buying rental properties with cash

buying rental properties with cash

Should You Finance Your Rental Property Purchase or Pay Cash?

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).

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.

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.

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%.

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.

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).

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%.

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.

Leave Your Comment (10 Comments)

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.

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.

What I Wish I Knew Before Buying Rental Property

In early 2006, my husband and I decided to purchase our first home in my hometown of Greenfield, Indiana. After shopping around for a few months, we decided on a 1,300 square feet home with three bedrooms, an open kitchen and living room, and a fenced back yard.

Since we had moved there from a one-bedroom apartment with only two windows and a total of 500 square feet, it felt like a mansion to us. All of a sudden, we went from sleeping, eating, and living in 2-3 rooms to having more rooms than we needed.

Still, our plan wasn’t to live there forever. You see, we had somehow set our sights on becoming landlords at a young age in order to reach our dream of financial independence as quickly as possible. And that’s exactly what we did.

A few months after the purchase of our own home, we put 10 percent down on a brick ranch nearby and turned it into our first rental. Shortly after that, we converted our “starter home” into a second rental and purchased a larger home for ourselves.

We learned most of what we knew about finding and screening tenants, creating and signing leases, and managing our properties on the Internet. Everyone we knew thought we were crazy, until they finally realized that, despite our lack of experience as landlords, we were, in fact, making it work somehow.

Here’s What I Wish I’d Have Known

Fast forward almost ten years, and our properties are still standing and as profitable as ever. One of our properties has been paid off for around a year, and the other one has a small mortgage that is set to be paid off in 2-3 years.

Of course, family members and friends who once thought we were crazy have changed their tune over the years. Once both our properties are paid off, we’ll have at least $2,000 per month in somewhat passive income on a monthly basis. All the while, our tenants actually paid off the properties with their money – not ours.

Still, it hasn’t been a painless experience, and we made many mistakes along the way. And there are plenty of things I would do differently if I could. Unfortunately, it’s true that some things need to be learned the hard way. Here’s what I wish I would have known before we became landlords:

Your Property Taxes Might Explode

One of the first lessons we learned about owning rentals came as a huge, scary surprise and ended with a night of tears and weeks of stress. I’ll never forget the day I opened our property tax bill for our first rental and realized that our property taxes had gone up 300 percent overnight.

I actually knew that our property taxes would go up somewhat — my state offers a homeowner’s exemption on your primary residence, and I knew that it wouldn’t apply to any properties we didn’t live in. Still, I was unaware that property tax caps on rental properties were a full percentage point higher than those on homesteads and your primary residence.

The problem was, I had based the rental price on our old mortgage bill – not the new one. So, for the first year we rented that home, we merely broke even instead of pulling in a profit. Fortunately, we were able to readjust the rent and raise it to take the higher property taxes into account once the first year’s rental lease came to an end. Lesson learned there, but it was definitely learned the hard way.

Renters Can Do More Damage Than You Realize

If you talk to anyone who has owned rental properties, you’ve likely heard a few horror stories about the kind of damage they can leave behind. I was fully aware that these things happen, but not quite prepared or expecting to live through it myself.

Unfortunately, I would soon find out how stressful it can be when one of our tenant families broke their month-to-month lease abruptly and moved out in the dead of winter. When I showed up at the house to do the final walk-through of the property, I honestly couldn’t believe what I saw.

All of the doors in the home were missing — gone. The carpet, which had been new when they moved in, looked as if someone had poured a giant can of motor oil all over it. The front door had been broken into and the door frame had been haphazardly glued back together in an attempt to hide it.

But the worst was yet to come. The giant picture window in the front of the house had been broken — and replaced with a window that didn’t even fit and didn’t match the rest of the windows in the house. What.

I couldn’t believe what I was seeing. The house had been in great shape the last time we visited, which was only eight months before. Unfortunately, I later found out that the mother of the family had packed her stuff up and left several months before, which left the father and kids to figure things out on their own. He worked long hours and left the two teenage boys alone during that time, which led to the total destruction of the home in a relatively short amount of time.

We ultimately fixed and replaced everything in the home, and even got the tenants to repay us for most of the damage. Still, I learned a valuable lesson from the experience: A lot of damage can happen in a short amount of time if you allow it to, and the only way to prevent it is to visit your properties frequently.

Good Tenants are Worth Their Weight In Gold

Spending $6,000 to repair our rental property taught us that we needed to be more careful when selecting tenants. However, it also taught us to appreciate the really good renters we have the pleasure of doing business with. You know the kind, and maybe you are one yourself: The renters who take immaculate care of the lawn and keep the home clean. The ones who decorate for the holidays and take pride in their rental as if it was their own home.

One of our homes has been rented to the same family for eight years at this point, for example, and I have grown to be very fond of them. We only drop in once every six months or so, and the property is always immaculate inside and out.

We hardly hear from these particular renters. The last time they called us it was because they want to stain and upgrade the deck.

Because they are such good tenants, I’ve pledged to never raise the rent as long as they are there. And, even though we’re losing out on some revenue by not raising rent, we get the peace of mind that comes with having a tenant that takes excellent care of our property. To me, that feeling is worth more than the incremental rent increases we could charge as time goes on.

