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Getting a Mortgage vs. Paying Cash for Investment Property: An Overview
The housing crash entirely restructured the American mortgage market. Part of that development has included tighter restrictions on obtaining mortgages, coupled with an abundance of newly available homes for sale. This, in turn, has allowed some investors to buy second properties for investment and rental purposes.
There are two major schools of thought when considering real estate investments and how to approach them: One believes it is wiser to pay all out cash for a second home, while the other side holds that being leveraged on a second—or even third or fourth property—is far more lucrative. Below are the cases for both.
Key Takeaways
- A leveraged investor can turn quite a profit with three or four properties while a cash-buyer might be limited.
- Cash investors can purchase quickly when there is a good opportunity rather than wait on the mortgage process.
- Whether purchasing property with a mortgage or cash, each requires a significant amount of disposable income.
Getting a Mortgage
This debate is heavily covered online, and several financial news sites and blogs state that being leveraged makes more sense when buying investment properties. For example, Ali Boone of BiggerPockets.com argues that the returns are higher and the risks are lower when leveraging this type of investment. The logic behind this is that if property increases in value, an investor will have put less down, but can then receive far more than the original capital.
For example, let’s supposed you put down 15% on a $500,000 house. Your initial investment would then be $75,000. Two years later, should that house increase in value to $650,000 you could sell and receive far more than your initial $75,000. In this scenario, your principal investment of $75,000 gets returned, plus an extra $75,000. In that case, you would have risked far less than a cash-buying investor would have in this situation, yet still made a considerable profit.
Multiply this formula and strategy over three or four properties, and the savvy investor can turn quite a profit. A leveraged investor has more opportunity than their cash-buying counterpart in these types of situations. Cash buyers will often buy a house outright with most of the money they have available for investment. In contrast, a leveraged investor can diversify the allocation of that money across several different properties, thus possibly increasing their rate of return in the long run.
The Risks of Being Leveraged
Taking on any type of investment has an inherent risk—especially when dealing with uncertainties in the housing market. First and foremost, the diversification of money across investment properties is an approach that should seriously be considered only by a well-informed investor. A sharp understanding of current economic conditions, the overall health of the housing market in general, and the area into which you are buying specifically is necessary.
While there are several advantages to taking out a loan to buy an investment property, things could go awry. Let’s assume each rental property depreciated sharply in value. The leveraged investor now owes far more than they ever put down. Should you misstep the market by even a little, you could lose massively, especially with a couple of properties in your portfolio.
While a benefit here is that the bank will certainly lose more than you will, your credit score could be severely impacted. The potential for significant returns attracts many to this type of strategy, but it should be approached with clear consideration for all the risks involved. This strategy will, of course, also require you to go through the mortgage process—in many cases, several times—which is another thing to consider.
Paying Cash for Investment Property
Cash investors can sidestep the entire mortgage application process and make a quick investment should they see an opportunity, which is highly advantageous. Another benefit to paying cash for a property upfront is that you don’t have to pay interest. Even if interest rates were as low as they were in 2021, it will always be more expensive over the long run to pay any type of interest than it will be not to have any.
For many investors who have the funds, buying property with cash makes sense, especially if you believe the market will upswing greatly in the next couple of years.
For example, let’s say you buy a home outright for $400,000 and sit on it until you see the moment is right to sell. Should you be right about an upswing, and the home appreciates in value to $500,000, that’s a direct profit of $100,000 to the investor, without having to consider paying the bank interest payments or the amount you borrowed in a mortgage. Having 100% equity in a home also makes it easier for an investor to take out a loan against it in the future, should that be needed. Buying a home outright in cash can also create immediate cash flow for the investor.
Certain investors look to create moving income with their properties, and the right type of renters can provide this.
Important
Buying real estate with a mortgage or with cash both require a substantial amount of disposable investment income.
Special Considerations: The Risks of Paying Cash
Tying up all of your assets in one investment is extremely risky. This approach might not then be the best strategy for the investor who has a limited amount of money to use in the long-term.
While a home can increase in value, it can just as quickly depreciate, and the money you lose will be outright. Diversification is one of the fundamental commandments of investing. Tying up the majority of assets in one asset class can provide massive loss. Putting hundreds of thousands of dollars into one asset class also ties up your liquidity until you have a seller.
