Is it better to buy an investment property with all cash or with a loan?
If a loan is used to purchase investment real estate, what is the best type of loan (term) to utilize?

This is a common topic of discussion among residential real estate investors. While there is no shortage of strong opinions about the subject, few people take an organized approach to ensure that they are selecting the financing option that is indeed best for them.

Since there is at least some truth in all three of these arguments, how do you choose which purchasing option is best for you?

We’ve studied the issue and have come up with a method to the madness. The steps outlined below are appropriate for a buy and hold investor, in other words, someone who intends to buy an investment property and hold it for a number of years. If you follow these three steps, you’ll have the satisfaction of knowing you made the financing choice that’s best for you before you’ve spent your first dollar.

In separate articles we’ll be discussing steps one and two in greater detail—where to get the information you need and how to analyze it with a straightforward financial analysis. For now let’s assume we’ve identified a property, done our research and completed the pro forma scenarios based on the following assumptions:

Property cost of $125,000 with projected net annual rent of $14,250, operating expenses of $4,930 and with the 30 year amortizing fixed rate for investors at 5.0% based on 75% loan to value. Our mortgage broker also mentions that a 15 year loan at 4.25% might be an option.

Based on these, we calculate the following comparing purchasing our proposed investment property with 30 and 15 year amortizing loans with fixed rates to an all cash purchase.

First, notice that the net operating income is not affected by financing. So if the property you’ve identified has poor income, high expenses or both, financing can’t fix it!

If your goal is to generate the most cash you can each month, it’s probably no surprise that paying all cash is clearly the way to go. By eliminating the need to make a mortgage payment each month, you’ll get an annual income of $9,320 versus $3,280 or $856 with the 30 and 15 year loans respectively. Since your goal is to generate the maximum amount of cash, you shouldn’t be concerned that you are getting a 7.5% return instead of the 10.5% return you’d get with a 30 year loan—making the loan payments on it would leave you with $6,039 less cash flow a year, a full 65% less than if you did not have a loan. Assuming you have the means to do so, you should pay all cash to maximize your property income.

If your goal is to generate the highest cash on cash return, leveraging your purchase with a 30 year mortgage is your best option. The 10.5% return you receive on the $31,250 you put down is significantly better than the 7.5% you’d get by putting $125,000 down with an all cash purchase. (If you had the money to buy three more properties just like this one, your $125,000 would generate $13,120 on four leveraged properties instead of the $9,320 on one unleveraged property.)

If your goal is to achieve the highest possible return without regard to generating income along the way, you should choose the 15 year loan. By using all the available cash flow to aggressively pay down the loan balance, you’ll own the property free and clear in 15 years and generate a whopping 17.4% annual return. The lower interest rate, reflecting the reduced risk of loan default for the lender, is an added benefit of this option. This strategy is a good match, for example, for someone who is 50 years old who would like to have the $9,320 income that an all cash strategy generates—but doesn’t need it until she retires in 15 years.

The takeaway is that there is no one “right” answer to deciding whether or how to finance an investment property. The best answer depends upon a combination of loan terms, interest rates and your personal investing goals.