The biggest barrier to entry in real estate investment is usually the money.
Buying property requires a large chunk of bills. If you have the cash on hand, you can buy property outright. If you don't, you must obtain a loan.
Both paths take you down the road to investment property ownership, but there are definite pros and cons to each purchasing decision.
Tax benefits, loss shelters, and liability issues are a few of the factors to consider when you are deciding how to make a property purchase.
Cutting the Tax Burden
One of the best reasons to get a loan when buying a property is the tax benefit.
Not only can you write off the property tax, you can also write off any interest you pay on the loan. Of course, if you pay cash, you avoid paying interest entirely.
The tax write-off helps reduce the cost of the loan but does not eliminate it.
Managing Investment Risk
A big part of any investment is the risk.
Typically, the riskier the investment, the more the potential payoff. In real estate, the same is true.
If you buy a property using cash, you can develop immediate cash flow. Every rental dollar you collect — minus taxes — is pure profit.
Of course, if the property sits vacant or the market drops out, you are left holding a worthless investment.
If you take out a loan to buy an investment property, you pay the bank most of the free cash coming from the property, but you don't put your own dollars at risk.
One of the first things you learn in investing is to use someone else's money whenever you can. That keeps your cash available for further investment opportunities.
Leveraging Your Assets and Cash
When you buy a property using cash, you limit your ability to buy additional investment properties. More of your money is tied up in the single purchase.
In the short term, you can generate more income from a property when you don't have a mortgage.
In the long term, leveraging your holdings to close on additional properties will generate more wealth.
The more properties you own, the more rent you collect and the less a vacancy will affect your cash flow.
With the money you spend to buy one property outright, you could leverage the funds to own as many as ten investment properties.
Using loans to buy properties allows you to buy more, but it can also encourage you to over-leverage.
Owning more properties means that you will eventually enjoy a comfortable income solely from rent, but you need to be cautious. The more mortgages you have, the more vulnerable you are to market shift.
f a property sits empty for too long, you could face foreclosure.
Before you choose to max out the number of loans available (typically 10 mortgages), you'll want to take a serious look at your cash flow.
If every property is showing positive cash flow, and you can sustain the loans even if you face a high vacancy rate, you should be in good shape to continue expanding.
If your cash flow fluctuates and you pull money out of your pocket to pay your mortgages, it's not the time to keep buying.
Over-leveraging and expanding too quickly are some of the risks associated with using a loan to build your property portfolio.
Quick Pros and Cons of a Cash Purchase
Buying with cash has some clear benefits and potential negatives.
- You own the property outright, so there is no threat of foreclosure.
- Less pressure to keep the property occupied.
- No mortgage loan that must be paid, even when the property is being repaired.
- All rent collected, after taxes, is profit and can go into property maintenance.
- Potential long-term property appreciation, increasing the value of your investment.
- You must have the cash in-hand to make the purchase.
- Almost every dollar you collect is subject to income tax.
- Reduces cash flow, which also reduces your ability to diversify and grow your portfolio.
- Risk of property depreciation is entirely yours.
Quick Pros and Cons of a Mortgage
When you either don't have the cash to buy outright or would simply prefer to dilute the risk, you need to understand the benefits and negatives of financing the purchase.
- You don't have to have the entire purchase price in free cash.
- The bank's money is at risk, not your own.
- Tenants pay off the mortgage, tying up cash flow in exchange for equity.
- Greater financial flexibility with less of your free cash tied up in property.
- You can deduct the interest paid on your loan, reducing your tax burden.
- Potential property appreciation in the long-term increases the value of your investment.
- A big chunk of rental income goes right to the mortgage payment.
- Foreclosure is a risk if you can't meet the financial obligations of the mortgage.
- Must fill vacancies as quickly as possible to avoid missing mortgage payments.
- You pay interest to make the purchase, adding to the price of the investment.
- Risk of property depreciation that could cut into your earned equity.
Deciding Between Cash and Loan Purchases
Ultimately, both cash and financing options have clear benefits. I
f you already have a well-diversified property portfolio, you might not need to finance.
If you have enough cash on hand to buy a rental property, consider the benefits of leveraging that cash to purchase several rentals. The amount of risk will influence your decision.
If you are comfortable taking moderate risks to increase your eventual return, financing is a great option for investing in real estate.
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