage
Many homeowners abandoned their homes when the housing market collapsed in 2008 because their homes were worth less than what they owed on their mortgage. Since then, lending practices have become more much conservative.
According to Peterson, currently, 30-year, fixed-rate mortgages are usually the best way to go. Mortgages that require the lowest monthly payments are typically of this type. Additionally, your monthly mortgage payment will always be predictable. Not having to worry about large changes in expenses makes it easier to budget, plan rent, and determine future investments. Plus, penalties for prepaying on a fixed-rate mortgage are not common nowadays, so you can make additional payments and pay off the loan more quickly if you would like.
With an adjustable rate mortgage, your monthly payments can go up or down based on the market. This means that you could be faced with sudden, unexpected increases in your mortgage payments.
Investment Property Financing Checklist
If you’re thinking about applying for an investment loan, it can help to gather as many of the necessary documents ahead of time. Your lender may ask for other types of documentation not on this list, but here’s what you can generally expect:
- Copy of your driver’s license.
- Bank statements for the last two months.
- Your two most recent statements (either for last two months or last two quarters) for all other assets and reserves, such as investment and retirement accounts.
- A credit report.
- W-2 forms for the last two years and pay stubs for the last 30 days.
- Federal and state tax returns for at least the last year.
- Mortgage statements and homeowners insurance declarations for your primary residence and any rental properties.
- Any current lease agreements for investment properties you already own, as well as official closing documents.
- Home inspection documents. Most of the time your mortgage lender will do an appraisal of the house. But it’s smart to pay for a home inspection yourself before you make an offer, so there are no surprises down the line.
- Bankruptcy, divorce, or separation papers, if applicable.
With all of that said, if you own investment properties, how are you financing them? Let me know in the comments below!
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