Mortgage or no Mortgage?

Question

I'm looking at the different advantages of purchasing properties cash vs mortgage. Obviously I like the lack of risk with purchasing cash but I also like the leverage of purchasing with a mortgage. IE buying 5 50k properties vs buying 1 with 50k cash.

What are your thoughts on the risks vs rewards? Which do you prefer and why?

I will probably have $50-$75k saved up in the next 6 months, I want to go the best route and that's what I'm still figuring out.

Kim Smith · Answer

It’s logical to think that buying a home with cash or sinking as much cash as possible into your home to avoid the massive debt associated with a mortgage, is the smartest choice for your financial health.

Marylynn Caruso · Answer

I just can't wrap my head around the fees the banks and state government are getting for mortgages.  I just got off the phone with a bank I wanted to have a relationship with.  The list of fees was about 5% of my purchase price!  It seems like every time the government wants to sneak a tax in, it is in a RE transaction!  Can anyone chime in and tell me your thoughts on this subject?  I just assume pay cash and do my own due diligence but as a "Professional" I want a relationship with a bank.

Juan Diaz · Answer

It depends on the situation. Some deals will have better ROI than others, but it's all about that margin. If your margin is big enough, go with leverage, because you'll be maximizing your profit.

Here's how I laid it out in one of my audiobooks:

Whatever your financial situation is, I would highly encourage you to use the financing available to you! Using financing allows you to leverage yourself, and spread your money further. I’ll give you a little example of how this works. Now, imagine that you’ve got $150,000 to invest in flipping. You’re excited, you’ve just found a house for $100,000 that needs $50,000 in repairs. After putting in your $150,000 in cash, you’re going to be making a profit of $30,000 in three months. That sounds pretty good, right? You’ve just gotten a 20% return in three months.

But wait. What if you found two houses just like that? Here’s what loans allow you to do. With a loan, you can buy these two identical houses for $20,000 down. You’re in a total of $40,000 now, and you’ve got $100,000 in collective repairs to do, so at the end of the day, you’re $140,000 into the deal. Now, you’ve had to make mortgage payments during these three months, about $1000 each month, so you’re at $143,000 invested. Now, you go to sell the houses. Before you cleared $30,000 profit for one house, with $150,000 invested. Now, because of origination fees and early payment penalties, you’ll probably have to pay about $4,000 as the cost of your loan. But you’ve just sold the houses, and the total return is in: you’ve made $56,000 on an initial investment of $143,000 in three months. You just transformed your return from 20% to 39%, without bringing in any additional money of your own. That’s the power of leverage.

39% isn’t bad is it? Well, how would you feel if I told you that you could make the return go even higher? Let’s go back to the example that I gave above. You’ve got that $100,000 house that you’ll put $50,000 into to clear $30,000 in profit. You went from using money only to using a mortgage. That allowed you to process two houses simultaneously. What if I told you that there was a way to process SIX houses simultaneously for your exact same investment?

Six you say? How in the world can you process six houses using the same amount of money that could process only one before? The answer’s pretty simple: more leverage. In this case, you would apply for a conventional mortgage, and you would also apply for a construction loan. Construction loans are loans that have a floating rate slightly above the prime mortgage rate that’s set by the market. These loans sometimes require no down payment, and are interest-only loans with payment due upon completion of work. If you’re able to get both a conventional mortgage as well as a construction loan from your bank, your investment in each house would look like this for a three-month flip:

$1,500 for construction loan interest payments$20,000 for the down payment$3,000 for interest on the mortgage

And you will have just invested $24,500 for the privilege of flipping one house. Your profit on each house is now going to be reduced slightly from the original $30,000 to $27,000. Multiply these numbers by six, and if you brought $150,000 ready to invest and took out these loans, you just invested $147,000 for a profit of $162,000. In three months. That’s a 110% return on your investment in three months. That is the power of leverage—you just multiplied your return on investment more than five times by using the loans and monies available to you.

The Downside of LeverageWhile leverage can do amazing things to multiply your profit, it can also have the opposite effect. Have you heard the saying, power isn’t inherently good or evil, it depends on how it’s used? The same principle applies to leverage. Leverage isn’t inherently a profit maximizer or a loss maximizer. All that leverage does is magnify the results of your profit or loss.

