How Do I Pay For My First Rental Property?

How Do I Pay For My First Rental Property

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My wife and I are approaching a big milestone in our financial journey. Our mortgage will be completely paid off by the end of the year. That exciting financial hurdle has gotten us thinking about the next steps on our quest for financial freedom. Over and over again, owning rental real estate continues to rise to the top of that list.

The excitement of finding the right home, fixing it up, providing someone a nice place to live and earning a solid passive income in the process gives us both goosebumps. We’re still a ways away from being able to buy our first rental home, but we’re starting the planning process … and it is getting pretty real.

Financing our wild and crazy adventures in buy-and-hold real estate is a whole other conundrum.

  • Is it better to leverage rental properties?
  • Do we save up the cash and buy them outright?
  • Should we borrow from our retirement funds (401k, IRA)?

All of these questions have been swirling in my head for the past few months. I thought writing down the advantages and disadvantages in this handy-dandy blog of mine might help heal my real estate headache.

Leveraging Properties

It is certainly feasible for us to start buying rental homes next year if we decide to get a mortgage, but is it worth it?

Advantages

    • We’ll be able to get in the game quicker and take advantage of appreciation. Over time real estate prices have appreciated at a steady rate (save the 2007-2011 timeframe – ouch!). As home prices rise, so do rents. Even if we get another big housing crash, my wife and I are in it for the long haul so appreciation will eventually work in our favor.
    • Rates are still super low. If I’m borrowing at 4% and I’m making 10%, I can still make a 6% return on my investment. Solid, right?

Disadvantages

  • We’ll make less profit with a mortgage. It makes sense really. We’ll not only have to pay for taxes, insurance, property maintenance and remodeling costs, but we’ll have to pay the principal and interest on the mortgage as well.
  • Home prices and rent can decrease. Remember the Great Recession?! The average home in the US dropped from $195k to $151k from July 2007 to December 2011. This can affect rent prices as well. If rent goes down, that would majorly affect our bottom line.

401k Loans

Originally I thought 401k loans were a quick way to light your hopes for retirement on fire, but I didn’t realize all of the passive income doors it could open up. As I investigated further, I’m thinking my original thoughts were spot on.

Advantages

  • Easy access to cash. My 401k plan provider allows me to borrow up to 50% from my account or $50,000 without a penalty.
  • Interest is paid to the “bank of me”. If I were to withdraw funds from my 401k, I would owe biweekly interest back to my 401k at the rate of 5.25%. The payback period can be anywhere between 12-60 months. It’s sure better than paying the interest to a bank.

Disadvantages

  • I have to pay back all of the money within 30-90 days if I lose my job, take a new one or leave the company for any other reason. Yikes! An HR manager on Reddit described some tough situations they experienced when employee’s 401k loans came due unexpectedly:

Why No 401k Loan

To protect ourselves against the immediate payback to our 401k, we could save up enough liquid cash for that emergency. If we did that, wouldn’t we just use the cash to buy the home in the first place?

  • We would lose out on crucial retirement returns. During the borrowing period, my 401k account would be severely depleted. The power of compound interest wouldn’t be so powerful.
  • Double taxation. If we took a 401k loan, the principal and interest we’d pay back would be after tax money. This means that when we withdraw funds from our 401k in retirement we’re going to be taxed again on that principal and interest! Two points for Uncle Sam and zero points for the Hill Family.

Withdrawing Roth IRA Contributions

Hey! What about all of that money I have in my Roth IRA that’s just sitting around?! I’ve already paid the taxes. Maybe I can grab some of that green?

Advantages

  • Tax free and penalty free withdrawals on our contributions. This does not include our earnings, only our contributions. We’d be sure to review with a CPA before doing anything, but it is my understanding that this withdrawal can happen at any time.
  • There is no silly immediate payback situation or additional interest owed like the 401k loan mentioned above. It is our money because we already paid the taxes on it when we initially contributed.

Disadvantages

  • We’re losing out on any returns we would have made with those contributions, like the 401k loan. Depending on when we withdraw our money, we could be “selling low” instead of “selling high”. Timing the market is tough impossible!
  • We can only contribute $5,500 per year (at the time of this writing) so once the money is taken out, it’s out for good. Since we’re maxing out our Roth IRAs currently, we wouldn’t be able to replenish the accounts until the following year.

Cash Purchase

Cold-hard cash. That should do the trick. Everyone speaks that language. But man, it is going to take us a LONG time to save up that kind of dough.

Advantages

    • Would not owe anyone a dime for the house. We’d own the title free and clear.
    • Avoid any of the closing costs associated with a mortgage.
    • Save money on interest payments. Yes, we’d still have to pay taxes and insurance, but we’d have no interest payments.
    • Allows for easier negotiation with sellers. “Do you accept cash? Cha-ching?” (shout out to Wayne’s World). Sellers would be more motivated to work with us because we could close on the home a lot faster.
    • Market fluctuations aren’t as big of a concern. If we owned the home outright, we wouldn’t be as worried if home prices and rent prices drop for a few years. We’d have a solid buffer between our income and expenses.

Disadvantages

  • It will take a lot longer to save up the money we need to buy our first rental property. That’s just the reality of it.
  • We’ll be saving our money in a savings account making 1% for a few years when our money could be in the market in low-cost index funds making 8%. That being said, the 1% is guaranteed and the 8% is not … anything can happen in our volatile stock market.
  • We’d give up any potential tax deductions that may be available if we had a mortgage.

So, what are we going to do?

The 401k loan is a big no-no for me. If I lost my job, that’d be a huge blow to my family especially if I had to pay the loan back right away. To protect against that situation, we could save up a large emergency fund … but then why wouldn’t we just use that cash to buy the home?!

Perhaps it’s the years of Dave Ramsey* teachings that I’ve been through, but a big part of me tells me to save up the cash and buy a property when we’re able to. We may experience another downturn in the market in the next couple of years and we could get a steal of a deal. Who knows? It could go the opposite way too!

Either way, we’re going to need to save up a boat load of cash. Whether we’re going to buy a house outright or with a down payment through leveraging a property, the piggy bank will need to be filled ASAP.


How would you buy your first rental property?

Or if you’ve already purchased one, how did you finance it and why?


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Author: Andy Hill

Andy Hill, a mid-30’s father of two living in the metro Detroit area, pens the MarriageKidsandMoney.com (MKM) blog taking you through the trials and tribulations of being a young parent and husband who is planning for his family’s future and winning with money.

2 thoughts on “How Do I Pay For My First Rental Property?”

  1. Good read!… We bought our rental for straight cash ($45k) and has worked out well.. we are thinking a 20% down 5 yr land contract next purchase.. we hear that there is a lack of “nice housing” to rent in our area so we capitalize on that..

    1. Thanks dollabuzz! Congrats on your first rental! We’re hoping to join you next year. I’d love to know where you bought that $45k property. Did you do it with a wholesaler or did you just find a wicked deal on the MLS? I’m like a sponge. Teach me your ways!

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