I also wonder if we will end up ahead anyway. After all, excellent tenants like them tend to require fewer repairs and will leave far less wear and tear behind when they do finally move out.

Repairs Will Be Expensive and Unexpected

In the ten years we’ve owned our homes, we’ve replaced a furnace, an air conditioner, a refrigerator (twice), and a stove. We’ve paid for a new sump pump and underwater drain system in one of our crawl spaces. We’ve spent hundreds of dollars on drywall repair, paint, and carpet. And that doesn’t even include the $6,000 we spent repairing the property our renters practically destroyed one year.

Fortunately, most of those funds have come straight from our renters themselves. Since both of our properties bring in a tidy profit each month, we are able to use the overages to pay for things like repairs and upgrades and whatever else comes up.

Still, some of the money has come straight out of our own pockets, and those surprise repairs always seem to come at the most unexpected (and worst) times possible. When we first became landlords, we didn’t have a huge emergency fund to deal with unexpected repairs and would often need to dip into our personal savings to pay for anything that popped up.

Everything always worked out fine, but I definitely realized over time that we needed to set some funds aside for what we knew would eventually happen. And now that we have an emergency fund big enough to handle nearly anything, I no longer stress out about those things — like the roof that needs replaced in the next year or two, or the 17-year-old furnace that will eventually die.

Instead of letting the unknown control us, we’ve learned to take control of the situation ourselves over the years. Stuff happens. The difference is, now we’re prepared.

It’s Okay to Set Rules and Stick to Them

One of our tenant families was constantly five to 10 days late with their rent for two years straight. And even though the lease said I was technically allowed to charge a $10-per-day late fee, I never did. Not once. What happened? I was simply being too nice.

It all started with the first month they were late. It didn’t seem like a big deal to me, so I told them not to worry about it. “Just pay when you can,” I said. And that’s exactly what they did.

Unfortunately, they continued to pay when they could, every month after that. And because I had been so nonchalant about it those first few months, it became harder to put my foot down as time went on. I was also non-confrontational at first, which is almost the worst thing a landlord can be. As a result, they were late with their rent for two years and I spent countless hours stressing out over the situation.

I’ve learned since then that it’s okay to stick to the terms in the lease – even if those terms end up costing someone else money. In fact, setting firm ground rules is the best way to let tenants know that the rules matter, and that there are consequences for late rent payments, damages, or anything else.

Buying Rental Properties Was an Excellent Choice… For Us

Although we were far from experts when we got started, I strongly believe that buying rental properties is one of the best financial moves we have made. First of all, we bought our properties near the bottom of the market which means they have already increased tremendously in value. And second, we’ve secured a future income stream that is separate from all of our other retirement accounts and not necessarily subject to the same risks.

Although our properties do bring in a monthly profit, we currently use that money to pay for repairs and maintenance. Meanwhile, any overages go straight toward the loans in order to speed up their potential payoff dates. Our properties currently rent for a little under $2,000, but I do expect them to rent for significantly more in the next 10 years. Once they are paid off, all of that money is earmarked to help our girls pay for college and finance part of our early retirement dreams.

Further, because of our penchant for real estate, we do plan on buying at least two more rental properties in the coming years. While I’m not quite ready to pull the trigger yet, I think we could benefit from having a few more paid-off properties in our portfolio by the time we retire.

Becoming a Landlord is Not for the Feint of Heart

Buying the right rental properties is a challenge in itself, but the act of being a landlord is by far the hardest part. However, owning rental properties can be the key to a great deal of profit and financial freedom if you do things the right way from the start – or at least learn from your mistakes along the way.

I wouldn’t change anything about our story, but I do wish I had known more about the business before we got started. If you are considering buying rental property, I hope you can learn from my mistakes instead of learning things the hard way.

My best advice is this: Screen your tenants carefully and keep an eye on your property at all times. Don’t be afraid to lay down the law if needed, yet be respectful of your tenants and their families — especially the most reliable ones. Also, save for the repairs you know about… and for the ones you don’t.

Because, when it comes to being a landlord, anything that can happen probably will.

Holly Johnson is an award-winning personal finance writer and the author of Zero Down Your Debt. Johnson shares her obsession with frugality, budgeting, and travel at ClubThrifty.com.

Have you ever considered becoming a landlord? If you’re a landlord already, what do you wish you would have done differently? Tell us in the comments.

How I Bought a Rental Property With Cash and Without a Clue

After moving back to the USA from Japan in 2012, I started a new job in Alabama. I met a fellow military member who shared my passion for real estate. Meeting him had a profound effect on my life financially.

What he did with real estate is exactly what I wanted to do.

And he was wildly successful.

When I met him, he had been living there for two years. In that time, he purchased four houses with cash, remodeled them mostly on his own, and rented them out providing substantial cash flow each month (especially without a mortgage!)

He bought in the range of $25-35k, putting a few thousand and sweat equity into them, then renting them out for around $750 a month. The numbers were REALLY working for him.

