I’d say one of the most famous debates that comes up on this website is the one about paying all cash for a property versus leveraging a property.
And by famous I mean, it gets ugly.
The heart of the debate seems to center around the difference in risk in buying a property using all cash or buying a property using leveraging. Those who leverage their properties boast that the benefit of doing so allows the investor to buy more properties with the same amount of money. Those who pay cash come back against that argument saying how risky leveraging is and that the risk isn’t worth it, even if it does get you more properties. From what I can tell, this point in the debate seems to always be the point of impasse between the sides. Being able to buy more properties by using leverage is an indisputable fact. Leveraging inducing more risk seems indisputable. So then, everyone stops debating at that point and goes about their merry ways.
I think this is the wrong place for the impasse. Being able to buy more properties using leverage, yes, that is correct. But leveraging being riskier?
For any newbies out there, “leveraging” refers to using ‘someone else’s money’ to buy something. That can include loans from a bank, loans from an individual, financing on a credit card, borrowing money, etc.
For the purpose of what we are talking about here, I’m going to stick with referring mostly to mortgages. A mortgage isn’t the only way to finance a property but it’s the primary one and a lot easier and more common than other methods. For the purpose of this article, I’m thinking mostly about mortgages because I want to look at long-term loans rather than short-term (just trying to keep it simple).
What is Risky about Leveraging?
Obviously there are factors involved with leveraging that are cause for concern. There may be others, but for the most part, the following issues are the things that should be looked at in terms of risk associated with getting a loan for a property:
- Cost. A huge concern with leveraging anything is that inevitably you will be charged interest which will make your actual cost significantly higher than the original purchase price. That extra cost can end up being quite substantial depending on the terms of the loan.
- Losing what you put into it. Let’s say you buy a house for you and your family. You get a 30-year mortgage on the property. You do great with the house until year 20 when you unexpectedly lose your job. You can’t find a job quickly and you don’t have much in savings (and even if you do, having no income can suck all of that up painfully quick), so suddenly you can’t pay the mortgage. The bank who you have the mortgage with takes your house from you. So for 20 years, you paid a huge amount of principle on the house, you paid a ton in interest, and who knows how much in miscellaneous expenses for the house, and now you have no house. You don’t get any of that 20-years’ worth of money back and you have no house either. Oh, and your credit is in shambles.
- Losing other assets in addition to that one. If you have a mortgage on a house that you lose, unless you have a non-recourse loan you are at risk for the bank taking away other assets that you own, in addition to the house with the mortgage, in order to pay for the loss. Luckily most mortgages now are non-recourse, meaning the only thing they are allowed to take is that particular piece of property and nothing else of yours, so that helps but recourse loans do still exist.
- Type of loan. Speaking of loan terms, let’s say you don’t lose your job but instead the payment on your mortgage goes up dramatically. This can happen with an adjustable-rate mortgage. If you have a fixed-rate mortgage you are locked in at the same interest rate for the entire length of the loan. If you have an adjustable-rate mortgage, after a set number of years the interest rate on your loan will change. It will change to match the current going market interest rate (with some restrictions), which could be much higher than what you originally signed up for. If you were to buy a house for yourself today, you might be able to get a loan with a 2.5% interest rate (primary homebuyers, not investors). What if with the real estate market booming like it is right now, the interest rates in five years jump to 8%? Don’t laugh, it can happen. Remember in the 1980s when interest rates hit 18-19%? Regardless, the difference in monthly payments may be enough to force you to not be able to pay and you could lose the house.
Well that all officially sounds pretty miserable, I must admit. If those were the only sides of the story, I too would only buy with cash. However, investment properties can work slightly differently than a primary home and when an investment property is bought correctly, a lot of those risks can disappear completely. I would even argue that they disappear enough to justify saying that buying a property with leverage is less risky than buying with cash.
Mitigations for the Risks
- Cost. As long as your mortgage payment (which includes the interest payment) is well-covered by the monthly rent collected for the property, you aren’t paying this extra cost out of your own pocket. Yes, you are less that money you pay out in interest but if you actually run the cash-on-cash return of a property that you finance versus that of buying with all cash, the returns are usually significantly higher so you still make more money than if you bought with all cash and avoided the interest payment.
