Small versus Large Down Payments

Many investors wonder whether it makes sense to plunk down a larger down payment when buying a rental property.

Some argue it is “safer” because it will produce more cash flow and less likely lead to negative cash flow.

This reasoning is often flawed for several reasons:

1. If you use up all your cash in the down payment, you don’t have a reserve for vacancies and unexpected repairs.

2. You could use that cash to buy a second property.

3. You could use the extra cash to make improvements to the property that produce a better cash flow and thus a better return on your capital.

Let’s have a closer look at reason #3.  If you are borrowing at 4.5% interest on a 30 year amortization, every $10,000 borrowed is about $50 a month in payment of principal and interest.  Suppose you are considering putting down an extra $10k on a property as down payment; that’s about $600 a year in extra cash flow or 6% return annually on your $10k.

Instead, what if you added a third bedroom or a garage that produced $100 additional rent per month.  That’s $1,200 a year in extra cash flow or 12% annual return on your $10k.  In addition, the improvement will increase the value of the property so you get more return when you sell the property.

I am not saying that it is always bad to put more cash down on a property, but consider at least the alternatives – you might find a better return for the extra cash lying around.