I am currently in the process of buying a rental property and one of the questions that came up was: is it better to buy a rental house with cash, or is it better to take out a mortgage? Personally, I always believe that it is better to borrow, especially in this low interest rates environment; but I want to make sure. So I did some research and between all the articles I’ve read and videos I’ve watched, I came up with the following explanation.
First, let’s assume we have $300,000 in cash and rental properties in our area sell for about $300,000 and that you can rent them out for about $2,000. By the way, this is the exact situation I am working with right now, and that is why I chose these numbers. When you start to follow along, you can change these numbers based on your situation.
This one is straight forward. You take $300,000 cash, buy the rental property for $300,000, and make $2,000 a month in rental income (or $24,000 annually).
| # | Description | Amount |
|---|---|---|
| 1. | Purchase price | $300,000 |
| 2. | Invested capital | $300,000 |
| 3. | Principal and Interest Payment (monthly) | $0 |
| 4. | Rental income (monthly) | $2,000 |
| 5. | Net rental income (annually) | $24,000 |
| 6. | Return on invested capital | 8% |
| 7. | Appreciation (assume 1%) | $3,000 |
| 8. | Net equity growth (annually) | 1% |
| 9. | Total return on investment |
$27,000 or 9% |
One thing to note is that we will ignore a few factors here (i.e., closing costs, insurance, homeowner association or condo fee, repairs, vacancies, and depreciation) because these factors would have similar impact whether you paid cash or financed. We will talk about one major tax implication a little later and show its significance.
Investing in real estate is similar to investing in dividend paying stocks in that you have two components for growth: appreciation (the rise in value of your home) and dividend (the profit that you make from renting out your home). Just keep this in mind for the explanation that follows:
Now let’s look at what happen to the numbers when you buy the house with 50% down payment and finance the rest.
| # | Description | Amount |
|---|---|---|
| 1. | Purchase price | $300,000 |
| 2. | Invested capital | $150,000 |
| 3. | Principal and Interest Payment (monthly) | $716 |
| 4. | Net rental income (monthly) | $2,000 |
| 5. | Net rental income (annually) | $15,408 |
| 6. | Return on invested capital | 10.3% |
| 7. | Appreciation (assume 1%) | $3,000 |
| 8. | Net equity growth (annually) | 2% |
| 9. | Total return | $18,408 or 12.3% |
For the mortgage rate, I am going to use 4% for a 30-year fixed mortgage, which is obtainable in the current environment.
But there is more!
Now let’s look at what happen to the numbers when you buy the house with 25% down payment and finance the rest.
| # | Description | Amount |
|---|---|---|
| 1. | Purchase price | $300,000 |
| 2. | Invested capital | $75,000 |
| 3. | Principal and Interest Payment (monthly) | $1074 |
| 4. | Net rental income (monthly) | $2,000 |
| 5. | Net rental income (annually) | $11,112 |
| 6. | Return on invested capital | 14.8% |
| 7. | Appreciation (assume 1%) | $3,000 |
| 8. | Net equity growth (annually) | 4% |
| 9. | Total return | $14,112 or 18.8% |
The numbers are laid out the same way, so you can follow the explanation above. But let’s look at the principal and interest components:
I don’t know about you, but 24% returns sound a lot better than 9%.
What you are seeing above is the power of leverage. You are leveraging a $300,000 investment with only 50% or 25% of the money, so your return is magnified 2 to 4 times. For instance, based on the scenarios above you can buy one house with cash, or 4 houses at 25% down each.
With 4 houses, your return increases by almost 4 folds. Based on these numbers, it is clear that you should borrow as much as you can to buy your rental properties.
Now, let’s take a look at the 25% down scenario in different ways. What happens if interest rates go up to something like 6.5% (which is still historically low).
| # | Description | Amount |
|---|---|---|
| 1. | Purchase price | $300,000 |
| 2. | Invested capital | $75,000 |
| 3. | Principal and Interest Payment (monthly) | $1,422 |
| 4. | Net rental income (monthly) | $2,000 |
| 5. | Net rental income (annually) | $6,936 |
| 6. | Return on invested capital | 9.2% |
| 7. | Appreciation (assume 1%) | $3,000 |
| 8. | Net equity growth (annually) | 4% |
| 9. | Total return | $9,936 or 13.2% |
In this scenario, your return on investment is still better if you financed. Also, you would have paid $2,515 in principal and $14,551 in interest during the first year, which contribute to your equity growth and tax savings.