If you apply the 1% rule to these properties, a house that totaled $40k in cost to rent out should pull in $40o to be “worth it.”

These were almost double that.

Let’s call this successful investor I met Bob.

He handed me on a silver platter almost everything I needed to get started in rental property investing in a new city.

Mainly, he provided:

  • a property manager
  • a real estate agent
  • a list of good contractors
  • a sense of where to buy and where to avoid
  • himself as a trusted advisor

Knowing I could lean on him if I got stuck, I decided to try my hand at buying a property for cash, fixing it up, and renting it out.

The real estate agent I used was recommended by Bob and the management company. She helped the management company purchase most of their properties (several hundred). She knew exactly what kind of houses and in what areas the management company liked.

This is golden. Buying in the wrong neighborhood, getting a house that your management company doesn’t like, or a house that doesn’t rent well can cost you a lot of money!

I asked the management company for advice on what to buy. Their most important advice to me:

  • Single family homes rent best.
  • Most sought after is 3 bed/2 bath. Less than 2 baths rent much slower.
  • Let the management company look at the house before I buy it. (I neglected to do so on this house, but always did after that!)

I found a 3 bed / 2 bath 1700 sq ft house on a big piece of land with a detached garage and workshop. It was listed for $55,000. It was a major fixer-upper.

Here’s the list of things I needed to fix (that I knew about)

  • exterior – several locations with rotting, soft wood
  • damage to floor under bathrooms from water
  • A/C and heater not working
  • roof over add-on room needs replacement
  • separate garage and workshop has damaged garage door, rotting wood, and is full of junk
  • numerous electrical and plumbing issues
  • carpet disgusting
  • hard wood below carpet has staples and glue as well as numerous stains in most rooms from cat pee (thanks, cat lady!)
  • house smells like piss (thanks, cat lady!)
  • several locations on walls and ceiling had holes, needed patching/painting

I used several different contractors and inspectors to get a ballpark idea what it would cost to fix everything. It was my first property, so I wanted to overestimate.

I made a list of stuff to be fixed and wrote a high estimate next to it. Came out to $15k. I had to get a good enough deal of the house to account for an extra $15k to get it move-in ready.

The house was listed for $55,000. I offered $30k.

What does this tell you?

I didn’t offer low enough.

If they accept your first offer, you lose. Your initial bid wasn’t low enough. You need to go lower than you imagine possible, and then work your way slowly up to a number you both can live with.

The inspection I mentioned earlier happened after they accepted my initial offer. This is common practice.

Make sure you use this tactic when you buy a property

  • agree on a purchase price
  • get an inspection
  • re-negotiate based on what you find

This gives me the opportunity to bring up deficiencies that are harder to find, and negotiate an even lower price. I was a rookie and didn’t do so on this property. Could’ve easily knocked $5k off, maybe more.

Due to lack of experience, getting the house fixed up was a slow and painful process. I had one major surprise I didn’t find until AFTER I bought the house.

I went into the add-on room and started cleaning a pile of trash in the middle of the room. What was under the trash?

After removing the seemingly randomly placed trash, I realized the floor under the trash was pushed up about 1 1/2 feet into the air. Something under the carpet had forced the ground up and made a huge bump in the center of the room. It was huge! It totally shocked me!

  • Shocked me because I didn’t notice before I bought the house!
  • Shocked me that the inspector I paid didn’t notice it either!

It was clear the trash in the room was meant to disguise the bump from the naïve purchaser (me).

BUT you’d have to be a real MORON to miss something that obvious. (me)

(and my inspector who I never used again)

Over the course of a month, I brought probably a dozen different contractors over trying to figure out how to fix it and how much it would cost. Some estimated as high as $4,000-$5,000 to fix, but nobody was sure what was wrong!

I lost sleep nights thinking about this. I obsessed about it! I vowed to never buy a house again!

  • the ground was shifting?
  • the house was falling into a sinkhole?
  • It was an ancient Indian burial ground?
  • It was caused by water pressure?
  • It was Pokemon’s hiding place?

Finally one day, a concrete guy just took out a sledgehammer, smashed the ground, moved some concrete out of the way, and what did he find.

A tree root! About four inches in diameter. Damn, I wish I took pictures of that thing!

He sledgehammered the concrete away, removed the root, and repoured concrete in the room. Cost: $1200. Could have been much worse.

I had a state farm agent come by the house and give me a list of things to fix before he would insure it. One thing I didn’t realize the danger of was the fire pit built out of bricks about 6 feet from the house.

Bad idea! Found someone to smash it up with a sledgehammer and haul it away for $100.

I was floored by how bad the floors looked!

The piss stunk to high heaven and the hardwood floors looked like hell. They also had glue and staples all over them from having carpet tacked to it over the years.

The price to sand everything down, stain it, and wax it: $2900.

It looked like brand new when they were done, but I way overpaid for this.

It’s like putting a massive crystal chandelier in a college dorm room. Nobody appreciates it or expects it to be that nice!!

Could have rented the machine and did it myself, or found a handyman to do it for me waaaaayyy less.

