For most people, financing real estate using mortgages is a fact of life. Most people don't have the cash to pay for the entire purchase price of a property, and many people want to leverage their cash to boost their return on investment.
So mortgages are here to stay... at least until tenants pay them off. In the mean time, mortgage payments must be made every month, easily accounting for 50% or more of a rental property's monthly cash flow.
While it's true that for most mortgages, a portion of each payment is principal repayment (and not really an 'expense'), with such a significant impact to the bottom line, a good investor does everything they can to minimize the monthly out of pocket cost and keep the cash flow positive.
Choosing an appropriate mortgage that reduces out of pocket costs is not always an easy decision to make. Anyone who has ever obtained a mortgage knows what it's like... they may ask questions like:
- is the cheapest interest rate always the best one?
- what amortization period should I pick?
- should I choose a long or short term?
- what about fixed interest rates or variable?
- is an open or closed mortgage better?
- do I need pre-payment or payment increase privileges?
- which lender should I choose?
These are not always easy questions to answer, as the mortgage industry varies widely and the answers depend on the individual. The answers for a new home buyer may be substantially different than for a real estate investor. Even among investors, the answers can different based on their tolerance for 'risk' (ie. the chance their monthly payments may go up, etc.). The following are some things to consider when making decisions:
- Interest rates - The interest rate affects your monthly payment and therefore your cash flow. Obviously, lower interest rates are better, but all mortgages are not created equal (see the section below about lenders). Most banks will lock in rates for you (even on a refinance or renewal) for 90-120 days. Use this to your advantage while shopping around for the best mortgage.
- Amortization period - This also greatly affects your monthly payment and therefore your cash flow. Longer amortizations are better, but as a result, it takes longer to pay off the mortgage. Normally investors don't care about paying off the mortgage early, so it is best to select a longer amortization (ie. 25 years or more)
- Long or short term - Deciding the answer to this almost requires a crystal ball. An investor must predict things like where interest rates will go over time, and how long they will hold a property. There is a measure of risk when using short-term mortgages, as rates could go up at renewal time, causing a severe reduction in cash flow. Long-term mortgages reduce that risk, but can prevent taking advantage of drops in interest rates, so it ends up costing more. Ultimately, flips should use short term mortgages, while the term can vary for buy and hold properties based on investor preference and risk tolerance.
- Fixed or variable - Most people use mortgages that are locked in for a fixed term. This can be a disadvantage if an investor decides to sell a property or interest rates drop substantially. On the flip side, variable rate mortgages allow an investor to take advantage of rate drops, but they can also easily increase. Variable rate mortgages also tend to have lower interest rates than fixed mortgages, thereby boosting cash flow. Flips should use fixed mortgages, as this allows accurate forecasting of holding costs. Long-term buy and holds can use fixed or variable, depending on investor preference and risk tolerance.
- Open or closed - Open mortgages tend to have higher interest rates than closed ones, but have no penalties for full repayment. Closed mortgages should be used for long-term buy and hold properties, while open should be used for flipping.
- Pre-payment or payment increase - For long-term buy and hold properties, ensure the mortgages terms allow partial pre-payment (at least 10%-15%) and an option to increase monthly payments. This provides flexibility to use excess cash flow to pay off the mortgage faster. For flips, a good sized pre-payment privilege will help reduce penalties if the property is sold before the mortgage term is complete.
- Lenders - This is a tough one and an investor will have to rely on their mortgage broker and referrals to find good lenders to work with. Some lenders may have the lowest rates, but the mortgage is difficult to qualify for, they may have high fees for breaking the mortgage, etc. Find a lender who is flexible, without high fees for everyday items (like extra statements, NSF charges, etc.), good customer service (this is important), and of course the easiest qualification criteria (would you rather jump through 37 flaming hoops to get a mortgage, or just 3?).
The above sections don't really provide the answer to choosing fixed/variable or long/short term because it really depends on the individual. However, the following articles published by Moshe A. Milevsky, Ph.D, a Finance Professor at York University and Executive Director of the IFID Centre, may help an investor make a decision.
- Mortgage Financing: Floating Your Way To Prosperity - Published in 2001, this article describes his approach to finally answering the question of whether to go long or short on a mortgage. He uses sophisticated mathematical analysis based on historical interest rates to come to his conclusions.
- Mortgage Financing: Should You Still Float? - Published in 2004, this article discusses his original suggestions in light of today's very low interest rates, and provides recommendations for different types of people (ie. new home buyers, etc.)
Once an investor has had a mortgage for awhile, they may discover that their cash flow is low, so they make want to find ways to boost it. The following are some suggestions on how to do this:
- Skip a payment - This is our favorite and one of the easiest. Many mortgages have the ability to skip one or more payments. Even if this isn't part of the mortgage agreement, many banks will make exceptions. The advantage of this is that you can boost your cash flow with one phone call. If you pay $1500 per month on a mortgage, that's $1500 you can keep in your pocket.
- Interest only - This requires refinancing, and may not be available in all cases (especially for rental properties), but it can dramatically boost cash flow. No principal repayment is included in your monthly mortgage payment -- only interest costs. The disadvantage is that no equity is being built up through mortgage 'pay down'. Instead, the equity is kept in your pocket every month by not having to pay the principal.
- Extend amortization period - If you've had a mortgage for a few years, normally upon renewal or refinance, the amortization period is reduced by the length of time you've held the mortgage. To reduce your monthly payments, extend the amortization period back out to 25 years or more.
Using the above information to select the proper mortgage, and the extra techniques to boost cash flow, an investor should be able to keep their monthly debt servicing costs to a minimum so they can keep more money in their pocket and for long-term buy and holds, keep the property long enough to benefit from one of the best parts about real estate -- long-term appreciation.
