Rental Property Financing Strategy

Before we get too deep into talking about some financing strategy for your rental property I need to point out the obvious.

Mainly because what should be obvious to everyone only seems to be obvious to a few…

So what’s obvious about this topic?

Well, how about what works for one person may not work for the next? Perhaps just because this works for someone in their fifties with a high paying job, maybe someone in their thirties’s making less money should have a different strategy.

There is no single strategy in Real Estate that works for everyone, YOU, yes YOU, must find what fits your individual time and circumstance.

You need to realize you must to have a plan in place that works specifically for you and depending on your current job (or lack of a job), your current age (young or old) and your current long term plan that strategy can vary drastically.

If you didn’t read the first two articles about financing rental properties, you can find them here, Buying Your First Rental – Financing Basics and Buying Your First Rental – Financing Terminology.

Now that that’s out of the way, let’s talk about the main strategies investors look at with their investments.

The Main 2.5 Strategies With Rentals

There are really two main strategies that Real Estate investors seem to focus on with their rental properties. Yes, I’m ignoring the long term play of property appreciation for several reasons.

One of those is inflation will do most of the heavy lifting for you in this department as the overall cost of everything rises and two, we’re talking about financing which is more of the here and now and less long term. Although it does come with long term implications. I’m also throwing in a half, because there is also a combination of these, which should make sense one we get a bit deeper into this topic.

Over the next portion of the article I’ll talk about these two main strategies and then I’ll explain some financing strategies to help provide ideas that can move you in the direction that best fits your needs.

So, let’s do this logically and start with strategy number one, which is cash flow.

Cash Flow NOW

As I’ve said before, Cash Flow Is King. With good cash flow a landlord has so much more flexibility than if they bought a property that was breaking even or worse losing money.

When the market slows down the extra cash flow gives you wiggle room to lower rents and when times are good the extra cash flow can be squirrelled away for reserves.

Cash flow can also be extremely important if it’s your source of income and that’s the goal of many investors, to have their rental income replace their job income. As quickly and as closely as possible so that there is little change in lifestyle.

So does that sound attractive to you? Stop for a second and think about it, what if you didn’t have to go to work anymore, at least at your day job? You could stop dreading Mondays and every day could feel like the weekend.

Now to be fair, some people love their jobs, but many don’t and they want out as fast as they can making the thought of enough cash flow to escape the 9-5 the ultimate dream.

Being in this situation can change your outlook on life. No more stressing about work, the freedom to sleep in, to stay up late, to paint, to go on vacation and to pursue your hobbies whatever they may be.

The Challenge of Cash Flow

The challenge you run into when focusing on replacing your job income is being able to realistically get enough income coming in to replace your wages.

If you’re currently earning $60,000 per year, that means you need to conservatively make $5,000 per month of rental income ($5,000 x 12 = $60,000). If you’re not working full time you will be saving money on transit, work clothes lunches etc, but you may also have to pay additionally for health insurance, travel expenses and more so it does become a balancing act.

If we’re working with the number $5,000 and your current rental property is cash flowing $500 after all your expenses and reserves, you only need to replicate this ten more times!!

TEN MORE TIMES……Ouch.

Now you need ten more down payments on properties, ten times more work and don’t forget, if you end up spending time traveling you’ll likely need a property manager who will charge around 10% of your rents. Suddenly you need eleven properties!

OR, you can focus on increased cash flow.

What if you were getting $1,000 per month cash flow? Now you’re down to 5 properties, what if it was $1,750 per month? Now it’s three… $2,500 and it’s only two!!

Al right maybe the $2,500 is getting a bit crazy, but we can all dream and there are some scenarios where it’s possible. More realistically though $1,000 or even $1,500 may not be out of line either though.

So how do we get more cash flow from properties?

Increasing Cash Flow

There are only two ways to improve your cash flow on any property. Either increase your rents, lower your expenses or do a combination of both.

As landlords we’d all love to be able to increase our rents (if you’ve never increased rents you may need to rethink that as even minor increases help you offset increases in taxes and insurance) but the reality is often the market won’t support it, but that still leaves many of us do have the option of lowering our costs.

One of the main ways to do this is to reduce our biggest monthly expense, our mortgage, which leads me to a couple mortgage strategies. Now both of these strategies have a significant plus (increased cash flow), but they also come with some negatives (risks, more overall debt), so go into this with your eyes wide open.

Option One

The first option is to extend the amortization period. If you recall from our last financing article, the amortization period is the entire length of the mortgage. By stretching a 25 year mortgage out to a 30, 35 or even 40 year mortgage where available, you can see cash flow increase significantly each month due to stretching the payments out over a much longer term.

Take a look at the image below to see the differences in both monthly payments, and total payment amounts for the 25 year amortization term on the left versus the 40 year on the right.

The difference is an increase in cash flow each month of $232.45. If you did this across four properties, that’s slightly under $1,000 extra cash flow per month ($929.80 to be exact) , that’s the plus side.

While this increases the cash flow, it also increases the amount of interest you pay out over the longer term. Depending on the mortgage amount and the term this could be tens of thousands of dollars more or even hundreds of thousands of dollars more.

In the example above the total interest paid jumps from $84,527 up to $143,685!!

The important part to remember about this is that none of this money comes directly out of your pocket, as the tenants cover it with their rent, you just end up stuck in the mortgage longer.

By switching to a longer term you’re adding five, ten or even fifteen years to pay off the mortgage, so if you have a very long term plan this also works well. If you’re targeting equity in the property as retirement funds in the next 10-15 years this wouldn’t work as well.

It’s very important for the educated landlord to understand the ramifications of both the good and the bad when making these decisions.