That being said, they did a good job on the stains. You can’t tell how nasty it was before. And the smell was GONE!

Bathtub was stained, chipped, and nasty. Couldn’t clean it. Stains wouldn’t come out.

Never knew this was possible, but they sprayed on new porcelain over the old stuff, turned out looking brand new. Cost? $99.85.

Quick summary of some of the other big ticket items

Partial roof replacement: $1550

Garage and kitchen: $2500

All in all, I put $13,683 into it.

The place rented out for $750 a month. We were excited.

But there was one more surprise.

On the day the tenants moved in, I got a phone call saying the water wasn’t working in the house, and water was flooding into the front yard.

Sent my trusty plumber over to investigate. He told me:

SOMEBODY HAD STOLEN ALL THE COPPER PIPES UNDER THE HOUSE WHILE IT WAS VACANT.

The water was running fine while we were remodeling, so this happened between remodeling and move-in.

Cost to totally redo plumbing with hose instead of copper: $1900.

I now had a rental property that cost me $44,800. It was renting for $750.

Passes the 1% test with flying colors. It’s a great rental giving me a positive cash flow. The fact that there was no mortgage to pay makes it that much sweeter!!

Cash flow is much harder to come by doing this with mortgages. Less room for mistakes, bad luck, and emergencies. Just keep that in mind.

Compared to Washington D.C., where I owned a $400k townhouse free and clear, this house was cheap. I had the cash on hand to do it again, but was gun shy after dealing with all this craziness!

Would I keep going?

Of course I would.

I love real estate.

And I figured if I could overcome these problems, I could do anything!

Four Important Lessons Learned

Why should you care about all the crap I went through to buy this house.

Because I learned a few things. Maybe you’ll do better than I did on your first house!

1. You need experts to look at the house before you buy it

I found a much better inspector for my future purchases. I also learned to use a free inspection done by state farm and a free inspection done by the management company to avoid surprises in the future.

I am now at the point where I make offers on almost every property that is a 3 bedroom 2 bath that hasn’t been condemned. These are low, low offers.

No matter how bad a house is, if it’s cheap enough, you can make it work.

If no one got back to me on a low offer, I moved on.

If they came back with a half-way decent counter-offer, I knew they were desperate, and I put more effort into negotiations and inspections.

If you don’t ask for a low enough number and they accept, you overpaid and you suck.

If you ask too low, you offend them, and you suck again. Also they don’t counter-offer. Experience will help you find that sweet spot.

Once they accept an offer for lets say $35k, you get a professional inspection. Forward them the results of the inspection, and deduct the cost of estimated repairs. You could then counter-offer much less, say $28k based on the inspection. They will negotiate and hopefully settle at a number that you both can live with.

Sometimes, you have to keep insisting on your lower price. If they are desperate enough, they’ll take it.

Sometimes they’ll reject your cash offer and sell to someone else who is getting a loan, but offering more $$ than you.

Often enough, these loan deals will fall through because the buyer can’t get a loan, and you’ll see it on the market again a month later. (This happens all the time)

At this point, I come in with a lower cash offer than I made originally, and they usually take it. By now, they are pissed and just want to be rid of the damn thing!

Sometimes, sellers haven’t had the house on the market long, and still think they’re going to get a fortune for their house. You don’t need to waste time on these people.

Wait until their house has spent several months on the market and they’ve been forced to lower their price a few times. Maybe wait until they’ve had an offer fall through. Then you move in for the kill!

Now that my house was rented out and bringing in money, I forgot about all the heartache and pain that went into remodeling. I wanted a second house. I even knew I wanted a third.

I liked the idea of all that passive income with no debt!

I had the cash, so I started making offers again. My goal was to catch up with my friend, who already had four properties.

But that’s a story for another day…

Click here to read about my 2nd buy and hold property. (much better)

How’s I get to 20 properties total in my spare time? All paid off?

I’m happy to answer your questions by comment or email. Been waiting to pull the trigger on buying a property? Have questions about getting ready to buy? I’m here to help.

Buying Rental Properties: Cash vs. Mortgage

I love houses. I love that I can touch them. I love that I can feel them. But most of all, I love that I can make money with them.

Owning rental properties is one of my favorite long-term investment strategies. Holly and I have owned 2 investment properties for close to 8 years now, and they are easily two of the best investment decisions that we have made. Not only will they be able to provide us with a steady income during our retirement, they are also assets that will (hopefully) continue to appreciate over time.

If history holds true, the value of real estate should continue to rise – meaning we make money on the front end (purchasing the homes at a discount), the middle (through rent payments), and on the back-end (on the sale of the property). Personally, I don’t know of a much more perfect investment vehicle.

Of course, not everybody shares my enthusiasm for buying rental properties. Heck, not everybody even agrees on how you should go about purchasing them. Should you get in on owning rental properties? If so, what is the best way to purchase them?

2 Ways to Purchase Rental Property

When it comes to buying rental properties, there are generally two schools of thought on how to do it. Some investors only purchase a rental property with cash, while other real estate investors don’t mind taking out a loan to purchase their properties. Both are valid ways to get exposure to the rental markets, and they both come with their own sets of advantages and disadvantages.

