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How to finance a rental home for the greatest return
Im going to be talking about a few different ratios of financing today and showing you what the return differences will be based on a case study that I’ll show you. Now, I’m going to be talking about traditional financing. There’s different ways to finance real estate and rental homes, and ways you can even get a greater return through some creative financing such as seller financing, assumptions, and subject-tos, different things like that, but I’m not going to talk about that today. We’re going to talk about traditional financing, which is what most real estate investors do, especially as you’re getting started.
There’s a few things to consider though. When you’re doing traditional financing, your credit is really important because you’re going to be getting a loan. If you don’t have good credit, maybe consider partnering up with someone that does so you can make sure you can get the best interest rate, which ultimately lead to higher cash flow, higher cash returns, and things like that.
Available cash. How much cash do you have available to put down on the property? That’s going to lead you down one of the paths of different ratios of financing. What are your investing goals? Are you looking more for cash flow in the short term or long-term returns on your money? Then understand that every deal is different. There’s not a one-size-fits all way to finance properties. You’re going to be looking at property A and property B, running them through pro formas separately and independently because every situation is different, every property is different, and you’re welcome to use the tool on our website. It’s an actual rental pro forma that can help you build that out for the properties that you’re looking at.
Here’s a case study. We’re going to be looking at five different ratios. The first one is putting all cash down. The second one is putting 50% down, 25, 20, and 15% down on the property, and we’re going to look at the returns on those. Here’s some of the foundation of the case studies. We’ve got a purchase price of 200,000. That’s remaining the same for all the properties, as well as rent of $1,600 per month. Few assumptions here: 10-year hold time, 3% appreciation, 3% annual rent/cost inflation, and average tax and operating cost remaining the same for all the different ratios. Now, that would include management fees, taxes, insurance, vacancy cost is budgeted in there, as well as maintenance cost that’s budgeted in.
Here’s the cash purchase. We paid 200,000. We’re putting 200,000 down. There’s no principle and interest, no interest rate. We’re getting cash flow of 1,149 per month. Now, one thing I want to point out with these numbers. This is a 10-year average annual, so cash flow in year one was different than cash flow in year 10. This is taking the average of the years, including the rates of return. Our average annualized return on the cash flow against how much money we’re putting down is 6.7%, and then our cash return after it’s sold after 10 years is 9%.
Let’s look at putting 50% down. We’re putting 100,000 down. We’ve got mortgage, principle and interest of 492 per month, interest rate of 4.25%, which is actually a lower rate. Because we’re putting more than 20% down, we qualify for a different program and it reduces our interest rate. Now, interest rates, of course, if you’re watching this video in two months or six months or two years, I don’t know that they’re going to be the same. They could be less or lower, they could be higher, but this is just an example for the case study. Cash flow is 657 per month. Cash return on the rental income is 7.4%. Cash return after the sale, 11.9%.
Now, you don’t need to write all this down yet because I’m going to be showing you a table. We’re going to summarize this together. We can look at the different programs.
25% down, so put a 50,000 down. Principle and interest payment is 738. Interest rate is 4.25%. We still qualifies for the lower rate because we’re putting more than 20% down. Cash flow, 411. Cash return on rental income, 8.8. Cash return is 17.2.
20% down. 40,000 down. 787 principle and interest. Interest rate of 4.5, so we’ve bumped up about a quarter percent because we’re at the 20% mark, so a little bit higher rate, which is still, in today’s money, still a great rate for a rental property. Cash flow of 338. Cash return on the rental income, 8.8, has stayed the same from the other one. Cash return, 19.1%.
Now, lastly, 15% down. We’re putting 30,000 down. 913 principle and interest, but we got PMI, or mortgage insurance, 125 per month. Interest rate went up as well because we’re under that 50%, or the 20% down ratio. We got a 5% rate, so that’s going to eat into our cash flow, but as you can tell, 89 per month cash flow. Now, this is actually averaged over 10 years, and so year one, it’s actually taking a loss, where in year 10, it’s higher. Cash return on rental income, 3%. Cash return after the sale, 16.1%.
Let’s look at this together. The 10-year cash return, 6.7%, and then it’s going up a little bit. Kind of levels off here at 25-20% down, and then it goes down at 3%. Now, why is that? Well, our cash flow is literally very slim, and for a couple of years, nonexistent, so we don’t have any cash flow to go against what we put down, so we’re taking a negative return on those first few years, but analyze after the sale with appreciation. One thing I’ll point out with appreciation, you can watch my video on leveraging, is if a property of 200,000 appreciates 3% per year, which is pretty normal, well, if I’m only putting 50,000 down, then you take that 3% over the $200,000 asset and apply it to what I put down, it’s actually closer to a 12% return on my investment.
9, 11.9, 17.2, 19.1. Now, with this 15% down, we still, after the sale of the asset, have a 16.1% return because we’re leveraging so much; however, that’s not a safe place to be unless you’re really planning on appreciation and you’re not looking for a great return on your cash, which most investors are looking for both. You want to look at where this plays out for you, getting the best cash return as well as, after a 10-year period, looking at maybe liquidating that asset.
I hope this is helpful for you to check out. Now, every deal is different. Use our investment pro forma to check out your situation and your property. Contact us if you have any questions. We can help you find properties, help you buy properties, help you analyze those to make sure you’re going to be in a good situation but we analyze it from the perspective of an investor, which we are, as well as from the property management standpoint because you want to make sure that you’ve got all the potential costs included and you’re not inflating the return by removing, say, vacancy and maintenance and some of those important things.