Summary: In this article, we will provide the top eight reasons for why you should finance your investment property. Topics include financing with fixed-rate loans versus adjustable-rate mortgages; how inflation eats up mortgage debt; keeping liquid assets in the bank; using leverage through financing for higher returns and positive cash flow; taking advantage of investment property tax breaks; flexibility to buy multiple properties; and financing a property to lower risk and diversify your investment portfolio.
Here at RealWealth, we are big fans of using financing to buy investment property. We have found so many advantages to financing income property, that we decided to narrow down our top eight reasons we like investment property financing.
Just because you can afford to put a big chunk of money toward a real estate investment, doesn’t mean it’s the smartest strategy. Debt has become almost a bad word (thanks Dave Ramsey). So when investors are eager to throw a bunch of money into one property, to either avoid mortgage debt or simply because they can, I’d suggest reconsidering for the following eight reasons.
Reason #1 – To Take Advantage of Fixed-Rate Loans
A fixed-rate loan is a loan that has the same rate for the life of the loan. If you choose to borrow from a mortgage company, in most cases, we think the best way to finance your investment property is with a 30-year fixed-rate loan. That’s because the interest rate never changes regardless of what happens in the market.
Key takeaways on using fixed-rate loans to finance your investment property…
- If your loan payments are $500 per month today, they will still be $500 per month in 10 years.
- As a 30-year fixed-rate loan is long-term, the payments each month will be less than a shorter-term loan, which helps with positive cash flow.
- Fixed-rate loans can be total wealth builders for real estate investors, due in large part to inflation. (Which leads us to reason #2…)
Adjustable-Rate Mortgages (ARMs) Versus Fixed-Rate Loans
An adjustable rate mortgage (ARM) or loan is where the rate of interest is adjusted periodically to reflect market conditions. The interest on an ARM is directly tied to a specific index in the stock market.
Generally, ARMs tend to go up. While there is a possibility your interest rate may go down, this typically happens as a result of a real estate market dip, which is good for your interest rate but bad for your investment property appreciation.
The good news is, initial interest rates are usually lower on an ARM than a fixed-rate loan. If you are not able to get a fixed-rate loan for less than 8.5 percent, an adjustable-rate loan may be a good option, suggests Fettke. After a few years, you may be able to refinance your loan and get a better interest rate on a fixed-rate mortgage.
ARMs are also a great choice for shorter-term investments, if you plan to sell your property within the timeframe of the loan, typically 2, 3 and 5 year terms respectively.’
Key takeaways on using adjustable-rate mortgages to finance your investment property…
- Interest rate changes according to market conditions.
- Interest rates on ARMs generally start out lower than fixed-rate loans.
- ARMs are a good option for investors unable to get a fixed-rate loan for less than 8.5%.
- ARMs work best for short-term investments (2, 3, and 5 year loan timeframes).
- Option to refinance from an ARM to a fixed-rate loan when interest rates are better.
Fixed-rate loans and adjustable-rate mortgages are not the only options for financing investment property. Many investors have found success through creative financing, like hybrid loans or HELOCs (Home Equity Line of Credit).
Reason #2 – Inflation Kills Mortgage Debt
Inflation is actually a good thing for real estate investors. That’s because inflation mostly drives up prices on items that people really need or want. There will always be a demand for places to live.
Past trends show that the value of real estate has increased consistently alongside inflation, and sometimes exceeding it. Home values will appreciate at 1.5 times the rate of inflation or more.
Another positive aspect of rising inflation rates is that rents also rise. Investment property owners should see their rental income increase every year with inflation. This is the “passive” part of real estate investing, where rising inflation gives property owners an automatic pay raise every year, for doing absolutely nothing.
Consider the following example:
- Imagine inflation eating up your cash and equity in your home.
- Now imagine that same inflation beast eating away your debt.
- A dollar will be worth more in 15 years than it is today.
- Thus, the debt from your mortgage will be far less, due to inflation.
- In other words, your loan will get cheaper as time goes on.
Kathy Fettke explains why people who buy-and-hold real estate long-term are able to achieve real wealth. “Inflation eats away debt, while asset values increase along with annual income from higher rents,” shares Fettke.