That’s where the downsides of leverage come in. Let’s say that you go through the scenario listed above. You’ve got $147,000 invested into those houses, but let’s say that you had decided to go ahead and pull a little bit from your rainy day fund to invest in housing. Because hey, the opportunity looks fantastic. Now, three months into things, you’ve got all your houses repaired and on the market. You thought that they would have sold by now, but the market’s a little softer than you thought. You’ve invested $171,500, which you were expecting, but now more interest payments are coming up. Next month, you’ll have to cough up $10,500 to cover the costs of your construction loans and mortgage.

What can you do in this scenario? You’ve already dipped into your rainy day fund, and none of your houses look like they will close anytime soon. This is the classic scenario for overleverage. This is what led us to the financial crisis of 2008. If you don’t strike the proper-balance between risk-taking and precaution, you can find yourself facing obligations that you’re unable to pay. As you look at your loan options in flipping, watch out for overleveraging yourself.

Overleverage is almost always accidental, and comes when you least expect it. In flipping overleveraging can occur in a variety of ways. For example, say that you flip the houses in the example above. You’ve got six houses, and instead of $50,000 in rehab expenses for each house, you end up spending $60,000. That extra $10,000 is coming from your pocket, not from the construction loan. You’ve underestimated the costs on the house, and it’s coming back to bite you.

Underestimating the time it takes for a construction project is another common pitfall. I’ve flipped houses within a week and sold within a month, but there are other times that a three-month project ended up taking an entire year to complete work on. The timelines for construction can vary drastically.

Underestimating the time you have available goes hand-in-hand with underestimating the duration of a construction project. If you find that you need to be at a project twice as much as you thought you would have to be there, you may simply not have the available time to spend managing multiple simultaneous flips at once.

And lastly, the example that I began with was an example of a finished house that took longer to sell than you had planned on. Those are the four pitfalls when it comes to planning your flip. These pitfalls can come back to bite you in the butt if you’re overleveraged.

Daniel Mohnkern · Answer

I hear people mention that there is more risk when you are leveraging with mortgages. I don't see it that way.  I believe the majority of the risk is on the person who actually has cash in the game. Therefore, in a leveraged situation, the bank would have the most risk because they have the risk of actually losing their money. If you buy a house for all cash, then you are the only one that has risk because you are at risk for losing all of your money.  As for whether or not you should buy a house for all cash or with leverage, I think it would depend on a couple of things. Personally, I would leverage if I was growing and was expecting to buy more properties, but I would purchase with all cash if I was done purchasing and wanted the most cash flow. Leverage is great when you are accelerating. Cash is great when you want the most cash flow but do not want to increase the number of properties that you own.  So, all in all, it would depend on what your motive is. If you are looking to increase your number of properties; leverage, leverage, leverage. If you are looking to purchase one property and have the most cash flow possible, use cash.

Kim Smith · Answer

It’s logical to think that buying a home with cash or sinking as much cash as possible into your home to avoid the massive debt associated with a mortgage, is the smartest choice for your financial health.

Robart Luis · Answer

Paying cash for home eliminates the payment of interest which you pay on loan. It makes your purchase attractive to seller. But mortgage will also make sense. It helps you in the condition when you dont have enough money at a time. Mortgage  helps you to fulfill the dreams of home easily. So it clearly depends on your financial condition , if you can pay the cash and take care of future expenditure then go for that else take a mortgage.

Jerry Padilla · Answer

@Matt Cramer

You will have much more cash flow most likely by getting mortgages 1 house versus 5 with interest rates at only 4-5% these days on investments...... You can't beat the rates and terms in today's market.

Juan Diaz · Answer

@Matt Cramer

Same principles apply. Be careful with your rehab costs/budgeting, and be aware that renting a house still entails some amount of admin/upkeep work that you or your employee will have to do. It all comes down to how the numbers work out--if you work them carefully, take all expenses into consideration, and leave yourself at least a 10% buffer for unexpected costs, you should be in pretty good shape for wisely using your mortgages.

Watch out for over-estimating rental income, underestimating vacancy/occupancy rate, and CapEx that you'll have to spend on the house (for CapEx see:

http://www.biggerpockets.com/forums/52/topics/187693-depreciation-is-real---dont-get-caught-like-i-did)

Matt Cramer · Answer

@Juan Diaz

What about with buy and holds?

Chad Duval · Answer

Leverage, leverage, leverage...

Mortgage or no Mortgage?

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