Which is better when investing in real estate – A cash investment or a mortgage investment?
All real estate investors know that when investing in real estate there are two options available to them: making a cash investment or acquiring a mortgage to finance the purchase of an investment property. Choosing one or the other depends heavily on the real estate investor’s personal preferences when it comes to the different aspects of their investment and what they intend to achieve from it.
For example, making a cash investment is usually a better choice when trying to make a quick investment and not commit for the long term, while obtaining a mortgage to purchase an investment property will typically force the real estate investor to commit to the investment for longer periods of time depending on the type of mortgage that he/she took and its duration.
Whether you’re a real estate investor or a first-time homebuyer, there are certain advantages and disadvantages whether you choose the option of a cash investment or a mortgage-financed investment that you need to learn about before you make your decision.
Cash Investment
In real estate investing, a cash investment is when a real estate investor purchases an investment property using 100% cash without relying on borrowed money to purchase the property. A cash investment is typically a good method for increasing the equity that you have on your investment property. The equity, in this case, is the percentage of your property’s value that you’ve paid using cash.
When it comes to a cash investment, there are certain advantages and disadvantages that you should take into consideration:
Advantages of a Cash Investment
The major advantages that come with a cash investment include the following:
- The simplest advantage of a cash investment is that it will save you the trouble and the daunting process of applying for a mortgage and getting an approval.
- Making a cash investment means that you won’t have to pay any interest to the bank.
- Most of the cash flow that you make from your investment property will go to your pockets instead of going towards paying off your mortgage.
- The chances of losing all of your investment are reduced significantly when making a cash investment.
- When you’re planning to pay all cash, you will be more prepared to act quickly and make your offers as soon as you find the right properties instead of waiting for the bank to give you approval for the mortgage.
- Making a cash investment means that you will be avoiding the risk of foreclosure on your property.
- Vacancies will not set you back or put you in a financial hole even though they will reduce your cash flow.
- Most of the rental income that you make will be pure profit for you.
Disadvantages of a Cash Investment
However, there are also certain disadvantages associated with making a cash investment, and they include:
- You won’t be able to deduct the mortgage interest from your tax payments.
- It is much more difficult to diversify your investments across multiple types of properties using cash investment as you won’t be able to purchase the same amount of properties.
Mortgage Investment
A mortgage investment is a process of purchasing an investment property using borrowed money through a mortgage or a loan. Real estate investors who prefer mortgage investments typically care more about having leverage than having more equity. Leverage, in this case, is the amount of borrowed money that you have on your properties. Meaning, the more borrowed money that you use for purchasing investment properties, the higher that your leverage will be.
If you decide to invest in real estate using borrowed money, there are certain advantages and disadvantages that you should first learn about:
Advantages of a Mortgage Investment
The major advantages that come with a mortgage investment include the following:
- It is easier to multiply your investments and purchase more properties using a mortgage.
- Using leverage (mortgage) you can purchase more properties for the same amount of money.
- The interest that you pay on your mortgage is tax deductible, which can greatly decrease the expenses that result from getting a mortgage.
- Mortgage investments have more potential to make a higher rate of return on the money that you’ve invested.
Disadvantages of a Mortgage Investment
However, mortgage investments also come with a number of disadvantages, including:
- If you fail to pay your mortgage for any reason, then your property might face the risk of foreclosure.
- Having vacancies on your rental units can put you in a financial hole and render you unable to catch up on your mortgage payments.
- If the bank calls your loan, you will have to pay in full or your property gets foreclosed.
- The interest that you pay to the bank each month will greatly decrease your profits.
- If the investment property depreciates in value, then you might be facing trouble covering the mortgage if you decide to sell the property.
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Examples Using Numbers
To give you an illustration of what the difference would be like in terms of finances when making a cash investment vs a mortgage investment, let’s first make assumptions for your real estate investment:
- The price of the investment property is $100,000
- The property is expected to appreciate at 3% each year
- You fall within the 28% tax bracket (you can deduct up to 28% of your mortgage interest)
- Your property makes $1,000 in rental income
- You intend to hold the property for 20 years.
Cash Investment
Based on the above assumptions, here’s what a cash investment would look like:
You purchase a rental property using all cash ($100,000). After 20 years of appreciation (at 3% annual rate), your rental property is now worth $180,611. During these 20 years, you’ve also collected $240,000 in the total amount of rent.
Based on these simple calculations, you can determine that in 20 years this rental property will have earned you a total of $320,611 on your $100,000 cash investment, which is a return on investment of 320%.
Mortgage Investment
Now, let’s suppose that you purchase the same rental property using an 80% mortgage and 20% cash. So, you have a rental property that you’ve purchased using $20,000 cash and $80,000 borrowed money.
Let’s assume that your monthly payments for the $80,000 mortgage are $485 per month, leaving you with $515 monthly profit (remaining from the $1,000 rental income). That is a total profit of $123,600 from rental income over the duration of 20 years. Same as before, the rental property appreciates by 3% each year, for a total value of $180,611 after 20 years.
Of course, you should also account for the interest rate on your mortgage. So, let’s suppose that the $80,000 mortgage will cost you $116,348 ($36,348 total interest) to pay off over 20 years (after including the interest rate). However, since the mortgage interest rate is tax deductible, you can deduct up to $10,177 (28% of the total interest rate) from your mortgage interest.
So, in total, your rental property’s total gains are $214,388 ($80,611 appreciation, $123,600 rental income, and $10,177 tax deductions). However, your rental property will also have a loss amount of $26,171 in mortgage interest, leaving you with a total profit of $188,217 over the course of 20 years, which is a 941% return on investment on the $20,000 you’ve paid in cash.
Results
What you probably noticed is that in regards to the rate of return, the mortgage investment had a very large rate of return (941%) compared to the cash investment (320%).
However, and because the mortgage investment’s rate of return is based on the amount of cash invested, you will also notice that the cash investment produced a significantly higher actual amount of profits ($320,611) compared to the mortgage investment ($188,217).
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Bottom Line
No matter which option you choose to go with, you should always consider your options and decide on the one that suits you and your investment goals better. Both cash investments and mortgage investments can be lucrative and beneficial, but each has certain tradeoffs in exchange for certain advantages.
Lastly, whether you choose one or the other, make sure to use Mashvisor during your search and market analysis when investing in real estate to enjoy access to a number of great tools and features, including a cash/mortgage calculator, to make your life much easier and to make investing in real estate more seamless and faster than ever before.