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I've a huge chunk of money saved up for a down payment on a property that I'd eventually like to pay off and use as a rental. The assumption is that the property value will go up substantially over time because I intend to buy in a great location.

I'm wondering if I should

  1. Put as much down on the property as possible and try to pay it off sooner - or
  2. Put as little as possible down, and try to use the remaining cash somewhere else (e.g. a second property in a few years).

Mortgage rates are quite low - so I'm debating which way to go. Property values are still going up fast in my city (Toronto, Canada), so its almost like waiting 10 years would make it difficult to afford that second property.

12

I'm a little confused on the use of the property today. Is this place going to be a personal residence for you for now and become a rental later (after the mortgage is paid off)? It does make a difference.

If you can buy the house and a 100% LTV loan would cost less than 125% of comparable rent ... then buy the house, put as little of your own cash into it as possible and stretch the terms as long as possible. Scott W is correct on a number of counts. The "cost" of the mortgage is the after tax cost of the payments and when that money is put to work in a well-managed portfolio, it should do better over the long haul. Don't try for big gains because doing so adds to the risk that you'll end up worse off.

If you borrow money at an after-tax cost of 4% and make 6% after taxes ... you end up ahead and build wealth. A vast majority of the wealthiest people use this arbitrage to continue to build wealth. They have plenty of money to pay off mortgages, but choose not to. $200,000 at 2% is an extra $4000 per year. Compounded at a 7% rate ... it adds up to $180k after 20 years ... not exactly chump change.

Money in an investment account is accessible when you need it. Money in home equity is not, has a zero rate of return (before inflation) and is not accessible except through another loan at the bank's whim. If you lose your job and your home is close to paid off but isn't yet, you could have a serious liquidity issue.

NOW ... if a 100% mortgage would cost MORE than 125% of comparable rent, then there should be no deal. You are looking at a crappy investment. It is cheaper and better just to rent. I don't care if prices are going up right now. Prices move around. Just because Canada hasn't seen the value drops like in the US so far doesn't mean it can't happen in the future. If comparable rents don't validate the price with a good margin for profit for an investor, then prices are frothy and cannot be trusted and you should lower your monthly costs by renting rather than buying. That $350 per month you could save in "rent" adds up just as much as the $4000 per year in arbitrage.

For rentals, you should only pull the trigger when you can do the purchase without leverage and STILL get a 10% CAP rate or higher (rate of return after taxes, insurance and other fixed costs). That way if the rental rates drop (and again that is quite possible), you would lose some of your profit but not all of it. If you leverage the property, there is a high probability that you could wind up losing money as rents fall and you have to cover the mortgage out of nonexistent cash flow.

I know somebody is going to say, "But John, 10% CAP on rental real estate? That's just not possible around here." That may be the case. It IS possible somewhere. I have clients buying property in Arizona, New Mexico, Alberta, Michigan and even California who are finding 10% CAP rate properties. They do exist. They just aren't everywhere.

If you want to add leverage to the rental picture to improve the return, then do so understanding the risks. He who lives by the leverage sword, dies by the leverage sword. Down here in the US, the real estate market is littered with corpses of people who thought they could handle that leverage sword. It is a gory, ugly mess.

  • 1
    Great answer - exactly what the rational part of my brain needed to hear! – Giablo Nov 24 '09 at 14:41
9

I'd suggest taking all the money you have saved up and putting in a mutual fund and hold off on buying a rental property until you can buy it outright. I know it seems like this will take forever, but it has a HUGE advantage:

  1. You won't lose ANY money to interest. Whenever you are thinking about a mortgage, total up the full amount you'll be spending on interest over the life of the loan. You'll be amazed to find out how much money you're spending on financing, even with a lower interest rate.
  2. You won't be in over your head when renters don't pay, or when you can't find renters.
  3. You won't be totally screwed if the value of your property goes down.

I know it seems like it will take forever to save up the money to buy a property for cash, but in the long run, its the best option by far.

  • Agreed. Debt adds risk. – Mike Apr 14 '10 at 4:11
8

I would go with the 2nd option (put down as little as possible) with a small caveat: avoid the mortgage insurance if you can and put down 20%.

Holding your rental property(ies)'s mortgage has some benefits:

  1. You can write off the mortgage interest. In Canada you cannot write off the mortgage interest from your primary residence.

  2. You can write off stuff renovations and new appliances. You can use this to your advantage if you have both a primary residence and a rental property. Get my drift?

P.S. I do not think it's a good time right now to buy a property and rent it out simply because the housing prices are over-priced. The rate of return of your investment is too low.

P.S.2. I get the feeling from your question that you would like to purchase several properties in the long-term future. I would like to say that the key to good and low risk investing is diversification. Don't put all of your money into one basket. This includes real estate. Like any other investment, real estate goes down too. In the last 50 or so years real estate has only apprepriated around 2.5% per year. While, real estate is a good long term investment, don't make it 80% of your investment portfolio.

  • Great answer - good point about the mortgage insurance and putting all my eggs in one basket. Thank you! – Giablo Nov 24 '09 at 14:40
6

My figuring (and I'm not an expert here, but I think this is basic math) is:

Let's say you had a windfall of $1000 extra dollars today that you could either:

a. Use to pay down your mortgage
b. Put into some kind of equity mutual fund

Maybe you have 20 years left on your mortgage. So your return on investment with choice A is whatever your mortgage interest rate is, compounded monthly or daily. Interest rates are low now, but who knows what they'll be in the future. On the other hand, you should get more return out of an equity mutual fund investment, so I'd say B is your better choice, except:

  • If you have no self-discipline, put it on the mortgage because it's harder to get it back out

But that's also the other reason why I favour B over A. Let's say you lose your job a year from now. Your bank won't be too lenient with you paying your mortgage, even if you paid it off quicker than originally agreed. But if that money is in mutual funds, you have access to it, and it buys you time when you really need it. People might say that you can always get a second mortgage to get the equity out of it, but try getting a second mortgage when you've just lost your job.

5

I would go with option B. That is safer, as it would leave you with more options, in case of an unexpected job loss or an emergency.

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