- Losing what you put into it. Same scenario as before: after 20 years of owning a property, something drastic happens and you can’t make the mortgage payment anymore and you lose the house to the bank. If you are an investor and bought smart and the property made you money for the entire time you owned it, even if the bank runs in and takes it out from under you, the only thing that will take a negative hit is your credit score. All you put into the house originally was the down payment and some closing costs, and after that, the tenants essentially paid all of your expenses in the form of giving you rent every month. Okay, so actual worst case scenario you lose what you paid for the down payment and your credit score. That’s assuming the money you made on the house didn’t pay you back the money you put down because it likely did. So then it really is just back to your credit score. This mitigation is of huge consideration when buying an investment property versus a home for yourself. This mitigation flat doesn’t exist if the house is yours because you aren’t collecting income on it along the way and it remains a major risk. (Just in case you are wondering if you should finance a house for yourself anytime soon…)
- Losing other assets in addition to that one. Never get a loan that isn’t non-recourse. For a mortgage, this shouldn’t be a problem but always make sure that is written in there. Then the only thing you could lose is that property and none of your other assets.
- Type of loan. Never get an adjustable-rate mortgage, always get a fixed-rate. With the fixed-rate interest included, your payment should be well-covered by the rent collected on the property. So then you have some wiggle room in case of changing rents, but you don’t have to worry about drastic changes to your mortgage expense.
So assuming you know how to properly buy a rental property, the only official risk in leveraging a rental property versus paying all cash for it is a potential bash to your credit score should something go totally wrong, no? What else?
Let’s break this down…
An Example of Paying Cash or Leveraging
You set your sights on a rental property that you are interested in buying. The purchase price is $105,000 and it brings in $1,150/month in rent. The total monthly expenses (including estimates for vacancy and repairs) are $376, so you will then bring home $774/month in profit. For an all cash buy on this property, you will be looking at a cash-on-cash return of 8.84%.
Now let’s say you finance the same property instead of paying all cash. If you get a fixed-rate 30-year mortgage at 5% interest, you’re monthly mortgage payment will be $450.93. Add that to your monthly expenses and you will bring home $323.07 each month. It sounds like a lot less than the $774 from the all cash buy, but remember, instead of putting $105,000 of your own money into this, you only put $25,000 or so in. So your cash-on-cash return actually ends up being much higher. In this case, 14.77% to be exact. That’s just under double the returns you would earn for paying all cash.
Okay, so you know the numbers now. What happens if for some ungodly reason this property goes completely bunk? You know it hasn’t gone bunk because of an adjustable-rate mortgage because you bought a fixed-rate. So clearly the apocalypse must have occurred in your neighborhood to make the property go bunk. So now you can’t get tenants ever again and you didn’t have an apocalypse clause in your insurance policy so you can’t get that money either. The house is done.
For both scenarios, let’s look at what is lost:
- If you paid all cash for the property, you are out $105,000 cash (less what profits you made along the way).
- If you had a mortgage on the property, you are out $25,000 cash (less what profits you made along the way) and your credit score/ability because you had to foreclose.
Which are you more comfortable with? For me personally, I’d rather lose my credit score all day long than an extra $80,000 out of my pocket. But maybe you’re obsessed with your credit score and would rather lose $80,000 in order to keep it high. To each their own.
Back to the Debate
So what’s the verdict?
The way I see it, if I use leveraging I can buy a property for 1/5th of the cost of paying all cash, my returns are higher, my tax benefits are substantially higher, and I’m more covered for vacancy and repair issues because having more houses can cover those expenses as they come. Then, if all goes south, I only lose 1/5th of what I would have had I paid all cash. Doesn’t that essentially mean my risk is only 1/5th of what it would be if I used all of my own money? The only major difference is the risk to my credit score. Not sure how to weigh that into this, but to me the risk of losing my credit score is literally the only big risk I see. I’m not risking near as much of my own money as I would if I paid all cash. Which is more important, money or credit score? And that’s assuming something even goes that drastically wrong with the rental property in the first place to cause the whole thing to go under.
What if the value of your property drops significantly and now you owe more on the mortgage than what the house is worse? Easy. The value of your property doesn’t matter unless you are trying to sell it. Being underwater on a house affects you zero if you aren’t trying to sell. So that’s no argument.
What if you are forced to sell though and it’s underwater from what you owe? If you don’t have the money to make up the difference, you just foreclose and you only lose your credit score. If you had paid all cash, you’re going to lose the full difference between the sale price and what you bought it for. That could be tens of thousands.
So? What’s the scoop. What’s the big risk with leveraging that I’m missing? Oh, and happy New Year!Is Leveraging Really That Risky? by Ali Boone