When Purchasing a Rental Property, Throw the Formulas Out the Window!
Everyone has a different method of deciding if a property makes money or not. Sounds crazy, but people have varying opinions about making money on their rental properties. Some think that if a property costs them money over a period of a few years, then they sell it and make $5,000, they’ve made money. But they neglect to consider all the money they’ve put into it during their ownership.
Other’s think that if they buy it and it “breaks even,” when they rent it out, meaning that the tenant is only paying enough to cover the mortgage, then they are making money. But they also neglect to consider all the money they will have to put into the property during their ownership, just for upkeep and normal wear and tear.
The 1% Theory
This is probably the most common I’ve heard. This when you see a house for sale for $150,000, some say that you should be able to rent it out for $1,500 a month (1% of the sales price). Some say that if you can make 1% of the cost of the property back on the monthly rent then this is a good buy. But let’s drive down deeper.
What the 1% Theory doesn’t take into consideration:
- Property taxes can vary from region to region, which means that a 1% blanket estimate isn’t going to hold true from a property in Valdosta, GA to a property in Phoenix, AZ.
- Your mortgage payment will also vary depending on how much your down payment was. If you put down 10% on $150,000 and finance the rest at 6% interest for 30 years, your payment will be $809, not including taxes and insurance. However, if you put 50% down, that principal payment drops to $450. So the 1% doesn’t hold true here either because it doesn’t take in the specifics of your down payment, the interest on your loan, and the length of your loan.
What I Recommend:
First, throw the formulas out the window and remember there’s a number of factors involved knowing if your property is going to make you money and deciding on how much you should charge your tenants for rent.
Second, always do a 30-year loan – this way your mortgage payments are smaller and more manageable. Plus it will help your cash flow easier. With that being said, I don’t recommend that you take the entire 30 years to pay the loan off, but create your own amortization length to shorten the payoff period.
For example, Let’s say you get a 30-year mortgage on a $150,000 house at 7% interest with 20% down. Your required principal and interest payment will be $798, but you want to pay it off in 20 years (instead of 30). How do you know what your payment will be? You do an amortization schedule for 20 years.
You’re thinking, “Great, how do I do that? There are all kinds of great website that can help with this and many are free. I use www.HSH.com or www.BankRate.com where you can also compare different lenders and what they have to offer while also getting a good feel for the going interest rates at the time. You can also download some great apps that will do these same features. Just look around and see what you can find as they’re changing all the time.
All you need to get started on these sites are your original amount financed and your interest rate. Plug those numbers in along with the number of years you want to pay it off, and they will calculate what your payment should be to pay off the loan. Then just start making that number your payment toward your mortgage.
Where to Apply Extra Mortgage Payments – Additional Principal
Now, LISTEN VERY CAREFULLY – It’s very important when paying above your scheduled payment to note where you want the extra money applied and in your case, you want to apply it to the additional principal.
If you don’t specifically say that, the lender may apply it toward your next payment or your escrow account, which holds your money paid for taxes and insurance. These choices will not pay off your loan any earlier, so make sure you mark your extra money as additional principal.
One more thing I’d like to mention is, once you make the payment — even if it’s above your scheduled payment — you cannot get it back. Even if you run into financial situation and need money, you can’t get your additional payments back, so make sure what you pay in, you can afford.
There are a lot of factors when it comes to calculating how much you can charge for a rental property. So remember there is no one theory, but have the numbers (price, insurance, taxes, interest rate, price, down payment, etc.), run your amortization schedule, and leave room for your cash flow and then decide what to charge for rent to your tenants.