(Note: I’ve tailored this situation for an investment property using a duplex rather than a single family house.)

The Scenario: 2 Cousins

OK, so let’s set the stage here for our analysis. In this scenario, we have two cousins who are going to buy a duplex. The price of each duplex is $250,000. Each duplex is exactly the same, consisting of two 2 bedroom/1 bathroom units. Each cousin will live in one unit and rent out the other unit to a prospective tenant. Each cousin is employed in a salaried job and makes $75,000 per year in income. Each cousin has $50,000 in savings. Let’s also assume that each of the cousins was able to negotiate zero out of pocket closing costs (for the sake of this analysis).

Cousin A

Cousin A is a highly motivated individual and wants to pay off the property as soon as possible. Cousin A only knows one way to use financing, and that’s the way that his parents taught him how to do it: Put down as much money as possible and finance as little as possible. Cousin A is going to put down 20% because that’s what his parents did when they bought their home, and he’s going to get a 15-year fixed, which will allow him to pay off the property in just 15 years.

Then, on top of that, any cash flow that is achieved by renting out the second unit should be put toward the monthly mortgage payment, and Cousin A might even be able to pay it off faster than 15 years. Cousin A wants to build as much equity as possible and as fast as possible, while at the same time paying down the mortgage as fast as possible. The duplex is kept up, and it appreciates at 3% per year.

Cousin B

Cousin B is also a highly motivated individual, but he grew up on the other side of the country. His parents didn’t teach him much about finance, so he had to study it on his own. He’s come to the conclusion that he’s going to do exactly the opposite of what Cousin A is going to do. He’s going to take as long as possible to pay off the mortgage, and that means getting a 30 year amortization on his mortgage loan

He’s going to put as little down on the property as possible, and in this case, it’s only 3.5% with an FHA loan. He’s going to save the difference in monthly mortgage payments ($302) and put that in his savings. Just as in Cousin A’s duplex, Cousin B’s duplex is kept up, and it appreciates at 3% per year.

The Initial Numbers

Here’s what each cousin’s scenario looks like today when they are purchasing the identical duplexes.

Cousin A Cousin B
Purchase Price: $250,000 $250,000
Down Payment: $50,000 $8,750
Loan Amount $200,000 $241,250
Interest Rate: 3.75% 4.00%
*Monthly Payment: $1787 $1485
Difference in Monthly Payment: $0 $302
Equity: $50,000 $8750
Cash after Down Payment: $0 $41,250
Rental Income: $1500/mo $1500/mo
Cash Flow -$287/mo +15/mo
Appreciation 3%/year 3%/year

For the next five years, everything goes as planned for both Cousin A and Cousin B. The renters seem to be long term. The rent hasn’t gone up or down, but at least it has been consistent. The property is most certainly worth more 5 years later, so they’ve both built a little equity in the property. They still have consistent income, so nothing seems to be wrong as far as monthly payments are concerned (except the fact that Cousin A has to pay a little bit every month, whereas Cousin B actually makes a few bucks every month).

The Numbers in 5 Years

Here’s where the cousins are at after 5 years:

Cousin A Cousin B
Duplex Value (5 years): $289,818 $289,818
Loan Amount (5 years) $145,355 $218,204
Loan Amortization: 15 years 30 years
Interest Rate: 3.75% 4.00%
Monthly Payment: $1787 $1485
Difference in Monthly Payment: $0 $302
Equity (5 years): $144,463 $71,614
Savings $0 $59,370
Equity + Savings: $144,463 $130,984
Rental Income: $1500/mo $1500/mo
Cash Flow -$287/mo +15/mo
Appreciation 3%/year 3%/year

Finally, at year 7 into the process, something happens. Cousin A loses his job, and since he put such a large down payment down on the property in order to “pay the property off faster,” he has absolutely no savings (also because he had negative cash flow). The renter in Cousin A’s duplex decides it’s time to move out, and he no longer has income coming in from the rental. I would call this a “rainy day” event because it’s a major malfunction of the system at this point in time.

Coincidentally, the same exact thing happens to Cousin B. He loses his job, and the renter in his duplex also decides to move out at exactly the same time as the renter with Cousin A.

The Numbers After 7 Years

Here is where each stands after 7 years financially.

Cousin A Cousin B
Duplex Value (7 years): $308,339 $308,339
Loan Amount (7 years) $120,468 $207,618
Loan Amortization: 15 years 30 years
Interest Rate: 3.75% 4.00%
Monthly Payment: $1787 $1485
Difference in Monthly Payment: $0 $302
Equity (7 years): $187,871 $100,721
Savings $0 $66,618
Equity + Savings: $187,871 $167,339
Rental Income: $0/mo $0/mo

This is where the situation becomes divergent. Since Cousin A has no more income whatsoever because of the job loss and rental income loss, he’s forced to make a tough choice. Either he can’t make his mortgage payment or he’ll have to sell the house. Most likely, he’ll have to sell the duplex to get his equity.

Cousin B, on the other hand, is totally good with where he stands financially after the job loss and the tenant loss. He can make the mortgage payment for many years with just his savings alone. He can take his time to find a tenant who fits the mold of exactly what he’s looking for. And he’s got the cash to cover expenses that he may run into for a while.

The End.

Now, I know there are several variables in this story that may or may not happen. I give you this story to illustrate a few points about residential investment real estate, real estate finance, and money in general.

Here’s my take:

The Takeaway

Cash vs. Equity

Cash is liquid money and is absolutely essential when you finance real estate. Cash is much easier to use if something goes wrong, whereas equity is completely useless. You’d have to sell your asset if you ever need the money quickly, and that is not always the choice that someone needs to make if an event occurs.

Value vs. Financing

The value of a residential property will go up or down regardless if you have a mortgage on the property. Value is completely out of your control in residential real estate because it’s usually based on someone’s opinion instead of cash flow (like commercial real estate). This is an important point when investing. Since mortgage money is the cheapest money that you’ll ever borrow, why not finance as much as possible?

If the numbers don’t work for the smallest down payment possible, move on to the next property. Remember, a good investment property is one that cash flows to your liking, not one with “equity.” That is to say that the income generated by the property is greater than the expenses of the property.

friends-family-financial-freedom

Smaller Down Payments vs. Bigger Down Payments

This goes along with reason number one. Nobody cares about equity unless you’re trying to determine your “net worth.” And net worth is as useless as the “g” in lasagna. So, when given the choice of putting down a lot of money or a little money, put down a little money and either save or invest the rest. Leverage is key. Use other people’s money (in this case, the bank’s money) to the best of your ability. Don’t put more money into a property to try and generate a cash flow. Just move on to the next one.

Long Term Mortgages vs. Short Term Mortgages

Remember, when you’re financing an investment property, you can always pay more, but you can NEVER pay less. Leverage is key here. A shorter term mortgage means that your payment is going to be higher — period. Regardless of the interest rate you’ve obtained on your short term mortgage, it will be more than a longer term product, even if the longer term product has a higher interest rate. Every single dime, nickel, or penny you give to the bank is money that you’ll never get back unless you refinance (borrow against the house as collateral) or sell. Those are usually major transactions.

As you look through the ideas listed above, realize that this is what commercial real estate investors do all day long. Commercial real estate is so much more about the numbers of a given property rather than emotions or opinions, like residential real estate is.

Challenge yourself to find a cash flowing residential property that enables you to make a small down payment, get a long term mortgage, and spend as little of your own capital as possible. The cash flow that you achieve will most certainly be better than the equity you’ve gained.

by Jeff Trevarthen | BiggerPockets.com