When it comes to investment property financing, some real estate investors argue that using cash is the best way to make money in real estate, while others argue that using debt to buy real estate has more advantages. In this article, we will shed the light on investment property debt financing, how it works, and what advantages it brings to the investor.
Not All Debt Is Bad Debt
While it is true that being in debt is not the best situation to be in, it is important to differentiate between the different types of debt.
1- Bad debt
Bad debt is the kind of debt you use to buy anything that loses value like personal loans and credit cards. While not always avoidable, it is better to save up and pay for things with cash.
2- Tolerable debt
A home mortgage is a good example of tolerable debt. This kind of debt does not make you any money but at least it’s keeping a roof over your head.
3- Good debt
Here comes the good stuff. Yes, you heard it right. GOOD DEBT. This is the kind of debt that you use to finance a rental investment property. As a real estate investor, by using debt to buy real estate, you simply leverage good debt to increase your real estate wealth. What is leverage and how does it work? Keep on reading to find out.
What Is Meant by Leveraging a Real Estate Investment?
When it comes to investing, leverage is the use of various financial instruments or borrowed equity to purchase a new asset or increase the potential return on investment. In real estate investing, the easiest example of leverage is the old fashioned property mortgage, which is basically using debt to buy real estate or in other words, when you use other people’s money to buy income producing assets that are likely to appreciate in value.
Types of real estate debt instruments
Real estate investment loans are not all the same. That’s why, as a beginner real estate investor, you must know the different types of debt instruments that you can use. Unfortunately, many mortgage lenders, sometimes referred to as “predatory lenders”, have no interest in the heart of the borrowers and offer them mortgages with unfavorable conditions. So, it’s a smart idea to know your options. Let’s discuss some of the most common types of mortgages:
1- Fixed-rate mortgages (FRMs) – This type of mortgage is fully amortized, which means that the borrower pays off the loan at a fixed interest rate throughout the life of the loan. As a real estate investor, you want to know exactly how much money is going out of your pocket to accurately estimate the cash flow of your investment property. This is the type of mortgage that investors are advised to take when using debt to buy real estate investments.
2- Adjustable rate mortgages (ARMs) – With this type of mortgage loan, the interest rate will adjust periodically based on an index reflecting the lender’s cost to borrow on the credit market. Financing an investment property with an ARM is not advisable as you cannot precisely estimate your total mortgage payments, especially when interest rates are not stable.
3- Interest only mortgages – Remember one rule when talking to mortgage lenders: Never accept interest only mortgages. With this kind of mortgage, a borrower only pays the interest portion of the loan for a predetermined term. Then at maturity, the principal is paid with a big large balloon payment.
Why Use Debt to Buy Real Estate?
1- Using debt to buy real estate gives you access to better investments
Making money in real estate is not easy, and certainly not with your own money. That’s why many real estate investors turn to debt to purchase rental properties. If you have $100,000 in cash, you can use that money as a down payment for a more expensive property with a higher return on investment. However, it is not always that simple. Real estate investors are advised to use an investment property calculator when evaluating an investment property.
Check out Mashvisor’s investment property calculator here with a free trial.
2- Using debt to buy real estate magnifies your return on investment
Using debt to finance real estate investments allows you to buy multiple properties that you wouldn’t have been able to buy with your own money. Let’s say you have $100,000. With that, you can buy 4 rental properties with a down payment of $25,000 each. So, instead of putting all your money into one real estate property, debt gives you the chance to build your real estate portfolio.
3- Using debt to buy real estate provides a tax shield
Real estate investors can deduct interest on money borrowed to buy rental properties. This tax break is allowed to encourage home ownership and investment.
Tips for Using Debt to Buy Real Estate
1- Make a sizeable down payment
As a rule of thumb, the higher the down payment you make, the better the mortgage loan conditions are.
2- Be creative
Don’t let your bad credit score hold you back from accessing debt instruments to finance your next rental property. Consider alternative financing options such as hard money loans or taking out some money through a home equity line of credit.
The Bottom Line
Using debt to buy real estate certainly has many advantages as discussed above. If you are a beginner real estate investor, it is important to do your homework and learn about the options available to finance investment properties. When it comes to succeeding in real estate investing, it’s all about knowing WHERE to put your money for higher returns on investment.
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