Mother f-ing boat

“No Money Down” is a Terrible Idea

Don’t have any money?  Want to invest in real estate?  No worries, find a house, go get a “no money down” loan and start your rental empire today!

This is exactly what you should NOT do.

Trust Me, I Know

I’ve been there.  When I first started out, I bought property at the highest leverage I could convince a bank to loan me (a mere 80% of value, much more conservative than “no money down”).  You know what happened?

Nothing good.

Following a certain drop in home prices in late 2007, I got into a bit of a lurch.  Home prices were down, which dropped my loan to value (LTV).  Interestingly enough, banks are just in it for the money, so, when the time came to refinance my loans, it took some…convincing.  When I did manage to talk them into refinancing, my interest rate jumped, my amortization dropped, and my monthly payments skyrocketed.  It didn’t take long for cash flow to dry up.

Fortunately, I had a good job and had invested in other properties more conservatively (not “no money down”), so I was able to make it through, although, I’m still for that mistake.

You might be saying: that sucks Kenny, but I’ve seen a lot of infomercials featuring people on mother f-ing boats who say it worked for them.  (If you don’t get that reference, click here.  Lots of explicit language).  They all did it why “no money down,” why can’t I?

This might be a good time to check out my post aptly titled why real estate gurus are full of it.  If that’s not enough, let’s look at some more reasons: based on numbers not boats.

Cash Flow

Recall, we purchase rental property for cash flow.  We’ll sell if the time is right, but for us cash flow is king.

How do you determine if a property is a good rental investment?  All investments depend on where and how you’re investing; however, a general guideline is if a property’s monthly rent is 2% of the price, it’ll make a good rental.  What does that equate to for monthly income?

Let’s look at some numbers.  These are “typical” numbers and will vary greatly depending on the investor and the locale.

Net Income without any financing

$840 bucks a month and over a 10% return a year, aren’t anything to sneeze at.

How does this change if you go with the “No Money Down” option?  Let’s start with a 80% loan with 6% APR and 20 year amortization.  For the remaining 20%, the interest rate on your loan is going to be higher, let’s call it 6.75% APR and 20 year amortization.  On top of this you’ll have to pay Private Mortgage Insurance (PMI) (around 1% of the second loan per year).

Well, that’s a lot of numbers.  Here’s the “no more down” scenario after a bit of crunching:

Net income using no money down

Wow.  “No money down” gives you a whopping $125 per month.

Considering most people are in this situation because they don’t have any spare cash, a furnace going out ($1,000-$2,000) might force them to start buying cardboard.

Homelessness is the risk of no money down

I find it immensely ironic that some of the same folks arguing for a “no money down” option have the stones to tell you should build up a reserve of six months worth of rent (just to be safe).  Let’s think about that gem for a second.  If you have income of $125.35 and you want to build a six month reserve ($12,000) it will take you 8 years!

But it’s ok, after 8 years the money really starts rolling in…

The Appreciation Play

What’s that you say?  This doesn’t apply to you?  You’re in a super hot market and you’ll be getting 10% appreciation a year?

if you do get those appreciation and go with “no money down”, your numbers would look pretty good.  In year 1, if your property value goes up by 10%, then your monthly profit will increase to $958.67 ( ($1,504 + $10,000)/12 ).  Looking good Louis.

Two slight problems:

You’re no longer an investor

This thought process makes you a speculator.  Unfortunately, my crystal ball cracked a few years ago, so I avoid using it to make investment decisions.  Remember my post on why we invest in rental property?

In a picture, here’s my summary of the appreciation play using “no money down”:

No money down is just gambling in another guise

Still no cash flow

Maybe the market does go up 10%.  You’ll never see a red penny of that unless you sell the property and foot the bill for the 8-10% closing costs.  In the meantime, if the furnace goes out you’ll still be investing in cardboard.

Technically there is another option: you could borrow MORE money by refinancing using the higher valuation.  More financing on top of “no money down?”  If you think this idea has merit, go ahead and click the x in the upper right corner of your screen because I’m doing a terrible job making my point.

Better Options Than “No Money Down”

Remember back in the day before easy credit, when everyone used this thing called lay away?  As I’m 29, I didn’t witness it first hand, but I imagine this is how it went down:

I walk into a store and I see a new phonograph I can’t live without.  The problem is I don’t have enough simoleans to buy it.  What do I do?

I wander over and have a pleasant conversation with the shopkeep.  He’s a nice young man and agrees to put the phonograph in a back room for a couple of months.  During that time I come in on a regular basis and pay money towards the purchase price.

One swell day I pay off the total amount due and I take my phonograph home to listen to the newest song by Jack Norworth: “Take Me Out To The Ballgame.”

The gist of my argument is the same:  replace “phonograph” with “house”, “back room” with “bank”, and “I take my phonograph home to listen to a new song by Jack Norwroth: ‘Take Me Out To The Ballgame'” with “cash flow”.

Save your money, don't buy with no money down.

Yes, that was a really long winded way of saying you should save up before buying a house.  This might sound a bit harsh, but if you’re too tight on funds to be able to save money then you’re not going to be able to weather any problems that arise with your rental property.  Don’t do “no money down.”

