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Should You Finance Your Rental Property Purchase or Pay Cash?

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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.

Buy Your Rental Property with Cash

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%

Explanation

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:

  • Line 3: Since you paid in full for the rental property, you don’t have any financing expenses…so your P&I cost is $0.
  • Line 4: Your monthly rental income is $2,000, since your P&I payment is $0 (line 3), you get to keep all $2,000.
  • Line 5: Your net annual rental income is your monthly rental income (line 4) minus P&I (line 3) over 12 months. In this case, it is ($2,000 – $0) x 12, or $24,000.
  • Line 6: This is your “dividend” component. It’s your net annual rental income (line 5) divided by your invested capital (line 2). In this case, it is $24,000 ÷ $300,000, or 8%.
  • Line 7: Home prices go up and down, but in general, it goes up at the same rate as inflation over the long-term. Long-term inflation is about 3%, but we are going to use a conservative 1% number here just to demonstrate. In this case, your $300,000 rental home appreciated 1% over the year, so your house appreciated $3,000.
  • Line 8: This is your “appreciation” component. It’s your appreciation (line 7) divided by your invested capital (line 2). In this case, it is $3,000 ÷ $300,000, or 1%.
  • Line 9: So your total return on investment is $24,000 + $3,000 = $27,000; and $27,000 ÷ $300,000 =  9%

Finance Your Rental Property and Put 50% Down

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%

Explanation

For the mortgage rate, I am going to use 4% for a 30-year fixed mortgage, which is obtainable in the current environment.

  • Line 2: You only paid 50% or $150,000 and the bank put up the other $150,000.
  • Line 3: Since you borrowed $150,000, you have to pay a $716 monthly mortgage payment. You can use this mortgage calculator to put in your own numbers. Also, note that your mortgage payment for the first year consists of $2,642 principal payment and $5,952 interest payment. I will tell you why this is important later.
  • Line 4: Your monthly rental income is now reduced by $716 (line 3). In this case, it is $2,000 – $716 = $1,284.
  • Line 5: Your net annual rental income is now $1,284 per month x 12 months, or $15,408 for the year.
  • Line 6: Your net is lower, but remember you also invested less. Now, it is $15,408 ÷ $150,000 = 10.3% — percentage-wise, you are making more!
  • Line 8: You also get more on the “appreciation” side. In this case, it is $3,000 ÷ $150,000 = 2%.
  • Line 9: So your total return on investment is %15,408 + $3,000 = $18,408; and  $18,408 ÷ $150,000 = 12.3%

But there is more!

  • Remember that you made $2,642 in principal payment, so your “appreciation” is actually $5,642. This change your total return to $21,050 or 14%
  • Also, you paid $5,952 in interest. Since mortgage interest is tax deductible, you will save about $1,500 in taxes (assuming you are in the 25% tax bracket)

Finance Your Rental Property and Put 25% Down

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%

Explanation

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:

  • At 25% down payment, you’d have paid $3,962 in principal payment, so your “appreciation” is actually $6,962. This change your total return to $18,074 or 24%
  • Also, you paid $8,928 in interest. Since mortgage interest is tax deductible, you will save about $2,230 in taxes (assuming you are in the 25% tax bracket)

I don’t know about you, but 24% returns sound a lot better than 9%.

The Power of Leverage

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.

  • Total return of buying 1 house is $27,000 annually.
  • Total return of buying 4 houses is $72,296 annually (after factoring in principal payments), plus $8,928 in tax savings.

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.

What Ifs…

Interest Rate is 6.5%

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.

Interest Rate is 8.5%

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).

Interest Rate is Low, but Rent Income is Also Low

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.

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Rob
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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… Read more »

S.B. @ Save Invest Give
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S.B. @ Save Invest Give

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%… Read more »

Kathy
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Kathy

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… Read more »

Steve
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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?

Jenny
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Jenny

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.

Angelo Troisi
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Angelo Troisi

In scenario #1, why r u dividing $27k by $150k instead of $300k??? Tx.

Reinaldo Pena
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Reinaldo Pena

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?

Elisa
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Elisa

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?

Should You Finance Your Rental Property Purchase or Pay Cash?

by Pinyo Bhulipongsanon time to read: 5 min
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