Buying Rental Properties with Cash

  • Own the property free and clear immediately
  • No risk of foreclosure
  • No mortgage to meet
  • Can keep the unit vacant until you have the right renter
  • Can keep the unit vacant if repairs are needed
  • Almost all revenue (rent) is profit
  • Not paying any interest
  • Long-term property value appreciation
  • Harder for beginners to buy
  • All income is taxable (minus expenses)
  • Can’t take advantage of mortgage interest tax deduction
  • Reduces cash flow which could be used for other investments
  • Risk of property value depreciating

Buying Rental Properties Using a Loan

  • Easier for young and beginning investors to buy
  • Use the bank’s money to purchase property
  • Renters pay off mortgage for you
  • Allows you more flexibility with your money (better cash flow) to make other investments
  • Can set rental rates high enough to pay your expenses (mortgage, taxes, utilities, etc.) in-full
  • Take advantage of mortgage interest deduction
  • Long-term property appreciation
  • Large portion of revenue will not be profit and must be paid toward mortgage expenses
  • Risk of exposure to foreclosure
  • Less flexibility in regards to vacancies
  • Income is taxable (minus expenses)
  • Paying interest on the property
  • Risk of property value depreciating

The Best Way to Buy a Rental Property

So, what’s the best way to invest in a rental property? In truth, the answer is different for each individual investor.

Personally, we have always used a mortgage to pay for our rental properties. When we were younger, we didn’t have the money to be able to purchase our investment properties outright. If it wasn’t for being able to borrow the money, we would have missed out on two of the best investments that we ever made.

We also like using mortgages because it has allowed us to put only a small amount of our money at risk, initially. Then, we let the renters pay off the rest of the mortgage through their rent payments. When the houses are paid off, we will own two major assets that have been paid for by other people, costing us very little money out-of-pocket. Sure, it isn’t as fun or a sexy as getting a chunk of additional income from rent each month, but it works with our long-term investment strategy. That seems like a pretty big win for us.

What are your thoughts? Do you think investment properties are worth it? Should real estate investors use cash or loans to pay for their investments? Fire away in the comments below!

September 23, 2013

February 23, 2018

Greg Johnson is a personal finance and frugal travel expert who leveraged his online business to quit his 9-5 job, spend more time with his family, and travel the world. With his wife Holly, Greg co-owns two websites – Club Thrifty and Travel Blue Book. The couple has also co-authored a book, Zero Down Your Debt: Reclaim Your Income and Build a Life You'll Love. Find him on Instagram, Facebook, and Twitter @ClubThrifty.

I like this post, because I’ve just looking for my house but for the moment I’m still in the phase of “saving for deposit”, there are alot info in this post, thanks for sharing.

You got it! Thanks for stopping by.

You know we are moving cross-country and trying to sell the house we have here. Well, it’s probably not going to sell or rent very quickly. I have made my peace with that. We have to have somewhere to live in the other state, so we decided to rent for several reasons. One of them was that I didn’t want to have two mortgages. There’s not concrete reason that I can point to – I just am risk averse. This goes to your point about the right solution being different for every investor; give me a few years and I’ll probably shrug at the thought of having two or three mortgages! So even with the individuals, the right answer changes over time.

Oh absolutely. As your situation changes, your risk tolerance and your ability to handle risk/cash flow issues/etc. change. I’m not sure I’d really love to own a rental across the country either. Plus, it is always a stressful thing to carry multiple mortgages. I think it is great that you realize your risk tolerance level and made a good decision because of it. You’ll probably be much happier.

Isn’t the key to buy the rental property at the lowest, best price? That’s how you’ll maximize profits over the long run.

Sure. That is the key to making money on anything (buy low, sell high). But it is only one part of the real estate investment process. You want to make money in 3 phases: purchase at a good price, while you own the property (through rent), and when you sell (sell high)…kind of like a income or growth/income stock.

Buying in cash sounds ideal, but not something many people could manage. I’m curious how long of a mortgage you took on yours, if you’re willing to share? Just how long-term of an investment do you advise?

We have them both at 15-year fixed, but should have them paid off a little bit early. IMO, if you can’t afford the payment on a 15-year fixed, you can’t afford the house – regardless of whether it is an investment or primary residence. Very few people live in a house for 30 years. Since interest in a mortgage is front-loaded, a 30-year mortgage often ends up to be almost a rental agreement.

Thanks. I agree with you about 15 yr fixed for primary residence, and it makes sense for rentals, too.

You’re scaring me

Stop it! Oh wait; I’m one of those that doesn’t share your enthusiasm. I had a bad experience quite a few years ago. You know, buying a rental property while I was broke with no money down! Thanks Carleton Sheets! No, in all seriousness I think either way is perfectly fine if you purchase the right property and you’re in a in a good financial position.

I agree. Being in a financially sound position is a must if you are looking to buy investment property.

If I were in the property investment game (which I’m not) I personally would go cash in though intellectually I understand that leveraging to the hilt is probably the “better” way to go in terms of return.

