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Mortgages for Rental Property
Mortgages for Rental Property
As an investment, rental property carries many persk like cash flow, equity building and tax breaks. Choosing the right mortgage type for your rental property is the biggest investment decision when it comes to owning rental property. When it comes down to it there are traditional 15 and 30 year fixed rate mortgages, interest only loans and option ARMs. Each bears its own risks and rewards and should be given consideration before purchasing a rental property.
Investment Term
As with any investment it's important to know the investment period (how long the investment will last). The investment period ends when the property is sold. You'll want to decide if the rental property is going to be held long term (over ten years) or only for a short period (less than 10 years). This will help determine the type of mortgage that is necessary.
With any investment the idea is to spend the least possible to make the most possible. You're going to do this with your mortgage. If you plan on holding the rental property for a long period of time a fixed rate mortgage is probably a better idea. It will cost more upfront than an adjustable rate mortgage but over time you'll be exposed to little or no interest risk and you'll have a solid expectation of what your expenses will be. On the other hand, a short investment period would most likely necessitate an adjustable rate mortgage like an interest only or an option ARM. With these mortgage types there will be more of a need to speculate the value of your property throughout the entire investment period. Since the payments with these mortgage types are lower you'll be looking more at the cash flow (rent) as a source of profit instead of the resale. This is because when only interest is paid the mortgage doesn't amortize. If the property value doesn't increase then you basically paid interest in order to receive rents. As long as the rents were more than what was paid in interest, there was a profit.
Interest Only Example
Let's say you purchase a rental property for $400,000, you plan to hold it for five years and the monthly rents total $4,000. You take out an interest only mortgage which makes your payment $1,916.67 if it's amortized over 30 years. If, at the end of five years, the property didn't appreciate in value and you sold it for what you paid for it, you would have profited $124,999.80. This can be computed by subtracting monthly rents by the interest only payment ($4,000-$1,916.67= $2,083.33) and multiply that by the number of months the investment is held (60 x $2,083.33=$124,999.80). Before taxes and maintennance costs the property profited $124,999.80. And as you can see the source of profit came from the cash flow as opposed to the equity with the interest only loan. With a traditional fixed rate mortgage the monthly payment would be much higher, leaving a lower cash flow and most of the profit occuring when the property is sold.