Liz and I recently purchased an investment property…with cash. The general reaction when people hear this: “Why on earth would you invest with your own money? Don’t you know that you could earn way more by borrowing money from the bank??!” During this retort, they usually make a face that says, “You are such an idiot.”
Yes, I realize that I could potentially earn more by investing with the bank’s money at a low interest rate, but there is risk in doing so – and for some reason, so many people forget this.
The Risk of a Cash Investment
As I see it, there are very few risks that come with a cash investment. By purchasing our investment property with cash, we have removed the bank’s fingers from our business and now only have tax payments, insurance costs, and maintenance expenses. Earning a positive cash flow is very easy when there’s no mortgage.
Many would argue that we have taken on the risk of “not earning as much as someone that invests with leverage.” Put simply, someone that borrows from the bank could use the bank’s money and invest in five properties instead of just one (20% down on each property), and could therefore earn more money in a given year. Yes, they might earn more, but they’re doing so at a price – with risk.
Here’s the basic risk of our investment. If our investment property sat empty for an entire year, the most we could lose is approximately $7,000. If we owned 10 rental properties with cash, we could potentially lose $70,000.
The Risk of a Borrowed Investment
Without going into all the details just yet, I want you to see the potential risk of an investment with borrowed money.
If a “wise investor” were to borrow 80% of the property value from the bank and the rental house sat empty for an entire year, they would lose approximately $19,000.
If, instead of buying just one rental property with 100% cash, the “wise investor” bought five properties (as we mentioned above – each with a 20% down payment), they would definitely have the potential to earn more, but their risk of loss in just one year becomes $95,000! That’s a pretty big leap from the slender $7,000 loss with a cash purchase.
5 Reasons Why I Never Borrow to Invest
A few months ago, Liz and I were toying with the idea of borrowing money to invest in the property next door. It was an impulse thought, and it was based purely on want and not on my investments beliefs.
Below are the five reasons why I would never borrow to invest in anything, no matter how great the deal sounded.
1) Capital Risk
As house values are rising again, many people are jumping on the bandwagon to buy a cheap house, fix it up, and sell it for a quick profit. This can work occasionally, but what if the value of the house actually goes down, not up? This is something that Tai and Talaat know all too well. They thought they were being smart by investing in property, but when the housing market tanked, so did their bank account. After the sale of the home, Tai and Talaat were in the hole $25,000. It happened to them, and it can happen to you.
This is the first reason I never borrow to invest. Never do I want to be pressured to make a bad sale decision because of recurring mortgage payments.
2) Investment Income Risk
As our graphs show above, investment income is not a guarantee. Typically, investors like to assume that they’ll rent out their property 90% of the time. In reality though, it might rent out only 70%. Or, perhaps your house develops a problem that you simply can’t resolve (termites, flooding, or an infestation), leaving you without rent for an entire year!
If this happens to you, do you have enough cash stashed away to stay afloat? Many don’t, and it’d sure be a rude awakening to discover investment income risk first hand.
3) Interest Rate Risk
As I was hunting for a deal on a home this summer, I ran into a number of investors that signed up for a mortgage with an adjustable interest rate and it was getting to the point where they were having trouble earning any cash flow at all with their investment properties. Unless you borrow with a fixed rate mortgage, you might be at risk of your mortgage payment ballooning on you and putting you into a terrible financial situation.
When property investors first start out, they often depend on their work income to foot the unexpected bills. If something were to happen to the property and the investment income wasn’t coming in, they could always cover the expenses with their day job paychecks. This seems logical for one investment property, but what about when you increase this to two or three?
And, what happens if the work income were to stop? You might get laid off, fired, or your entire company could go under. Without your work income, would you still be able to make your mortgage payments as well as your investment property’s? Chances are, probably not. And just think, your tenants might decide to stop paying you at the same time! When it rains, it sure can pour, which is why I’ll never borrow to invest.
5) Term Risk
When times are good, banks are open to handing out lines of credit for business use. If you continue to pay on time (which earns them easy money), they might increase your borrowing limit and time period. In good times, a loan from the bank can seem like a blessing.
But, when times get tough and the bank is hard up for cash, they have the right to call your short-term notes and expect payment almost immediately. If you borrowed $600,000 for three rental properties, how quickly do you think you could come up with that cash? Well, you’d probably have to sell all three houses, and at a discount since you were in such a rush.
In the end, you’ll probably face at least two issues. Either all your homes won’t sell in time or if you do sell them, you still won’t have the $600,000 because you basically had to give them away so that you could close and collect the money for them is such a short time frame.
And there you have it – 5 solid reasons why I’ll never borrow to invest. Sure, I might never be worth $20 million because of this decision, but wouldn’t $5 million be enough…..?
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.