I don’t think that I would ever leverage to the hilt. I’m far too conservative for that. Too much risk. I need the peace of mind to be able to cover the expenses relatively comfortably should anything happen.

We’re cash only, but we always buy off the MLS. Although anyone with a big checking account can handle vacancies, I prefer the ability to be picky.

I would also rather have the cashflow of a single asset than have to deal with multiple mortgages, leverage helps you build wealth, but not necessarily cash flow which is more important to me.

Yeah, if you are going to use a mortgage, you need to be able to cover the cash flow if there are problems. For us, we’ve always been able to cover it without a problem, even if they go vacant.

I think you’re right that it depends on the situation. I suppose ideally you would pay cash for an investment property, since that makes it cheaper by avoiding the financing costs, but it seems unrealistic for most people. Real estate investing can still be a great deal if you have a mortgage, so if you can make that work I would think it would make sense. I hope to rent out my condo when I eventually move to a larger place, and I will likely maintain the mortgage on it. As long as the rent is higher than the mortgage I should be in good shape.

Ideally, cash would probably be best. There is obviously no risk of default that way, plus the rent money is instantly cash flow. However, I don’t mind using the mortgage at all for the reasons stated.

Ali – you bring up a great point ‘financing costs’. I am surprised that the original well written article does not mention financing costs. In my mind, leveraged returns vs financing costs is the main deciding factor.

For me and most of my friends, foreclosure/ monthly payments etc are not a factor – we have large portfolios that are well diversified and can sustain medium term down turns.

But if someone is paying the financing cost for you (rental income), then it is a win-win.

I’m glad you are having a positive experience with your properties. I became a reluctant landlord when I acquired several rental properties from my mother and I hated it. One thing that you do need to keep in mind is that unless you are constantly monitoring your tenants, the property can very easily become quite used (i.e. trashed) requiring a lot of repair before selling. It is the rare tenant that cares for a rental the way they would their own place. And the mortgage loan requirements are more stringent for property that is not owner occupied. There are also no real estate tax breaks on rentals- such as owner occupied or senior citizen exemptions. Then there is the vacancy situation which creates no cash flow for the period of time the unit is empty. If you go into the venture with eyes open and knowing all the pros and cons, you can make money. But never think of is as a passive or easy endeavor.

Owning real estate is great when there are no problems. However, I just found out that the water heater died at one of our rentals. These are the days that suck As far as exemptions go, those would totally depend on your locality. We still get a county-level “mortgage exemption” as well as being able to write the interest off on our income taxes. These are great things to think about though! Thanks for the comment.

We have used mortgages because of the reasons you said. Otherwise, we’d still be saving up for that first property and would have missed years of equity. I think the key is to not over mortgage. Make sure the cash flow covers the mortgage plus expenses, not just barely the mortgage payment. The properties we’ve bought have all been cheap with stuff wrong with them so we’ve been able to cash flow from day one. The first rental, which is the commercial building, will be paid off in about 4 years and then we will probably have the ability to pay off the others pretty quickly, so I think our strategy has worked ,but it would be cool to buy a whole house in cash!

“I think the key is to not over mortgage. Make sure the cash flow covers the mortgage plus expenses, not just barely the mortgage payment.’

Exactly. If you cut it too close, you’ll be miserable and hate real estate investing. Plus, you could have a financial problem on your hands.

I live in NYC so I thought it would be impossible to buy rental property. However, after reading some blogs and doing my own research I’ve decided to buy rental properties out of state and have someone manage it. Yes, that cuts into the profit but as long as it still has good cash flow, I’m fine with that. Personally, with the mortgage rates, I think it makes sense to take on a mortgage. I know some people do no like any debt but sometimes you need to leverage your money. I’m hoping to buy multiple properties so paying cash would be near impossible.

We are interested in getting into rental real estate one day. We keep going back and forth about it so right now we plan on just thinking about it for now We would probably take out a mortgage on it so that too much of our money wasn’t tied up into rental real estate, especially considering the somewhat low rates that are out there right now.

These are all excellent considerations to understand when buying properties. I have actually encountered every one of them in my history of investing in properties. I think it is important to understant that your perspective may change as you get older, risk adverse, and have built more wealth.

When you are younger, fearless, and risk taking: It is great if you can find the properties, do your own work on them, and manage them for maximum return. Put as little money down as possible, leveraging Other People’s Money (OPM), refinance later to use funds to buy the next property.

When you are older, do little or none of the work, and have cash reserves:

Continue to buy properties leveraging OPM. Aggressively pay of high interest notes and refinance when rates drop or you need cash. Have an entire team that manages your properties. Work toward paying them off so you have your passive income stream secure for life.

I have moved toward the last phase! 

Investment properties definitely seem like a fun way to invest your money into something you can actually touch and feel! My Mom is in real estate and has that same passion for investment properties that you do, she loves something tangible to be able to invest in.

Looking forward to buying our first rental property. When we do we\’d like to go the 15 year mortgage route and use a property manager. So you get the leverage, and avoid some of the landlord hassles.

