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?
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.
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.
$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:
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.
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”:
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”.
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.
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?
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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