Does a 40% Down Payment Ever Make Sense?
Hello everyone! My husband and I are investors and have 3 doors in Los Angeles - all LTR. We're interested in STRs, but given the current interest rates are nervous about having to keep an STR afloat if/when the property isn't performing well. We are considering putting 40% down with a conventional mortgage to ensure that we can make payments on a bad month... and wondering, does this ever make sense?
For some background, we'd be pulling this capital from a stock portfolio in which we are very over-invested in one industry, so my husband is eager to divest a good amount and put it in RE.
TIA for your thoughts and input!
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@Erin Hong, 40% down will help with getting a better rate as loan to value impacts the rate if all other details are equal. The middle mortgage FICO score will also impact the rate. If more than one person is on the loan, it will be the lower score of the two.
If you decide to go DSCR, below are some more factors. '
DSCR loans are based off of down payment, credit score and either actual or market rents so it helps to supercharge an investor's real estate goals and net worth.
Here's a bit more in detail about how rates are calculated for DSCR loans:
1. Credit score- the higher the best. 760+ generally gets best pricing for investment property loans with most lenders
2. Loan to value ratio: The higher the loan to value ratio (LTV) is, pricing takes a hit. So your pricing will be higher for a 80% LTV loan than for a 60% LTV loan.
3. Prepayment penalties- usually 1-5 year terms. The shorter the prepayment term has an impact on increasing the rate.
4. Are you cash flowing the property? Is your DSCR ratio greater than 1-meaning are you cash flowing. Many lenders will not do a DSCR loan unless cash flowing. If they will do a loan with less than 1, the pricing takes a hit.
I've included an example below to help illustrate this.
So different lenders have different rates (which do vary even for DSCR loans) but these are factors they all consider.
See example below:
DSCR < 1
Principal + Interest = $1,700
Taxes = $350, Insurance = $100, Association Dues = $50
Total PITIA = $2200
Rent = $2000
DSCR = Rent/PITIA = 2000/2200 = 0.91
Since the DSCR is 0.91, we know the expenses are greater than the income of the property.
DSCR >1
Principal + Interest = $1,500
Taxes = $250, Insurance = $100, Association Dues = $25
Total PITIA = $1875 Rent = $2300
DSCR = Rent/PITIA = 2300/1875 = 1.23
This property cash flows.
DSCR lenders generally let you vest either individually or as an LLC. It's a great way to increase your net worth and these loans can also be used to pull cash out of a property as it appreciates allowing you to reinvest money into new deals.
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I did a total of 50% down assuming that interest will drop in the next 5 years so I can refinance. I got a nonQM loan structured as below :
30% down, 4 years of monthly loan payment up front, 5 year term with 30 years amortization. interest locked in at 6.75% for the term.
It basically got me to approx 50% down in total, but I won't be paying loan payments on it for the next 4 years as I already did upfront and will have cashflow from the rental.
It was either this or the conventional way but the price was a steal and I wanted to get it before some other buy came in. Since its a nonQM they don't ask for any financials, and it only took 1 week to close after submitting application and appraisal was completed.
Erin,
Based on this market and the possibilities of a property value decline as a possible outcome. I would tell you put 15% down and save the rest. It would be much easier to use the other 25% cash reserves to help pay any mortgage payments if something should happen as a what if factor or use as a "Rainy Day Fund". You can also use a larger portion to buy the rate down to ensure a lower payment as long as you can calculate a burn rate where it helps recoup the costs within 24-36 months if it is a long term hold.
In most cases where I see buyers put 30-50% down they are trying to pull it back out in 2-3 years regardless. Maybe even consider buying two properties with that 405 so you can spread the money over (2) rentals. That will increase your passive income and add another property for future leverage/equity. Both of those options puts you in a better situation financially and leverage wise than total cash injection into one rental.
Kind of like the saying "Do not keep all your eggs in one basket" is one way to think about the risk/reward.
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Also if you think it the other way around, our next generation maybe surprise and asking the reverse question "oooh there was a day in America that they can put 15% down using other people money" LOL
I think by the time we accept 50% is new normal, it would be business as usual, it's just we're in the major transition time right now.
You pre-paid 4 years, but the interest will continue to accumulated until you make the next payment, I don't see the benefit.
Erin,
Everybody has added much value already. I don't think I can add any more in regards to the question.
However, I recently came upon this, and I think it might be useful for you if you're considering 40% down and have good cashflow from other properties - www.allinoneloan.com.
It's basically using a HELOC to pay down your mortgage faster. I have used this strategy myself. However, through this program you can get a HELOC on your primary at 7.25% (depending on a few factors of course), but everything is automated for your in regards to using a HELOC strategy. I'm considering this to purchase an investment property.
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Sure. Sometimes buying all cash makes sense. All depends on the deal, your situation and your goals/risk tolerance.
These days, borrowing 75% on an investment property is really hard given DSCR requirements that all these banks have.
Pulling from your stock portfolio, are you going to have significant tax cost relating to that. You'd have to factor that loss into your future gain.
My assumption is you are looking for something nearby to you in LA
As I am sure you are aware of that LA has restrictions to standard STR's, making it all but impossible to do. Unless you were looking elsewhere.
Airbnb is legal in Los Angeles. However, there are some regulations that hosts must follow:
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What type of rental are you looking at? House or condo etc?