Ideally, we\’d do periodic 1031 exchanges to grow into larger properties over time – house, duplex, complex. But we still have to take the first step…

We currently own a single family rental that we have a mortgage on. I just think it makes more sense when you are just starting out and don’t have a ton of cash floating around. Our tenants pay the whole mortgage and then some!

I like that you laid out the pros and cons of both choices and that you recognized that there’s not only 1 right answer for everyone. Thanks for sharing Greg!

If only I have enough money to pay cash for my future house, I would definitely paid it with cash. But I also want to make sure that I have extra money and have a solid emergency fund.

Owning a rental property is something that seriously interests me. We live in a city with quite a few universities as well, an airforce base which makes for an appealing market. My husband isn’t quite as keen though as we’ve had friend have tens of thousands of dollars worth of damage done because of renters and it’s just turned him off. Something we’re still considering for the future though

We are half and half. One we bought in cash, and the other has a mortgage. They are a lot more manageable now. At some point, we had 7 properties and they became a nightmare. Both are empty now, the stress level is so much less as the carrying costs are not bad. We can afford to wait for good tenants, hopefully. I don’t think l would want to own anymore. We are loving the option of just “packing up and go”. It’s especially annoying managing things from another continent :-).

Buying a property with cash anywhere here in Australia would take a LOT of cash. Too much to be practical for most folks.

I’ve dabbled in rental properties before and been burnt. I’m not sure I’m ready to give it another go anytime soon, but I have a couple of friends who love it as much as you do. So, maybe I was just unlucky. Twice.

I think leverage can be an amazing asset for turning real estate into an investment. But it can also be very restrictive. I think if I was buying a property with not too much required in the updates department I would put 20% down and pay that mortgage with the rental payments for the next 30 years. If I was buying a complete gut job, I’d consider cash because I have heard how restrictive the banks can be with those type of properties. Also depends on people’s personal feelings towards debt. Debt used to generate income would not bother me at all.

Buying property in cash is ideal, but I can’t afford or do it. So, that leaves me with mortgage. And, I think that there is potential here especially in long-term investment.

I live in Australia and that’s really only true if you insist on buying in the capital cities. We’re looking at investing in a regional town. The town has a depressed property market, but a very low vacancy rate and very low unemployment and lots of business and industries moving in. We’ve passed on two great properties with a guaranteed 4% return for the first couple of years (the renters are keen to stay and both take great care of their properties) because of the area they’re in – it’s a lower socio-economic area so the houses will only ever increase with the market. We’ve put an offer in on the stereotypical “worst house on the best street” – with about $2000 in materials and a few weekends of work we can increase its value by about $35,000, and then get about a 7% return through renting it out. The house is a foreclosure so we’re still waiting to hear from the bank. We only have normal, middle-class jobs but we can afford to pay it outright, which helps because, the shape it’s in, we’re not sure a bank would loan us the money! But the plan is to buy it outright and fix it up and then take out a mortgage to free up some cash for other investments. I don’t want to go too heavily into property; I want to diversify. My BIL owns more than a dozen homes in a regional town where both the rental market and property market have seriously declined; all heavily mortgaged, at least half of them are valued at less now than when he bought them, and he’s struggling to find renters. I would not be comfortable with that level of risk. I’d rather have some diversification.

I bought three rentals during the downturn, when the prices were great. Then I refinanced two years later and got the money out, so they ended up costing me absolutely nothing, and I can invest that money elsewhere. I don’t have a high cash flow, but in 30 years (when I’m 65) my tenants will have have bought me three houses! That’s going to be a great retirement!

Personally the mortgages are a great way to do it (and I couldn’t afford it otherwise), and I can make money at a higher rate than their interest. It’s not hard to manage once the auto payments are set up. The most important thing is to run the numbers before you buy so that you know the rent will be higher than your expenses each month.

These are some great considerations to make in regard to cash vs. mortgage rental property purchases. My wife and I are currently evaluating rental properties in our area. We’ll probably end up going the mortgage route to free up our cash flow, but the risk of a mortgage payment is definitely something that we’re concerned about.

A very timely post for us. We have been considering buying a rental property and I am leaning towards borrowing. My problem is it is a first for us and am still gun-shy pulling the trigger and committing to do it. I have nightmares about bad renter stories that make me wonder if I have the temperament to be a landlord.

I’d prefer using mortgage as well only because I have no funds to pay cash. Your investment strategy of letting other people pay for your properties is just brilliant and would work even for those with not much funds to invest in property.

thank you Greg for the clear explanation. Wondering if you could advise how /where to look at to buy investment properties.

Who cares if the rental property increases or decreases in value? Why would you ever sell it? To me, a rental property is like a cash cow — it keeps generating that cash flow month-after-month. Selling it (especially after it’s paid off) would be like killing the goose that laid the golden egg. Keep the goose!

So if I buy a home cash and rent it out. The amount I paid, can I deduct that as an expense?

That’s probably a question for an accountant or lawyer, but in my experience no. You can not write off the purchase as an “expense” because that forms the “basis” in the property. However, you should write off the depreciation over 27.5 years. Certain closing costs may also be deductible as expenses. But again, check with your accountant/attorney.

