The 30-year mortgage with fixed rates is one of the best tools for rental property investors in the U.S. This type of mortgage, which is unusual in comparison to other nations’ offerings, has a high risk. The majority of countries offer variable or adjustable rate mortgages.
Fixed-rate mortgages are a great way to avoid unexpected increases in interest rates. There have also been periods when the mortgage’s rate was remarkably low. This made borrowing money extremely cheap.
What happens if interest rates rise to levels that we’re not used to? The monthly payments for mortgages are suddenly higher. This has a negative impact on our cash flows. Is it time to stop or slow down investing in rental property? What can you do to counter the higher mortgage interest rate and still make money with your rental?
Understanding how rental properties earn money and the things you can do to influence its profitability is the best way to determine whether you will be able to make a profit, even with a larger mortgage.
Rental Properties are Long-Term Investments
Rental properties are long-term investment. Some people will see quick returns on equity through value-added improvements, while others may find deals that generate significant cash flow right from the beginning. As a rule of thumb, rental properties will yield the highest profit in the long run.
When we examine the finances of a rental, we often only look at what’s in front us. When analyzing a rental property’s finances, we often only see the cash flow number that’s right in front of us. This number does not account for inflation, appreciation, or rent increasing over time. These factors are constantly changing, hopefully in a positive way.
How a Rental Property Makes Money
You may not have realized that real estate investments can yield high returns on investment.
Five ways to make money from rental property are:
- Cash flow
- Appreciation
- Tax benefits
- Equity built via mortgage paydown
- Hedging against inflation
Once you have mastered the of each profit center , you will realize the benefits of renting a property over the long term. The higher interest rates you pay won’t even come close to the profits you can make.
It’s possible that you are already saying “But these other profit centers were speculative and my cash flow was still very important. The higher mortgage expenses increase my risk because they lower my cash flow.” This is very true. What you need to do is:
- Balance the profit centres. Look for potential profit centers if cash flow drops, as it will with an increased interest rate. You might be buying in an area that is undergoing gentrification and high demand, which would suggest a high appreciation potential. You might be investing in a period of high inflation. In such a situation, what could you possibly do? Imagine it as a graph, with bars for each of your profit centers. Are any others higher if one of them is lower? It’s not good if they are all lower. Do they balance themselves if some of them are higher than normal? It all depends on the unique circumstances of your situation.
- Focus on the location and demand. As in the example above, investing in property that is likely to increase the value of your home, along with inflation, rent, and rental demand, will be a wise investment. Profit centers are more likely to grow over time if people continue to want the properties they own.
You can start to put on the investor’s hat instead of the consumer one when you know how rental properties generate income. The consumer’s hat is what makes people think higher interest rates are a deal-breaker. However, those who understand the rental property profit model will learn how to not just look past interest rates but how to compensate.
Rent Increases
Rents today, and not rents tomorrow, are used to project the cash flow of a rental. Rent increases are due to two factors: inflation and appreciation.
What does not increase with time or is unaffected by inflation and appreciation? When you’re on a fixed rate mortgage, your mortgage payment will not increase over time.
Your cash flow spread is likely to continue growing over the course of your property’s life as your rent continues to rise.
Rents are likely to rise faster than your expenses such as insurance and property taxes. Rents are likely to continue increasing at a rate that is far greater than your mortgage fixed cost. Your profits will also continue to increase.
Forced Profit Growth and Lowering of Expenses
There are things that you can do now to increase equity sooner. We’ll go through them.
Improving property
It is a fact that the more attractive your property becomes, the higher its value and demand will be. You can increase your property’s desirability to force the profit increase more quickly.
Renovating a home is the most straightforward way to improve it. You can increase rents by upgrading a home to make it more appealing and nicer. The higher interest rates are just a way to speed up the profits.
Refinancing your mortgage
You may not have to pay that high interest rate for the rest of your life. As with rents and property values, mortgage interest rates can fluctuate. You can refinance your property if the rate is lower than the one you signed up for. It’s impossible to predict when rates will fall, but you could take advantage of the opportunity if it happens.
Choosing the best location
You’ll see that this isn’t the first mention of the location for a rental. You can make more informed decisions when you know how to identify neighborhoods with a high potential for appreciation. Values can be increased by factors such as gentrification and population growth.
As with all appreciations, speculating on the gentrification of a particular area is purely speculative. Not only should you learn to recognize areas likely to experience gentrification but also have a plan for if gentrification does not occur. If your profit center were to fall, you wouldn’t put all of your eggs into that one basket. Gentrification will certainly increase profits if you purchase at the right moment (which means that you must act quickly, and avoid wasting time hesitating or else you could lose out on the deal).
Going Up Against Inflation
Renting properties can be a positive impact of inflation, even though it is a negative in most other areas. The fixed rate mortgage cost remains the same throughout the term of the loan, regardless of the value changes in the dollar. The loan is paid back in dollars of yesterday, and not those of tomorrow.
Compare the rate of interest on the mortgage with the inflation. Inflation has led many experts to argue that paying mortgage interest over a fixed 30-year mortgage term is cheaper than buying the same home in today’s money.
If the inflation rate exceeds the mortgage interest rate, you will still be able to make more money than your mortgage.
Keys to Remember
You could read this and think that holding onto your rental property will make it very profitable, because whatever expenses you have today will eventually catch up to the profit.
Not all rental properties will be profitable. Many factors may affect the profitability of rental properties. You should always avoid speculation, as it doesn’t work out all the time.
This article’s goal is not to deceive you, or to make you believe that any rental property can be profitable. Instead, it will show you how you should analyze and evaluate potential rentals with an understanding that higher interest rates won’t take as much income as you might think. The Bigger Pockets How To Buy Rental Property Guide has all the tricks and tips you’ll need to start your rental portfolio strong.
Being educated is also very important. What you consider a high interest rate could be considered “normal.” Because we’re used to historically low interest rates, it is easy for us to forget that they are not normal. It’s a fact that we are spoiled and misled into believing we will only make money if our mortgages have ridiculously low interest rates.
If the rate of interest continues to be a source of stress, you may want to consider paying more on your loan in order for the payment amount will decrease. You may also get a lower rate of interest if you put more money down.