And by famous I mean, it gets ugly.
The heart of the debate seems to center around the difference in risk in buying a property using all cash or buying a property using leveraging. Those who leverage their properties boast that the benefit of doing so allows the investor to buy more properties with the same amount of money. Those who pay cash come back against that argument saying how risky leveraging is and that the risk isn’t worth it, even if it does get you more properties. From what I can tell, this point in the debate seems to always be the point of impasse between the sides. Being able to buy more properties by using leverage is an indisputable fact. Leveraging inducing more risk seems indisputable. So then, everyone stops debating at that point and goes about their merry ways.
I think this is the wrong place for the impasse. Being able to buy more properties using leverage, yes, that is correct. But leveraging being riskier?
For any newbies out there, “leveraging” refers to using ‘someone else’s money’ to buy something. That can include loans from a bank, loans from an individual, financing on a credit card, borrowing money, etc.
For the purpose of what we are talking about here, I’m going to stick with referring mostly to mortgages. A mortgage isn’t the only way to finance a property but it’s the primary one and a lot easier and more common than other methods. For the purpose of this article, I’m thinking mostly about mortgages because I want to look at long-term loans rather than short-term (just trying to keep it simple).
What is Risky about Leveraging?
Obviously there are factors involved with leveraging that are cause for concern. There may be others, but for the most part, the following issues are the things that should be looked at in terms of risk associated with getting a loan for a property:
- Cost. A huge concern with leveraging anything is that inevitably you will be charged interest which will make your actual cost significantly higher than the original purchase price. That extra cost can end up being quite substantial depending on the terms of the loan.
- Losing what you put into it. Let’s say you buy a house for you and your family. You get a 30-year mortgage on the property. You do great with the house until year 20 when you unexpectedly lose your job. You can’t find a job quickly and you don’t have much in savings (and even if you do, having no income can suck all of that up painfully quick), so suddenly you can’t pay the mortgage. The bank who you have the mortgage with takes your house from you. So for 20 years, you paid a huge amount of principle on the house, you paid a ton in interest, and who knows how much in miscellaneous expenses for the house, and now you have no house. You don’t get any of that 20-years’ worth of money back and you have no house either. Oh, and your credit is in shambles.
- Losing other assets in addition to that one. If you have a mortgage on a house that you lose, unless you have a non-recourse loan you are at risk for the bank taking away other assets that you own, in addition to the house with the mortgage, in order to pay for the loss. Luckily most mortgages now are non-recourse, meaning the only thing they are allowed to take is that particular piece of property and nothing else of yours, so that helps but recourse loans do still exist.
- Type of loan. Speaking of loan terms, let’s say you don’t lose your job but instead the payment on your mortgage goes up dramatically. This can happen with an adjustable-rate mortgage. If you have a fixed-rate mortgage you are locked in at the same interest rate for the entire length of the loan. If you have an adjustable-rate mortgage, after a set number of years the interest rate on your loan will change. It will change to match the current going market interest rate (with some restrictions), which could be much higher than what you originally signed up for. If you were to buy a house for yourself today, you might be able to get a loan with a 2.5% interest rate (primary homebuyers, not investors). What if with the real estate market booming like it is right now, the interest rates in five years jump to 8%? Don’t laugh, it can happen. Remember in the 1980s when interest rates hit 18-19%? Regardless, the difference in monthly payments may be enough to force you to not be able to pay and you could lose the house.
Well that all officially sounds pretty miserable, I must admit. If those were the only sides of the story, I too would only buy with cash. However, investment properties can work slightly differently than a primary home and when an investment property is bought correctly, a lot of those risks can disappear completely. I would even argue that they disappear enough to justify saying that buying a property with leverage is less risky than buying with cash.
Mitigations for the Risks
- Cost. As long as your mortgage payment (which includes the interest payment) is well-covered by the monthly rent collected for the property, you aren’t paying this extra cost out of your own pocket. Yes, you are less that money you pay out in interest but if you actually run the cash-on-cash return of a property that you finance versus that of buying with all cash, the returns are usually significantly higher so you still make more money than if you bought with all cash and avoided the interest payment.
- Losing what you put into it. Same scenario as before: after 20 years of owning a property, something drastic happens and you can’t make the mortgage payment anymore and you lose the house to the bank. If you are an investor and bought smart and the property made you money for the entire time you owned it, even if the bank runs in and takes it out from under you, the only thing that will take a negative hit is your credit score. All you put into the house originally was the down payment and some closing costs, and after that, the tenants essentially paid all of your expenses in the form of giving you rent every month. Okay, so actual worst case scenario you lose what you paid for the down payment and your credit score. That’s assuming the money you made on the house didn’t pay you back the money you put down because it likely did. So then it really is just back to your credit score. This mitigation is of huge consideration when buying an investment property versus a home for yourself. This mitigation flat doesn’t exist if the house is yours because you aren’t collecting income on it along the way and it remains a major risk. (Just in case you are wondering if you should finance a house for yourself anytime soon…)
- Losing other assets in addition to that one. Never get a loan that isn’t non-recourse. For a mortgage, this shouldn’t be a problem but always make sure that is written in there. Then the only thing you could lose is that property and none of your other assets.
- Type of loan. Never get an adjustable-rate mortgage, always get a fixed-rate. With the fixed-rate interest included, your payment should be well-covered by the rent collected on the property. So then you have some wiggle room in case of changing rents, but you don’t have to worry about drastic changes to your mortgage expense.
So assuming you know how to properly buy a rental property, the only official risk in leveraging a rental property versus paying all cash for it is a potential bash to your credit score should something go totally wrong, no? What else?
Let’s break this down…