Do you have any experience in owner finance properties or done any comparisons? I know it depends on the market as to if too many of these are available but we stumbled upon a few investment properties we owner financed from someone. We flipped one and owner financed out the other one since it was in too bad of shape to fix to flip or rent. We have now sold that property 3 times. Taking it back each time after default was not fun but each time produced a down payment which ads to your cash flow and the payments each month were made through an escrow company and were profit. We loved the flexibility to do payments, interest and terms we drew up. We have always wanted to do rentals and after this happening, we are thinking about trying to acquire more through this process we stumbled on since it requires no maintenance or responsibility like a rental and the income is still there. Long-term you would lose the money if they do indeed pay off the property but the income now and the fact that there is no loan might give you cash flow to get into more properties- at least that is what were are thinking. Any ideas/expertise in this? (We do think if it defaults again we might just rent it and keep it since every owner has fixed it up a bit and it is in much better shape then when we got it.)

Buy a rental property using a mortgage or cash?

In real estate, deciding which method is better has turned into an infamous debate. In a nutshell, some investors argue that using cash is a great way to avoid debt and interest, while others argue that there’s no point in putting all your cash into something that tenants will end up paying for. Well, both ways are valid; both have solid arguments. To help you decide which method is best for you to buy a rental property, we list the pros and cons for you below.

Pros and Cons for Using Cash to Buy a Rental Property

Using cash to buy a rental property comes with a nice set of pros:

Cash real estate investors are able to benefit from closing deals much faster than those using a mortgage because they do not have to wait for the bank’s procedure. Instead, they’ll close the deal as soon as the home inspection is done.

2. More options to choose from

Cash investors have more options to finding deals. All cash investors do not need any real estate financingcontingencies, so they’re usually more attractive for eager sellers, who put out deals and want to close as soon as possible. Those eager sellers are less willing to give financing contingencies for the mortgage type investors that might delay or disrupt the deal if the lender does not approve the loan.

3. Almost all revenue (rent) is profit

If you’re a cash investor, then you have no mortgage payments and no interest to pay. Typically, the largest expense for a property is its mortgage. It’s not uncommon that almost 70% of the property’s revenue goes towards the mortgage payment. But, when you don’t have mortgage or interest to worry about, you’re able to enjoy all the revenue from the rental property as profit.

With that being said, using cash to buy a rental property still has some cons that you need to know about:

1. Your own capital is at risk

When you’re using cash, you are using your own capital. Putting your own capital at risk in an investment property, especially if you don’t have more than you need, is generally riskier if you have other options.

By using cash, you are basically tying up your own money in an investment property. Every year that money that sits there, tied up in the home, can actually buy you a different asset that might pay you interest and create a growing balance.

3. Can’t take advantage of mortgage interest tax deduction

When you’re using cash to buy a rental property, all of the income is taxable (minus expenses) and you are unable to benefit from the rental property tax reduction that come legally with using a mortgage.

Pros and Cons for Using Mortgage to Buy a Rental Property

Here’s another nice set of pros, but this time for using the mortgage method:

Perhaps the best part about using the mortgage method is that it allows you to buy more properties. With more properties, your cash flow, equity pay down, and tax benefits all increase as well. And with more properties, you also have more diversification. If you have more than one property, then you are less affected when one of them is hurt for some reason (neighborhood changes, storms changes, etc.)

2. Renters pay off mortgage for you

Yes, the mortgage payment is largest portion of expenses as stated before. But, if done smartly, your tenants easily pay off the mortgage for you. You are able to adjust the rent prices to pay off the mortgage payments and keep an additional profit.

3. You can take advantage of mortgage interest tax deduction

Rental properties have many tax benefits. For instance, the IRS allows you to depreciate a percentage of your rental properties every year and write that off as an expense. If you have more than one rental property, your tax deductions increase as well. So, let’s say you have two rental properties, then your tax deduction is double!

And along with the nice set of pros, comes the not-so-nice set of cons to using mortgage to buy a rental property:

1. Banks may not be too willing to help

You might have a rough time before finding a loan. Banks are often more willing to lend money to homeowners, rather than real estate investors because there is less risk involved in these deals.

2. Risk of exposure to foreclosure

When you’re not using your own money to buy a rental property, you have the risk of foreclosure, in which a lender attempts to recover the balance of a loan from a borrower, who has stopped making payments to the lender, by forcing the sale of the asset used as the collateral for the loan.

When you’re using the mortgage method to buy a rental property, you have less flexibility in regards to vacancies. Since you rely on the tenants to pay off the mortgage, you’re less able to keep the property vacant until the right renter comes along or until you make needed repairs.

Shall we we answer—cash or mortgage? Well, we choose not to take sides in this heated debate. Instead you should decide for yourself which method is best to use to buy your next rental property. Ultimately, both methods have come with a set of advantages and disadvantages. You just need to choose what is best for you given your resources!

Start checking where you can buy your next rental property at Mashvisor. You can also see how your returns are affected if using a mortgage or cash.

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