Some of you have asked “Why do you take out a loan to buy a property?
Why not just save up enough and pay cash? You’ll have no mortgage payment, doesn’t that make you more money?”
Real estate differs from stocks in that $100,000 can buy only $100,000 worth of stocks. That same $100,000 on a typical real estate purchase with a 25% down payment, can purchase $400,000 worth of property! ($400,000 x .25 = $100,000). This is called ‘leverage’ or ‘borrowing money from the bank.’
But what we care about is the returns, right?. At the end of the day, do we get more money in our pocket if we pay cash for a property? Or if we use leverage to buy a property.
Let’s look at the different scenarios, and calculate our cash on cash returns.
1. You pay CASH.
You buy a property for $100,000 that has a yearly net income of $10,000 before taxes.
Remember, since you paid cash, you have no mortgage.
Let’s calculate your cash on cash return in this scenario…
$10,000 (net income) ÷ $100,000 (total capital invested) = 10% cash on cash return. Not too shabby!
2. You use the power of LEVERAGE.
You buy that same $100,000 property with only 25% down ($25,000).
Your yearly net income is still $10,000 before taxes.
But since you have a mortgage, you will have to subtract $5,000 of mortgage payments from your profit (this, of course, will vary depending on your loan terms).
$10,000 – $5,000 = $5,000 net income.
Remember, you only put down $25,000. So let’s calculate your cash on cash return in this scenario…
$5,000 (net income) ÷ $25,000 (total capital invested) = 20% cash on cash return.
By using leverage, you have doubled your cash on cash returns for this property. Oh, and by the way, you still have $75,000 from your original $100,000 to go buy 3 other properties just like this!
Note: The numbers used here are for example only. I used nice round numbers to make it easy to digest. Every real estate deal is different, but simply put, the numbers are in your favor when leveraging the bank’s money to buy rental property.