If I have a house worth $100,000 and it rents for $900 per month
900 * 12 = 10,800 / 100,000 = 10.8% cash-on-cash ROI
10.8% is good but now we have zero cash and the equity is sitting in the house not making any money. It also has a payback period of 9.25 years which means we won’t be able to buy another one for almost a decade! Paying a rental property off for the cash is a common goal but this blog doesn’t advocate for common returns, We can do better!
This time let’s use a conventional loan with 20% down payment.
$100,000 – $20,000 = $80,000
The mortgage will be at 5% for 30 years.
The loan is $80K so the payment will be $420
(900-420) = 480 * 12 = 5760 / 20,000 = 28.8% cash-on-cash ROI
This formula is: rental income – debt service = cash flow * 12 months = 5760 gross yearly income / 20,000 cash invested = cash ROI
So do we prefer a 28% ROI or a 10% ROI? Sure there is less cash flow per month using plan B, but remember when using the 20% down, we still have the $80,000 remaining in the bank! We could repeat this 4 more times using the same capital as plan A, make far higher returns, and much higher cash flow. The payback period here is only 3.4 years as well so in less than have the time as Plan A we can recoup our initial investment and still make some cash flow each month. Debt is looking good!
Here is the plan I personally use, the numbers will be slightly different than real numbers for consistency and ease of explanation, but the overall math is the same. Let’s say I buy a distressed house at a major discount. After the house is purchased and repairs are complete I have 60K in the house
$65,000 my total cost
$100,000 value the bank says its worth
$75,000 is what the bank will lend on this house. (75% loan-to-value)
75K-65K = $10,000 (I get this cash back right now)
100K -75K= 24,000 is the amount of equity I still have in the house
$402 is the monthly payment for this loan (75K for 30years @ 5%)
$900 is the monthly income from this unit
(900-402) = 498 x 12 = 5976 / 0 …….. Wait it’s not possible to divide by zero.
This is what is sometimes called “infinite return on investment”. When you try to divide the cash return, by the amount left invested in the deal, but all the money invested in the deal has been cashed out with my loan. This results in a house that makes $5976 per year and not only is there nothing remaining invested in the property but it’s also already made that $10,000 in cash right at the start.
Also, let’s not forget about the original 100K we started with.
plan A: Use the entire 100K, make 10.8% yearly and then wait 9.25 years for it to come back to me
plan B: Use 20K cash, still keep 80K and good cash flow each month. I make 28.8% ROI and it only takes 3.4 years to be repaid
plan C: Keep the 100K, an additional 10K in cash, plus good cash flow each month. Infinite CoC return and instant payback period.
So which do you want?
$10,000 per year income with ZERO cashOr$6,000 per year plus $110,000 in cash?
It must be noted that none of these examples include ancillary and overhead costs, so the returns won’t be this extreme in real life. In fact, the real world numbers would be even less favorable towards paying cash since that 10.8% would likely drop to a return that is closer to low-risk stock market gains. Regardless of this information, the basis for how the money works out is identical. If I added a 40% expense ratio to each scenario, the total returns will fall, but relative to each other would be the same.
Paying cash is actually the riskiest part of my business
The method I use to buy houses requires me to pay for houses with (someone’s) cash, and then get a mortgage on them usually around 6 months later. It wasn’t until I paid cash for my first investment property that I not only learned the lesson this post tries to teach but it also really made me FEEL the risk of being cash poor. Being cash-strapped and running a business is not fun, and it creates a risk where there wasn’t any before. I’ve heard plenty of people say being debt free gives them peace of mind but a much safer peace of mind comes from keeping $100,000 cash in the bank. It will protect against a lot of unexpected costs and a lack of cash opens up to 2 kinds of risk, opportunity risk, and emergency risk.
Let’s say we use our $100K to pay the house off. On $100K the principle and interest payment will be about $540 each month, so once the house is paid off we save that $540 per month but what if something comes up that is unexpected and expensive? By letting go of all that cash we have gotten rid of the REAL safety net and the peace of mind people claim they so desperately want! Once the house is paid off and some unexpected $10,000 expense for (anything) comes up how are we going to pay for it? Will we borrow against the house, which is possible but not easy? Wouldn’t that be ironic, to “save money” by paying off a house only then to loan back to it going back to square one? Also, loans are nowhere near as easy to put together as writing a check is. Houses are very illiquid, meaning spending the equity is not easy, this is why the saying goes: cash is king.
Also we must consider opportunity risk, which might be the most expensive cost of all. means, the cost spending money is all the other opportunities that were available. If I spend $100K on a house, and the next day a GREAT deal comes across my desk and I don’t have the cash to close, that’s my opportunity cost. I can’t afford to do that deal because my money is tied up in dead equity. Paying cash literally costs me money! The cash I use isn’t usually tied up for long thankfully, but if I left the house paid for in full I would miss out on a lot of opportunities. This is why I mortgage everything and I do it as quickly as possible.
But Alex, you’re paying so much in interest!
Seems like most people are one of two ways lately, lousy with money, or anti-debt.
How much is the interest really?
$100K loan @ 5% interest, again, $536.82 monthly
$536.82 * 360 = 193,255 Total payment
193,255 – 100,000 principle loan value = $93,255 total interest paid.
Admittedly $93,000 sure is a lot of money (well, for me it is, you may think it’s chump change!) but people act like this interest is a fee they aren’t willing to pay no matter what. It’s important not to look at the costs of doing business as an unfixable problem, it’s much more valuable to look at the upside. Why worry about a measly 93K when this house could make me $500,000 over the same amount of time or maybe better. Think about what will happen over the next 30 years: The tenant is going to pay that interest, plus profit, 92% of the time (I factor in an 8% vacancy and it’s calculated before profit). This means as the loan gets paid down I gain equity, which I could borrow against again down the road if I want. Another thing that is going to happen, and is very commonly overlooked is inflation. Inflation makes future dollars worth less than today’s dollars so that $93K is going to scale down in buying power relative to what money can purchase at the time. Also, I intend to keep growing for the long term, 93K is going to be a much smaller portion of deal size as time goes on as well, making the 93K cost less burdensome. Lastly, inflation helps me on the income side as well, what happens to rent prices over time? What happens to all goods over a long period time? The costs of goods go up and rent will be no different, the $900 rents now will be $2000 or better 20 years from now. All these small effects compound over time to really add up, and it was still profitable from the start! Worrying about the interest compared to how much wealth that can be created is a mistake, chase the HUGE upside and don’t let the fact that someone else is going to pay all these costs bum you out too much.
Ive tried to explain this topic clearly and thoroughly but it can be hard to grasp at first because sometimes it doesn’t FEEL right. It’s important to always trust the math, and to understand the process as deeply as possible. I was very opposed to using debt when I first started but it was simply out of fear, not logic. As i’ve learned the process more clearly and had experience to show me which is better ive learned that debt is a valuable tool, and hope to help other people understand it better as well.