For the majority of investors, financing real estate using mortgages is a fact of life.
Most people don’t have the cash to pay for the entire purchase price of a property, and many people want to leverage their cash to boost their return on investment.
So mortgages are here to stay… at least until tenants pay them off. 🙂
In the mean time, mortgage payments must be made every month, and can easily use up 50%-80% or more of a rental property’s monthly cash flow.
While it’s true that (for most mortgages) a portion of each payment is principal repayment (which builds equity and is not really an ‘expense’), the impact of the payment is significant to the property’s cash flow.
Smart investors do everything they can to minimize the monthly out of pocket cost and keep cash flow positive.
Choosing an appropriate mortgage that reduces out of pocket costs is not always an easy decision to make.
Anyone who has ever obtained a mortgage knows what it’s like… they may ask themselves questions like:
- Is the cheapest interest rate always the best one?
- What amortization period should I pick?
- Should I choose a long or short term?
- What about fixed interest rates or variable?
- Is an open or closed mortgage better?
- Do I need pre-payment or payment increase privileges?
- Which lender should I choose?
These are not always easy questions to answer, as the mortgage industry varies widely and the answers depend on the individual’s particular situation. The answers for a new home buyer may be substantially different than for a real estate investor.
Even among investors, the answers can differ based on their tolerance for ‘risk’ (ie. the chance their monthly payments may go up, etc).
What To Consider
The following are some criteria to consider when making a decision on what type of mortgage to use for financing investment property.
The interest rate affects your monthly payment and therefore your cash flow and overall profit. Obviously, lower interest rates are better, but all mortgages are not created equal.
There can be many other mortgage factors that will affect your cash flow and overall profit, so investors should never select a mortgage simply based on the lowest interest rate (see the section below about lenders).
This also greatly affects your monthly payment and therefore your cash flow. Longer amortizations are better for cash flow, but it takes longer to pay off the mortgage and you pay more in total interest costs.
If you don’t care about paying off the mortgage early, it’s best to select a longer amortization (ie. 25 years instead of 20 or 15). However, if you want to pay off the mortgage early and keep more profit, select a shorter amortization with payments you can afford.
Long or short term
Deciding the answer to this almost requires a crystal ball. An investor must predict things like where interest rates will go over time, and how long they will hold a property. There is a measure of risk when using short-term mortgages, as rates could go up at renewal time, causing a severe reduction in cash flow.
Long-term mortgages reduce that risk, but can prevent taking advantage of decreases in interest rates, so it ends up costing more. Ultimately, if you’re flipping property, you should use short term mortgages. But for buy and hold rentals, the term can vary based on your preference and risk tolerance.
Fixed or variable
Fixed interest rate mortgages are common, as they guarantee the interest rate and payment won’t change during the term of the mortgage. Variable rate mortgages allow an you to take advantage of rate drops, but the rates can also easily increase. Variable rate mortgages also tend to have lower interest rates than longer term fixed mortgages, thereby boosting cash flow.
If you’re flipping property, you can use either variable mortgages (if you’re concerned about cash flow) or fixed mortgages for longer term flips (if you’re concerned about knowing your profit). In either case, be certain you accurately forecast your ongoing monthly holding costs. For long-term buy and hold properties, you can also use fixed or variable, depending on your preference and risk tolerance.
Open or closed
Many people use closed mortgages, which have lower rates and are locked in for a fixed period of time. This can be a disadvantage if an investor decides to sell a property prematurely or interest rates drop substantially.
Others use open mortgages, which tend to have higher interest rates than closed ones, but can be paid off at any time with no penalties. In general, closed mortgages should be used for long-term buy and hold properties, while open should be used for flipping, but it really depends on the plan for the property.
Pre-payment or payment increase
For long-term buy and hold properties, ensure the mortgage contract allows partial pre-payment (at least 10%-15%) and an option to increase monthly payments. This provides flexibility to use excess cash flow to pay off the mortgage faster (if desired).
For flips that are using closed short-term mortgages, a good sized pre-payment privilege will help reduce penalties if the property is sold before the mortgage term is complete.
This is a tough one and an investor will have to rely on their mortgage broker and referrals to find good lenders to work with. Some lenders may have the lowest rates, but the mortgage is difficult to qualify for, they may have high fees for breaking the mortgage, etc.
Find a lender who is flexible, without high fees for everyday items (like extra statements, NSF charges, etc.), good customer service (this is important), and of course the easiest qualification criteria.
Boosting Cash Flow
Sometimes investors find that even after selecting the right mortgage, the cash flow for their investment property is low, so they may want to find ways to boost it. The following are some suggestions on how to do this:
Skip a payment
This is one of my favourite methods and one of the easiest. Many mortgages have the ability to skip one or more payments. Even if this isn’t part of the mortgage agreement, many banks will make exceptions.
The advantage of this is that you can boost your cash flow with one phone call. If you pay $1500 per month on a mortgage, that’s $1500 you can keep in your pocket (note: you will pay more overall interest using this technique).
This requires refinancing, and may not be available in all cases (especially for rental properties), but it can dramatically boost cash flow. No principal repayment is included in your monthly mortgage payment — only interest costs.
The disadvantage is that no equity is being built up through mortgage ‘pay down’. Instead, the equity is kept in your pocket every month by not having to pay the principal.
Extend amortization period
If you’ve had a mortgage for a few years, normally upon renewal or refinance, the amortization period is reduced by the length of time you’ve held the mortgage.
To reduce your monthly payments, extend the amortization period back out to the maximum allowed with your lender (e.g. extend from 20 years to 25 years).
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Using the above information to select the proper mortgage, and the extra techniques to boost cash flow, investors should be able to keep their monthly debt servicing costs to a minimum.
That way, they can keep more money in their pocket and for long-term buy & hold properties, and keep the property long enough to benefit from one of the best parts about real estate – long-term appreciation.