I just finished up a big long article for our Rev N You with Real Estate Newsletter subscribers…and this is such a huge and important point for all potential real estate investors to understand that I thought it’s worth repeating (in summary).
Let me cut to the chase and say that there are only three sources of funds I would recommend you use for a down payment on a real estate investment. They are:
1. Your own money (from retirement savings, stocks, bonds or selling something you own like your car).
2. Equity in your home or in other investment properties. If you have over 25% equity in your home and have quite a few years before you plan on retiring, consider using a portion of the equity in your home to get started.
3. Find a great property…one where the rent will cover the costs with as little as 10% down. Get an accepted offer and then find a partner that has the money to invest in the property with you. Be prepared to sell yourself AND the property.
Technically, only #1 is using your own money. The other two use none of your own money…but are not considered “no money down real estate deals”, which is when you finance 100% of the purchase price of the property.
We’ve bought several properties when we’ve had very little money ourselves. The no money down deals where we financed 100% of the purchases using vendor financing or lines of credit blew up in our face. Those were hard lessons learned. But, the deals we did with our own savings or a partner, where we did all of the work finding and purchasing the property, and now oversee the property, have been a great success. The partner puts up the down payment, we do all the work, and then when we sell, the partner gets their down payment out first and the proceeds are split 50-50.
Having money for a down payment allows us to buy better properties in better areas, gives us equity in the property from the start, and helps reduce the monthly mortgage costs so the property is more likely to cash flow from day one.
Some real estate guru’s suggest credit cards or lines of credit to come up with down payments for your first real estate investments.
In fact, Julie reminded me the other day that one of the first things we were taught at a “get rich quick, no money down” real estate course we took in Toronto many years ago. The guru told us to use the break time to call our credit card companies and get the limits increased and the interest rate dropped. The room was buzzing with excitement after the break. Everyone proudly told stories of getting credit of $5,000, $10,000 and even $20,000 added to the limits on their cards! And some even excitedly reported that they now would only be paying 18% interest instead of 21%.
What if something goes wrong with your investment and you end up paying that 18% interest on that $20,000 for years to come? Do you want me to do the math on that?
A no money down deal where you borrow 100% of the cost of the property, and have no equity in the property from day one, makes it very high risk. If the value decreases even by 5%, you will find yourself owing more money on the property than it’s worth. And it’s tricky to find a property that will cash flow when you finance 100% of it. Here’s a simple example:
75% Financed Deal, Purchase Price $200,000
Down Payment $50,000
Mortgage of $150,000 at 6%
Amortized over 25 years
Monthly Payment = $960
Now, using the rule of thumb that your mortgage should not represent more than 65% of your income on the property, you need to make $1,477/month in rent on this property (divide $960/.65) to break even.
100% Financed Deal, Purchase Price $200,000
Down payment: $0
1st Mortgage of $150,000 (same as above)
2nd Mortgage of $50,000 from vendor at 8%, 25 Year Amortization
Monthly Payments of $960 + $382 = $1,342
So, you need at least $2,065/month in rent to break even.
You need almost $600 more per month in rent to make this property break even!
It’s nearly impossible to find desirable properties with numbers THAT good. But it is possible to find properties that could generate $1,800/month rent on a $200,000 property. If you have $25,000 (either from a partner or from refinancing your home) vs. nothing for a down payment, then your monthly mortgage payment drops from $1,342 to $1,142 (87.5% financing plus a mortgage insurance fee of 2%). So, now you need about $1,757/month to break even.
No money down deals are not only MUCH riskier because you have no equity in the property, they are also pretty darn hard to find because they rarely cash flow.
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