Board Topic: Pay cash or another mortgage? Using home equity to pay cash for rental
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Pay cash or another mortgage?

Posted by: Tim Sep 25 2003, 08:03 AM
Hi,
We have just refinanced our primary residence and come out with about $75,000 cash. Loan is 30 yr. fixed at 5.5%. I'm disabled and looking for additional income for longterm.
We are looking to purchase two, two unit rental properties (duplex) for total of $64,000 that have been in the family for years (new roof,siding,windows). Extra cash is to fix up kitchen, paint, bathroom in one unit that has not been rented for 20 years. Should we pay cash for the units ($1,110 income at present plus another $400 upon renting 4th on completion of renovation) or maybe only 20% down and then look for other rental property in the same area and buy several more with 20% down and their own mortgages?
Thank you
Tim

Posted by: loanuniverse Sep 25 2003, 01:09 PM
Tim:

The answer to your question depends on a couple of things. The most important of which is your capacity to stand risk. One thing you can not divorce is the relationship between risk and reward. From an investment standpoint you will have to look at the options this way:

Option #1 You can pay for it in cash. For argument sake lets say that you end up spending all $75,000 available to purchase and fix the property. Lets also assume that you have operating costs of $5,000 a year {maintenance, insurance, taxes, utilities, etc}. Then your net operating income is $18,000 in rental income - $5,000 in operating expenses = $13,000 in net operating income. This means that your return on investment is 17.3%. This is a great rate of return on any investment right now.

Option #2 The numbers are the same and you have the same operating profit, but you need to pay the bank about $5,000 in debt service on a $55,000 loan. This is all based on quick assumptions Then you only have about $8,000 left as cash flow coming to you. However, your investment is only $20,000. This means that your return is about 40%.

Of course you need to take the following into account:

1- You need to make sure that financing is readily available.
2- You need to use your real numbers. Get an estimate of what your expenses for the repairs will be. Get the actual operating expenses. Get the cost of financing…etc.
3- Supposing you decide to get a loan for the $55,000 or a similar figure, do you have the opportunity to buy a couple of more properties like this one. Using leverage is great, but only if you are going to be making more money than the interest you will be paying the bank. It would do no good to get the loan if all you are going to do is open a certificate of deposit and make 2% a year. Also those properties might not be as profitable as this one is.

Hope this helps.

P.S: A couple of weeks ago someone posted a very similar question about the use of loans as opposed to using your own money. Look for a post by Kim.

Posted by: Tim Sep 25 2003, 05:11 PM
Thank you very much for your kind response! I'll look for the other post as well.
Tim

Posted by: loanuniverse Sep 25 2003, 06:31 PM
It occurred to me that when I first wrote my answer I was thinking about the relationship between risk and reward, but did not finish my thought. What I meant to say was that you can make more money using leverage, but you are exposing yourself to more risk since you will have to pay the bank independent of having a tenant.

If you buy the house cash and have no tenants, all you are really responsible for is the operating costs, which might decrease since the property is vacant. Lose the tenants while paying a mortgage and you have to come up with operating costs and the mortgage payment from your own pocket.

Good luck
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