Ok so we have talked about the why of owning a vacation rental:
Why you should own a vacation rental instead of traditional rental property.
And the how of choosing the right property:
5 steps to choosing the perfect vacation investment property.
Now let’s discuss how we can safely leverage debt to pay for our real estate. Leveraging debt is basically borrowing money in order to multiply your returns (borrow money to make more money).
Lets work through an example:
You recently inherited $100,000 and want to invest in Real estate. After some research, you find an great vacation rental for $400,000 and a loan program that will allow you to put just 10% down. You have run the numbers and found that the rents for this property will cover all the costs (mortgage, PMI, taxes, insurance, repairs and upkeep, utilities, etc). This property grosses $60,000-70,000 per year and after all expenses are paid you will be left with an income of $25,000-$35,000 per year.
Because you have chosen a loan program that allows you to only put 10% down, after paying your $40,000 down payment, you still have $60,000 leftover to help create a reserve fund, or to purchase an additional property.
A conservative person may ask, why not put the entire $100,000 as a down payment so your mortgage will be lower? It’s helpful to remember that the down payment you put down, will be the only money you pay for this property. Every other expense related to this property will now be paid for by the renters. That means that you want to tie up as little cash as possible to save for future projects. It also means that when the house is 100% paid off, you will have only paid for 10% of it!
| Example 1 (10% down payment) | Example 2 (20% down payment) | Example 3 (2 houses) | ||
| purchase price | $400,000 | $400,000 | $800,000 | |
| down payment (total investment) | $40,000 | $80,000 | $80,000 | |
| gross yearly income | $60,000 | $60,000 | $120,000 | |
| Yearly expenses | $36,000 | $32, 000 | $72,000 | |
| Net yearly income | $24,000 | $28,000 | $48,000 |
In the chart above, you will notice that example 2 and 3 both have the same down payment but example 3 has almost double the income (Based on purchasing 2 similar properties. This also means double the debt and risk). The more you leverage, the more you stand to gain! I recommend putting the smallest down payment as possible and keeping the rest as a reserve or future investment fund.
Now, a word of warning. Leveraging debt means that you owe money to the bank every month. If you have a slow season, or you have a major repair to the home (new roof, flooded basement broken heat pump) then you need to have a reserve fund set up and ready to pay for these expenses. Money tied up in real estate is not a liquid asset. That means that it usually can’t be exchanged quickly or easily for cash. If you have a personal emergency and need money quickly, you may or may not be able to get it when you need it. Unless you are trying to flip properties, you should always purchase real estate with the intent to keep it for several years.
So is real estate investment worth the risk? Yes! If you follow these guidelines!
- Research and learn all you can so you feel knowledgeable going into a real estate transaction.
- Use trusted professionals. Talk to several mortgage companies and compare to find a loan program that makes the most sense for you. They can advise you on how much you can afford. Trusted realtors can sometimes advise on loan programs to stay away from.
- Do not over leverage yourself! Only borrow what you can afford to pay back each month in your mortgage. There is always the chance that something can go wrong and leave you without rent for a few months.
- Have a reserve fund! If you use every bit of savings you have as a down payment, then you are asking for trouble! Always have a little extra set aside for major repairs, or a few months mortgage payments set aside.
- Don’t get fancy with your leveraging. Some people purchase rental properties that will operate at a loss each month. (Your expenses are greater than your income). People may choose to do this because they are hoping to flip the property once the value goes up enough. They will operate at a loss for a few months hoping to recoup the lost money when they sell the property. You normally only see this in HOT real estate markets. This can cause a lot of trouble if the real estate market experiences a downturn and doesn’t allow you to sell for months or years!
Keep following as next time I will talk about ways to save money for a down payment and general money saving ideas!
Want to read more? Here is a great article on How To Use Leverage (Debt) In Real Estate Investing – WealthFit
So many great insights here…love it!