Option Two

Now, option two is a lower interest rate and similar to how we’d like higher rents, we’d also like lower rates and lenders don’t typically help us out in this scenario. Unless of course we look at other products than standard fixed term mortgages.

In this case I’m talking about variable rate mortgages. Variable rate mortgages tend to be lower than fixed rates by as little as .5% to as much as 2% lower. This can make a huge difference to cash flow, but it too has it’s dangers!

You’d want to go over the options with a qualified mortgage professional to see how a lower rate could help your monthly payments. Just be aware rates can change fairly fluidly as the markets change, so what may work well at one point, may be a poor option with a market where interest rates are rising rapidly.

And that’s the danger of variable rates.

If rates do start moving upwards it doesn’t take too many increases to wipe out any savings you have from the initially lower rate and you could even find yourself looking at a higher rate than you would have been able to obtain with a fixed rate mortgage.

So understand the risks, do your homework and see what works for you.

Now is also probably a good time to point out you also need the right type of property to achieve the goals you have set out.

One student of mine owns multiple properties that each have two suites and an external garage that gets rented out. That is the type of property he targets, because he knows it works and it gets him to his goal.

The majority of those properties generate in excess of $1,200 per month cash flow and during low vacancy periods he’s seen cash flow well above $1,500 per month.

How many properties like that would it take to replace your job?

For this fellow cash flow is key as he has several children attending college and the leftover cash helps support his lifestyle, so always know your goals and have a plan!

Another example is my rooming house property portfolio. My rooming house properties provided huge cash flow and changed all the rules for me. I had several rooming houses that provided $2,000 per month cash flow after all expenses and one larger property that was closer to $3,500 per month so you could see the appeal.

Just keep in mind that huge boost in cash flow also came with much more management!

Bottom line though, each individual needs to have their own plan so they can make decisions accordingly

Are you ready for strategy two?

Cash Flow Later

Strategy two involves a longer term goal of getting your property or properties paid off in time for retirement or even early retirement. This is ideal for someone who loves their work, but wants to supplement their retirement or even someone looking to cover their bases as they approach retirement.

Or maybe they just want a larger stream of cash flow once they quit work so they can finally travel and have all their expenses covered.

Imagine owning a property with $2,000 or more of gross income coming in and having the mortgage paid off. You’d still have insurance costs, some taxes and maintenance bills to save for, but a majority of that cash flow would go directly into your bank account. How freeing would that be?

The goal for this strategy is to put as much of your extra cash flow (and possibly extra earned income) back into the property to pay the mortgage down as quickly as possible.

This is where a couple simple strategies can pay huge dividends and the first one to talk about is switching to bi-weekly payments from a single monthly mortgage payment. Note I said bi-weekly versus bi-monthly which is a big difference.

The difference being two extra payments against the mortgage per year (bi-weekly is every two weeks, so 26 times per year (52 weeks /two) bi-monthly is only 24 payments (12 months x two)). This by itself makes a small difference and as per the image it can take three years off the mortgage amortization term. To accelerate that even faster, by increasing those bi-weekly payments by as little as 10% you can shave as many as eight years off a standard 25 year mortgage.

If you’re able to increase those payment amounts by 20%, you can get to that nirvana of being mortgage free that much quicker! And don’t forget you may also be able to make an annual bulk payment each year allowing you to accelerate to your goal even faster.

Now the caveats. Not all mortgages and/or mortgage products are created equally and not all lenders treat additional payments the same.

Many mortgages only allow you to pay a certain additional percentage towards the mortgage each month and/or year. This can be as low as 5% or much higher for some mortgages. On top of that, you need to ensure the additional payments go towards the principal and not towards the interest owing.

I’m mentioning this because while the majority do this by default, you need to ask just to be sure or you could be in for an unpleasant surprise when you look at your statement at the end of the year and see no change. In the end, if your goal is to be at mortgage amount zero as quickly as possible, making sure you have a product that allows you to do that is paramount to your success!

I can’t stop hammering this part enough, but part of ensuring your success with either of these strategies is having a long term plan. If you have this and are able to share this with your lender when shopping for a mortgage it will help you avoid any ugly surprises like not being able to make these extra payments.

The .5

I mentioned 2.5 ways, well the .5 is a combination of both of these ideas. Sort of a mix and match!

If you know you need increased cash flow in five years, but right now you have strong income from a job it could be hugely beneficial to pour as much money as possible into the principal on your mortgage for those five years.

You could make the extra payments on top of the normal payments, you could pay bi-weekly and then throw extra money on the principal again each year for five years. Then once you hit your five years, if cash flow is the priority, you have a huge amount of principal pay down in place and could reverse strategies.

You can switch back to lower monthly payments increasing cash flow, you could refinance and extend the amortization period and suddenly your cash flow is way up. The extending of the amortization prospect may set you back time wise, but again, it depends on your ultimate plan.

If your need for lots of cash flow in five years is the priority, this allows you to get there strategically, which is what smart investing is all about.

Wrapping It Up

There is no one size fits all solution for your financing strategy with your investment properties. There is only what works for you, or what you let happen to you when you don’t plan ahead.

If you understand your upcoming needs, your future goals and what you want your properties to do for you it becomes a much more freeing proposition rather than just accepting the standard fixed rate 25 year mortgage.

The real message from this article and the previous articles is to show you there are options, to educate you about some of those options and to inform you that you can make some real strategic decisions that can benefit you, yes YOU, going forward.

Now, I want to hear from you.

I would like to have you comment below and let me know if this helped, if you’re going to be talking to your broker and if you’d like more “strategic” thinking articles like this or just want me to stick to the basic stuff?

If you don’t make your voice heard you end up just accepting what you’re given, so I look forward to your thoughts. And don’t forget, if you found it helpful, be sure ot share it with your mortgage broker, other landlords and other investors so we can help as many people as possible.