Now if only our government would switch to this model…

Thoughts on Yachts

In a former life (back in the good ol’ days of 2006), I was invited onto an acquaintance’s boat.  Thinking it would just be another day on the lake, my friend, Will, and I trotted down to Monroe Harbor on Lake Michigan.

Monroe Harbor, Chicago

Imagine our surprise when we found out this particular boat was a yacht.  This particular yacht turned out to be at least half again the size of any of the other ~300 yachts in the Harbor.  It was as glitzy as you could imagine and had a year round full time staff.

This owner made his money in a way loosely similar to “no money down” investing.  For those of you in finance, he sold a lot of volatility.

Ironically, his yacht was named “Perseverance.”

When the market tanked in late 2007 he “blew up.”  The “Perseverance” was the first thing to go.  Followed shortly by his court side Bulls tickets.  Then his home.  (I have since lost contact with him but I sincerely hope he’s doing well today.)

Putting “no money down” is pretty dang similar to what that owner did.  If everything goes perfectly, you can indeed make some quick money.  After all, where do you think the folks preaching to you about real estate investing from atop a yacht come from?

Eventually your luck will run out.  Heck, Donald Trump has filed for bankruptcy four times and he had a $200 million head start.

Wrap Up

Want to build a real estate empire without losing sleep at night?  Find great properties and save enough so you can buy them with conservative financing.  I recognize this doesn’t have the same appeal as the get rich quick approach using “no money down”.

However, it does have the distinct advantage of working.

All this being the case, in my last post I explained why you should think long and hard before personally buying real estate.  If you’re saving money already, you’re better off finding someone who already has a strong track record and investing with them.

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During Kenny's decade in finance he bought many single family rentals in rural areas, as a hobby. Along the way, he talked some brave souls into joining him as investors and recently retired from finance to take his hobby to the next level. Keep up to date with everything he's doing on twitter!

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12 thoughts on ““No Money Down” is a Terrible Idea

  1. Andriy

    Your table with cost analysis is nice. It’d be even nicer if it had a probability of accidental repairs (stupid furnaces, etc.). By now you should have enough data to have produce good statistics.

    Reply
    1. Kenneth Estes Post author

      Good point. I crunched the numbers and in 2012 approximately 8% of our homes had any individual expense over $500. The issue is that when we fix up our properties we replace any roof/furnace/water heater/fridget/etc that we don’t think will last at least five years. This really helps with managing our expenses but skews our numbers quite a bit from the “industry standard.”

      Reply
  2. Kevin

    Some interesting thoughts, though cash flow is usually calculated as cash received less cash expended for a given period. :-) I think your Monthly Cash Flow is really more like Pro Forma Gross Rent. One of my profs liked to say “pro forma” is Latin for “make believe!”

    The 2% rule is interesting – the milk rule? I personally like the 10/30 rule best: buy a house when it’s priced 30 times the annual rent. For example, you should buy a property that rents for $2,000 a month if it’s priced below $240,000 ($2,000 * 12 * 10) and sell it if you can get $720,000+ ($2,000 * 12 * 30).

    Reply
    1. Kenneth Estes Post author

      You’re correct. How I use cash flow should indeed probably be something like Pro Forma Net Income, but cash flow rolls off the tongue a little easier. :)

      Interesting point on the 10x multiple on annual rent. That would really make all of the numbers above a LOT worse. Our “monthly pro forma net income” using the numbers for a no money down purchase of our example property would go aggressively negative.

      Reply
  3. KRB

    This is a really interesting post. But what about the equity you are accumulating each year? If you start out with nothing and end up having the tenants buy you a house over 15 years, what is the downside?

    Thank you!

    Reply
    1. Kenny Estes Post author

      Thanks for the comment KRB!

      I’m not claiming there is not potential upside. There is! The issue is if you go no money down, you leave yourself very little room for error. Thoughts?

      Cheers,

      Kenny

      Reply
  4. KRB

    Fair enough. That could leave you in quite a bind, depending on your circumstances. Still, if you do your best to pick a safe house and end up paying for some repairs out of pocket (or out of the cash flow of other properties), you still end up with a “free” house (not to mention potential appreciation) at the end of your mortgage. I recently refinanced a rental property I owned outright in order to buy an additional property in cash, so I’m most certainly just being defensive, but I got a 15 year loan at 3.25% and have a $200/month cash flow on a $45k property, and to me this seems like a great deal. I’m new to this though and open to learning the hard way.

    Thanks again for this post and for this blog.

    Reply
    1. Kenny Estes Post author

      KRB,

      Thanks for following up!

      One topic we’ve not brought up is Loan to Value Ratio. With houses, especially ones in the $45k range you can get some amazing deals. Right place, right time, sort of thing. If you’re picking up a house at 50% of what its true price should be and pay no money down, then you’re at 50% LTV, which doesn’t qualify for my diatribe against no money down. :)

      Is that the case here? The most common situation I see is someone finds a property, pays close to full price, and forced the cash flow using large amounts of leverage.

      Everything in moderation right?

      Cheers,

      Kenny

      Reply

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