Key Takeaways on financing your investment property to kill mortgage debt…
- Historically, real estate values consistently rise with inflation.
- Home values will appreciate at 1.5 times the rate of inflation or more.
- Rents also rise along with inflation.
- Rising inflation gives real estate investors an automatic pay raise every year, simply for owning property.
Reason #3 – To Keep More Liquid Assets in the Bank
Financing your investment property requires less money upfront. Meaning, you tie up less money in one asset.
Draining your savings in order to buy a property without financing can be risky. In fact, one of the biggest pitfalls for real estate investors is not having enough cash reserves in the bank to cover repairs or expenses.
Investments like stocks or bonds are considered liquid assets because you can pull your money out at any time. Real estate, on the other hand, is an illiquid asset. It’s not quick, easy or free to sell and get your cash back.
Taking out a mortgage to finance your investment property will leave you with more money in the bank, and more flexibility to invest that money into another property or somewhere else.
And if you find yourself low on cash, many investors will do a cash-out refinance, and take money out from the equity in the property. But that’s sort of irrelevant with the topic of our article because you’ll avoid this problem if you finance your investment property in the first place.
Key takeaways on financing investment property to keep more liquid assets in the bank…
- Less money upfront = less risk
- Less money in one asset = diversification
- More money in the bank
- Flexibility to invest money elsewhere
Reason #4 – For Higher Return Potential Using Leverage
It’s a common misconception that you have to be rich in order to buy real estate. Financing an investment property makes it possible for people to invest, even if they don’t have a ton of capital.
It’s definitely easier to throw down a bag of cash purchase a rental property. You will avoid the entire mortgage process, which can be time-consuming and include lender fees, closing costs, etc. However, investors will likely see much higher returns if they opt to use financing to buy real estate. Here’s why: leverage.
How Leverage in Finance Works
In finance, leverage is a general term for any technique to multiply gains and potential losses. Most often it involves buying an asset using borrowed funds, with the belief that the income from the asset will be more than the cost of borrowing.
Example of Loan Leverage
In Retire Rich with Rentals, Fettke shares a simple example to help explain the power of leverage through financing.
Kathy Fettke, Retire Rich with Rentals, 2014.
“Joe wants to buy an investment property valued at $100,000.
He only has $20,000 in savings so he gets a 30-year fixed-rate
loan for $80,000 and uses his savings as the down payment.
Let’s say his monthly loan payments are about $400 per month
(30-year fixed-rate mortgage at 5%). That’s $400 in today’s
money. But with the standard rate of inflation, those loan payments
might feel like $150 per month in ten years, based on
what the dollar may be worth at that time.
Plus, the property Joe bought in 2015 for $100,000 could easily
be worth $150,000 in 2025 simply due to a 4% annual inflation
During that time period, Joe’s $80,000 loan would now be paid
down to $60,000. But he didn’t have to pay this $20,000 himself.
He used money from the rental income to do it.
Plus, after all the expenses of property taxes, insurance, and
management, Joe still gets about $300 in left over cash flow
from rents (assuming a $1000 rental income minus the $400
mortgage and $300 in expenses.)
If he set aside that $300, he’d have an additional $36,000 from
cash flow alone after 10 years.
In summary, Joe could have made $106,000 on his $20,000
investment ($50,000 in equity, $36,000 in cash flow and $20,000
in loan pay-off).
Where else can you get a passive return like that?“
Key takeaways on using leverage to finance your investment property for higher returns…
- With financing, you don’t have to be rich to invest in real estate.
- Leverage is buying an asset using borrowed funds, with the belief that the income from the investment will be more than the cost of borrowing.
- The less cash you invest into a property, the higher your leverage and potential return, due to value appreciation and/or rental income.
- The more cash you invest, (little or no financing) the lower your potential return.
- A property with high appreciation potential will significantly increase the return on your leveraged investment.
To learn more about the power of leverage in real estate and how to use it, check out our article and video.
Reason #5 – For Increased Cash Flow Potential
Cash flow refers to the amount of money you have coming in versus the amount of money going out each month. If you have more money coming in from your income property than going out, this is positive cash flow. Negative cash flow is the opposite, where you’re losing money on an investment every month.