Now, let’s take a look at the 25% down scenario in different ways. What happens if interest rates go way up to something like 8.5%.
| # | Description | Amount |
|---|---|---|
| 1. | Purchase price | $300,000 |
| 2. | Invested capital | $75,000 |
| 3. | Principal and Interest Payment (monthly) | $1,730 |
| 4. | Net rental income (monthly) | $2,000 |
| 5. | Net rental income (annually) | $3,240 |
| 6. | Return on invested capital | 4.3% |
| 7. | Appreciation (assume 1%) | $3,000 |
| 8. | Net equity growth (annually) | 4% |
| 9. | Total return | $6,240 or 8.3% |
In this scenario, your are getting to the tipping point where financing vs paying cash becomes a tougher decision (even after factoring in the $1,900 equity growth from principal payment, and tax savings from $19,060 interest payment).
I am not going to set up a chart here, but I encourage you to work out the numbers yourself. See what happens if the interest rate is low, e.g., 4.0%, but you can only get $1,5000 rent per month. See how that would impact your decision to pay cash or finance.
Note: Thanks to SB from Save Invest Give whose comment prompted me to add the What Ifs section.
Am I missing anything in my analysis? If you agree or disagree, please leave a comment and I will update the article to be more accurate.
| Purchase Rates | Refinancing Rates |
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Mortgage Calculator with Amortization |
The calculation is much more based on 1 year base. Based on formula, the more years you hold the property the more principle you accumulate. It changes the base of the equation. Does this mean resale house and frequent sale and buy might yield best return of investment, all risk aside?
I think this works out well if you have a long time horizon. But I think if you need a lot of positive cash flow immediately is paying cash the way to go? It appears after paying taxes on your income it doesn’t leave a lot of cash in your hands if you finance. Am I right on this?
In scenario #1, why r u dividing $27k by $150k instead of $300k??? Tx.
@Angelo – It’s an error. Dividing by $300k is correct.
In case things go totally wrong, buying real estate on credit as an LLC is the way to go. Traditional advice about not having debt is all about the risks of debt and how it can destroy your entire net worth if things go wrong. With a real investment, you can restrict that risk TO THE INVESTMENT, and an LLC to buy investment property gives you that safety net.
Pinyo-
Thanks for the clear and well explained article. What can you expect to see in terms of maintenance costs over the life of the rental property? 1 vs 4?
I was able to purchase a practically new home in Las Vegas for a 60% discount to its original selling price. Super location, great construction quality, however, without 100% cash, you couldn’t compete with the big money buyers. I paid $64.00 per square foot. The house is rented and I have a net yield of 9.2%. The appreciation in just one year is pretty amazing. Most newer homes in this location are back to roughly $100.00 per sf. Demand is very stong and supply is very low.
I would have loved to purchase several with financing but it really was and still is a cash only market for the very best deals. Overall, I am very happy with the return.
This article is very clear and well written, but only discusses return. If your cost of capital (tax-adjusted interest rate) is less than your expected return (before borrowing), then leverage will always improve your return. This is the case in all your examples. I, too, would choose to finance the property. But while financing always improves returns when cost of capital is less than expected returns, it may also produce unacceptable risk in some circumstances.
For example, there is almost always some uncertainty to the expected return. If the interest rate is close to the expected return (e.g. a 5% interest rate and a 6% expected return), there is risk that if the expected return is slightly less, then the borrowing may actually end up leveraging losses.
Also, the overall borrowing for an individual may simply be too high. For example, if you buy 10 houses like you show above and finance all of them, the returns will be great if everything goes as planned. However, if things go substantially wrong, there could be big trouble. If the properties all declined in a real estate downturn, your collateral would be worth a lot less than the amount you owe in absolute terms. If you don’t have other money or cash flow to offset this, it could be risky if you need to sell the property for any reason (e.g. unoccupied units, job loss, medical issue, etc). Having other cash on hand to mitigate these sorts of issues is just another way of saying not go beyond a certain reasonable overall borrowing level.
I think the article could be improved by including another section or another article about risk. You always have a ton of content on this site. Perhaps there is already such an article about leverage and risk on your site that you could link from the article above about leverage and return.
First, excellent analysis, Pinyo. As a real estate investor, I’ve always financed 100% of the purchase price AND rehab costs through a portfolio lender. But there is risk involved. Lose a tenant and you could be in a negative cash flow situation, so it’s important to be well capitalized.
All of that said, I’m currently buying a home with plans to flip it. For this transaction, I’m paying cash to avoid the fees associated with a mortgage. But I don’t plan to own the home more than 6 months. And if I do end up renting it out, I can always do a cash out refi.
@Rob – Thank you. I am blessed with good friend and the opportunity to learn from some very good people in the business. I am not quite at the buying with cash and flipping yet, but I’ll be there one day. Good luck with your new house and please let me know how it goes.