Key Differences
Both strategies offer advantages, but for different types of investors. One important thing to note is that either strategy requires a substantial amount of disposable investment income. Even leveraged buyers who spread out their investment across several properties will need to assume the risk that all of those properties depreciate. Further, when purchasing a new home for cash, do not use retirement savings or your emergency fund.
For the investor who has a large amount of money ready to invest, propensity for risk is what will truly drive the direction of the decision here. Leveraged positions in investment properties will undoubtedly yield higher returns, but for the less-involved or dovish investor who still seeks equity and return, cash purchase might be the better option.
Tax Implications
Tax implications play a role in deciding between paying cash and using a mortgage for investment properties. Mortgage interest deductions are a key benefit for financed purchases, meaning investors can deduct interest payments from taxable income which lowers their tax liability. This deduction can be especially advantageous for high-income earners or in cases where the mortgage interest is substantial.
On the other hand, paying cash avoids the need for interest payments entirely, eliminating this potential deduction. However, cash buyers might face higher capital gains taxes when selling the property since they lack the opportunity to offset taxable income with interest expenses. Additionally, they don’t benefit from the tax relief that financing provides during the holding period.
While cash purchases simplify tax filings by removing complexities like interest deductions and loan amortization, cash buyers may miss out on the potential tax advantages tied to leveraging. The basis of deciding which tax strategy depends on many of your own personal factors.
Note
Even if you purchase a house with cash, you’ll still be responsible for annual expenses such as property tax assessments.
Factoring in Market Conditions
The decision on whether to get a mortgage or pay cash also depends on the current market conditions. In a seller’s market, characterized by rising prices and high demand, financing allows investors to secure more properties without tying up all of their capital. For example, in the mid-2010s, cities like Seattle experienced rapid property price increases, and many investors chose to leverage mortgages to buy multiple properties, maximizing their investment potential while taking advantage of low interest rates.
Meanwhile, in a buyer’s market where property values stagnate or decline, paying cash becomes a more attractive option. Investors can avoid the risks associated with holding mortgage debt when property values may not appreciate as expected. For example, during the 2008 housing crisis, many cash buyers were able to acquire properties at discounted prices without the pressure of mortgage payments, allowing them to hold the properties until the market recovered. This means they never had an outstanding liability in excess of the market value of the home.
Local economic conditions also influence the decision to finance or pay cash. In markets with high volatility or uncertainty, such as some parts of Florida after major hurricanes, cash buyers can sometimes have the advantage, as sellers may be eager for a quick sale without the complications of financing. This gives cash buyers more negotiating power.
Understanding Opportunity Cost
We’ll wrap up this article by talking about opportunity cost. When you choose to pay cash, you forgo the ability to invest that same capital elsewhere, potentially missing out on higher returns in other investments like stocks, bonds, or additional real estate. This is called the opportunity cost of the transaction, or the next best alternative.
For example, if an investor has $500,000 in cash and decides to buy a property outright, they lose the opportunity to invest that amount in a diversified portfolio with an average annual return of 7%. The year-one opportunity cost of buying the $500,000 house with cash is the $35,000 of income revenue foregone, though this does not consider any appreciation of the home value. Note that the second year opportunity cost may be higher due to potential earnings made on year-one earnings.
What Are the Key Advantages of Paying Cash for Investment Properties?
Paying cash for investment properties offers several immediate financial benefits. First, Plus, cash transactions eliminate the risk of foreclosure due to missed payments and could simplify the buying process, leading to quicker closings.
What Are the Key Advantages of Using a Mortgage?
Using a mortgage allows investors to leverage their capital, enabling them to purchase more properties or higher-value ones than they could afford with cash alone. This leverage can lead to higher returns, especially in a growing market where property values are appreciating.
How Does Liquidity Factor Into the Decision?
Financing a property preserves cash flow and gives investors the flexibility to use their capital elsewhere, such as investing in other assets or covering unexpected expenses. This can be particularly valuable, especially if the investor may not have the capital upfront needed (i.e. they do not have liquid assets or enough assets).
Which Option Is Better in a Competitive Real Estate Market?
In a competitive real estate market, cash buyers often have the upper hand. Sellers are more inclined to accept cash offers because they reduce the uncertainty of financing falling through.
The Bottom Line
While paying cash offers advantages like faster closings and no-interest payments, financing allows investors to leverage their capital and take advantage of tax benefits, such as mortgage interest deductions. The best approach depends on factors like market conditions, liquidity needs, and long-term investment goals.