Better to Finance Rental Properties or Buy Outright?

2 May

Somebody recently asked, “Wouldn’t you be better off saving up and paying for your rentals in cash?” Conventional wisdom says there’s power in leveraging, but I couldn’t say I had run the numbers to prove it.

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(photo by 401(K) 2012)

Let’s say we’re an ambitious investor with $4,000/month in disposable income. The goal is to eventually live off our rental income, which means a minimum of $5,000 net a month or 5 paid-off properties.

We’ll use the same assumptions:

  • $160,000 purchase price per property
  • $40,000 down payment per property (25%)
  • Financed with 30-year fixed loans at 4.5% interest
  • $400/mo. in positive cash flow per financed property
  • $1,008/mo. in positive cash flow per paid off property

Option 1: Purchase with Cash
By paying in full, the first property takes just over three years to acquire. Each purchase adds $1,008 in additional cash flow, accelerating the savings rate.

  • Month 40 – Purchase Property 1
  • Month 72 – Purchase Property 2
  • Month 99 – Purchase Property 3
  • Month 121 – Purchase Property 4
  • Month 142 – Purchase Property 5

Total Time: 11.8 years

Option 2: Finance with 25% Down Payment & Pay Off
Each property provides an additional $400/month. Since we only need a $40k down payment, the 5 properties are acquired in about a third of the time.

  • Month 10 – Purchase Property 1
  • Month 20 – Purchase Property 2
  • Month 28 – Purchase Property 3
  • Month 36 – Purchase Property 4
  • Month 43 – Purchase Property 5

We now have $6000 a month to put towards the first mortgage (original $4000 + $400 cash flow * 5 properties). We’ll pay them off from newest to oldest; the most recent purchase is paying the most interest because it isn’t as far along in the amortization schedule. Each paid off property frees another $608 a month.

  • Month 62 – Pay Off Property 5
  • Month 78 – Pay Off Property 4
  • Month 93 – Pay Off Property 3
  • Month 106 – Pay Off Property 2
  • Month 118 – Pay Off Property 1

Total Time: 9.8 years (3.6 years to purchase, 6.2 years to pay off)

Option 3: Finance with 25% Down Payment without Paying Off
If we aren’t concerned about mortgage debt, we could also reach our income goal with the cash flow from 13 financed properties ($400 * 13 = $5,200).

  • Month 10 – Purchase Property 1
  • Month 20 – Purchase Property 2
  • Month 28 – Purchase Property 3
  • Month 36 – Purchase Property 4
  • Month 43 – Purchase Property 5
  • Month 50 – Purchase Property 6
  • Month 56 – Purchase Property 7
  • Month 62 – Purchase Property 8
  • Month 67 – Purchase Property 9
  • Month 73 – Purchase Property 10
  • Month 78 – Purchase Property 11
  • Month 83 – Purchase Property 12
  • Month 87 – Purchase Property 13

Total Time: 7.3 years

Epilogue – Is it Better to Get a Mortgage or Pay Cash?
It ultimately depends on what “better” means to you. These calculations have an emphasis on timeline, but perhaps net worth, cash flow, overall return, risk aversion, or the momentum of making progress is more important.

Also, it’s worth noting that you would get different results if there wasn’t positive cash flow when financed – at least enough to offset the mortgages’ interest.

Finally, please don’t get stuck by the exact numbers in my example. The lessons of this post are relative – regardless of how much you can invest, your rental market, or what happens to interest rates.

If you want to input your own variables, I’ve consolidated these calculations in an Excel spreadsheet – which can be downloaded here.

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2 Responses to “Better to Finance Rental Properties or Buy Outright?”

  1. Eric July 6, 2014 at 4:08 pm #

    Of course each person’s investment goals are different but agree with your findings – if you want to maximize return, use the power of leverage, and make payments over time. Your cash flow might suffer, but over time equity will kick in. On the other hand, if you want guaranteed high monthly income, pay off the property in cash, and you will maximize your cash flow.

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