By paying cash for an investment property, the cash on cash return will be the same as its cap rate or capitalization rate. Putting less of your own money toward an investment property and using financing to supplement the rest, will produce a different cash on cash return, which can generate higher cash flow.
Taking out a mortgage on an investment property should cover your entire monthly mortgage payment, plus some. A successful real estate investment produces enough income to cover your entire mortgage and produce positive monthly cash flow. It’s much easier to create cash flow on a property through financing.
Key takeaways on increasing your investment property cash flow potential through financing…
- Positive cash flow is more money coming in from investment property than going out.
- Financing has the potential to generate higher cash flow.
- Fixed-rate loans help with positive cash flow.
Reason #6 – To Take Advantage of Investment Property Tax Breaks
Most people aren’t aware that owning an investment property comes with better tax advantages than a primary residence. Any repairs made on your primary residence are not tax deductible.
With income properties, you are allowed to deduct most expenses related to the property. Rental property owners can write off mortgage interest, property taxes, repairs, maintenance, and travel. Investment property owners are allowed to deduct mortgage interest on the first $750,000 on both first and second homes. This tax deduction may be extra useful for retired individuals who don’t have a lot of options to reduce their taxable income (i.e. 401k contributions).
You can also deduct and cost of doing business. For instance, the cost of a property management company, may be deducted on your tax return. This is essentially free money at the end of the fiscal year.
Key takeaways on income property tax advantages…
- Investment properties have better tax benefits than primary residences.
- Can deduct most expenses on your taxes related to your income property.
- Qualified tax-deductible expenses include: mortgage interest, property taxes, repairs, maintenance, travel to and from rental, and property management fees, etc.
- Can deduct mortgage interest up to $750,000 on first and second homes.
Investor Tip: tax laws can change at any time, so make sure you stay up-to-date on current tax laws.
For more information on qualified income property tax deductions, check out another article here.
Reason #7 – To Buy Multiple Investment Properties
Did you know that Fannie Mae allows investors to have up to 10 rental property mortgages at a time? (If you are bored, check out their mortgage underwriting requirements here.)
Carrying multiple mortgages on multiple investment properties can present its own set of challenges. I would suggest taking the time to do some due diligence in order to find the right lender for you. Good lenders can help strategize your short-term and long-term investment plan, while making sure you are maximizing all 10 of your loans.
I should add that several lenders (usually larger banks) will only lend real estate investors up to four loans at a time. Again, finding the right lender and securing the right financing will literally make or break your investments.
Key takeaways on financing to buy multiple properties…
- Some lenders, like Fannie Mae, offer investors up to 10 rental property mortgages at a time.
- Some lenders, like larger banks will only lend up to four loans at a time.
- Finding the right lender and the right financing can be the difference between a successful real estate investment and a failed one.
Reason #8 – To Lower Risk and Diversify Your Portfolio
Any type of investment has a certain level of risk, including real estate. While there is always a risk of foreclosure if you take out a mortgage on a property and are unable to make your monthly payments, there’s less risk because there’s less of your money on the line. Even if your property starts depreciating, you should have enough cash reserves to cover the mortgage, and hold onto the investment long-term or until it starts appreciating again.
On the flip side, choosing not to finance an investment property, i.e. pay in cash, there will inherently be more risk involved. If you put a huge amount of your capital into one asset, in our case a property, and that property begins to depreciate, there’s a good chance your investment will suffer.
Key takeaways on financing your investment property to lower your risk…
- All investments carry some risk.
- A mortgage lowers the risk on a depreciating property because there is less capital invested.
- A mortgage allows you to keep more cash reserves on-hand.
- Financing frees us money for savings or other investments, creating a low-risk diversified or balanced portfolio.
This concludes our top eight reasons to finance your investment property. If you’re new to real estate investing, financing might seem like a long and complicated process. But finding a great lender, who is willing to help with your strategy and provide the best options for financing investment property, should make all the difference.
For more information and resources on financing investment property, join our Network today (it’s free!) and receive personalized financing strategies and advice from one of our pro investment counselors.
Fettke, Kathy. 2014. Retire Rich with Rentals.