Its really hard to make the numbers work as a house in LA
Ask why do you want STR - just better cashflow? You are not in the rental business anymore you are in the hospitality business and there is constant turnover, cleaning, managing and handling every few days or week etc. Do you have the extra time to do so.
All that being said, and you want and can buy a property in LA, and want better cashflow, Id skip STR and do MTR [Medium Term Rental]
We rent furnished units to nurses and traveling professionals from 3 to 6 months. Better cashflow than LTR and lots less headaches than STR.
It opens your options up, you do not need to buy a big house but a decent condo works fine or duplex etc.
Also less risk of being affected by any downturn and you are in compliance with housing rules etc.
If you're financially fit-- have reserves, have means to withstand some down times-- then do what makes you more at peace. If it's 40% or 25% or 20%.
I would say this is more of a behavior question not a math question.
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I would say you make a great case and justification for what your doing right there Erin.
You have some experience under the belt, have a desire to divest from one investment, a desire to enter another so capital is in active use, and taking actions to mitigate risk exposure. yeah, gold-star!
All the other stuff seems to be arguments of the finite details, and really getting off in the weeds. Look, your foundation is solid, your "why" is a dang good "why", all around, so I say go out there and stuff happen.
Yes
Erin,
Have you thought of converting 1/3 LTR into an STR/MTR to give it a try? Would that minimize the risk for you?
What does DSCR stand for?
remember one thing, cash is king in real estate. the more cash you have the more deals you can do. there is obviously risk with each new deal. but if you can handle the load, understand the risk, and scale correctly, i would spread my cash around as many deals as possible...
40% can make sense to keep leverage low. It just depends on your goals and resources.
- Ian Walsh
Higher Rates? Yes
Why do people use them? Here's why:
For regular financing, the more income you make (while your monthly debts stay the same), the more you can afford. Qualification is based on YOUR ability to generate income. Whether that's your job, or other properties, or your sneaker business.
DSCR loans are based on the ASSET'S ability to produce income, not you as a borrower.
Asset based vs Income based
- So, what happens when you make more income? You pay more in taxes.
- Why would folks use a loan with a higher rate (like a DSCR)? Well, they can keep their income low or the same, but they pay extra in interest every year.
- You, as an investor, have to ask yourself, "Does it make more sense to pay more in taxes so I can receive a lower rate? Or, does paying more in interest still amount to LESS than if I paid more in taxes to qualify?"
- The answer is different for everyone and different for every deal. You just have to make the comparison to see which option you pay less each year.
- Also, make sure the property still cash flows with a reasonable CoC return.
I know investors, including myself, that are doing deals today that are at higher rates because simply just increasing income may be more costly as a result of the tax burden.
Hello! Firstly, congratulations on your ventures in Los Angeles. Investing in real estate, especially in dynamic markets, requires a keen understanding and strategy.
Having been in this field for over 20 years, completing 4000 transactions as a broker-wholesaler and investor, I've gleaned some insights that might be valuable to you. My sweet spot, from experience, is ensuring that 70% of the current market rent covers the property's debt, uncommonly when projecting rent increases of 3-5% annually.
Regarding the down payment, a substantial sum offers a buffer concerning monthly obligations. However, the down payment size is sometimes the definitive predictor of an asset's long-term performance.
With your interest in short-term rentals (STRs), it's essential to understand the inherent volatility compared to long-term rentals (LTRs). While a considerable down payment minimizes your monthly mortgage commitment, it won't fully shield you from the STR market's fluctuations, especially in a place like Los Angeles.
I recommend conducting a rental stress test on potential properties. This would involve simulating various scenarios – such as diminished occupancy rates, unforeseen maintenance costs, or shifts in the tourism sector – to gauge the property's resilience.
Diversifying from being over-invested in one industry is commendable. The capital you're considering reallocating should be invested in a way that matches your risk appetite and overall investment objectives. If stability is a chief concern, think about dividing your investment between an increased down payment and retaining a segment as a safeguard for unforeseen expenses or vacancies.
Real estate is a delicate balance between strategy and numbers. All the best in your STR journey! Stress test your property; everything else will be fine!
- Jorge Vazquez
H Erin,
I am new to REI and currently trying to get as much education as I can. In regards to your question, I feel that if after the calculation (with that 40% down payment) and this property is still breaking even or even getting cash flow from it, you might want to consider going ahead with the offer! Afterwards, when the mortgage interest drops, you could always choose to refinance with those new terms.
Wish you all the best!
@Erin Hong
40% usually the minimum I put down
I won’t scale as high but when I put down 40 60 or 100% cash I have zero fear of what may happen to the market obviously ensuring I’m buying in a market that will grow and has a lot of people moving in the area for jobs
I’m strictly doing ltr’s but what scared me was friends and acquaintances that over stretched themselves and went short sale when the market crated over a few years
The more you put down the more you can weather the storm if/ when it hits
t’s all about doing a rental stress test on your property and on your reserves of cash. The percentage of a down payment doesn’t necessarily guarantee safety. It’s about assessing the potential of the asset relative to its liability. If the asset has significant potential compared to its liabilities, a smaller cash input may be sufficient, making the asset less marginal. So whether you put 20% or 0% as a down payment, the percentage alone doesn’t guarantee safety. Sometimes, having cash in the bank and buying power reserves can be more important than the down payment percentage. It’s about balancing potential and liquidity in your financial strategy.
- Jorge Vazquez