Last updated: 2024

I’ve already written all about the first house I bought in Memphis:

I’m going to use that house as a case study for this post, which will focus on how mortgages can supercharge your rental property returns.

If you haven’t already, you can go back and read that post first. But if you’d rather not, here’s the short story: using all cash, I bought a tenant-occupied 3-bed, 2-bath in a B/B- neighborhood that I projected would have a cap rate of 8.23%. In the first 18 months, the actual cap rate has been over 9% — so far, so good. (And that article, like all my Property Spotlights, has a section at the bottom that is updated annually with the story of what happened that year, including new financials and metrics.)

But I bought this house before I realized how powerful a mortgage could be. I figured that using leverage would allow me to buy more houses, but would hurt my overall cash flow. This assumption was completely WRONG. So let’s get into it the details!

What Exactly Makes Mortgages “Magic”?

The availability of loans at a low fixed rate make rental property investing unique. There is no other asset class that allows you to leverage “other people’s money” so cheaply. (High yield and tax advantages are the other two unique characteristics of rental investing; together, these three factors make rental properties the best investment you can make.)

The fact that mortgage rates are currently so low makes this even more true. At the time of writing, the average rate on a 30-year fixed mortgage is 3.26%. For the past decade, rates have almost always been under 5%, and have frequently been under 4%. This is incredibly low by historical standards, as you can see from this graph showing rates going back to 1972:

These super-low mortgage rates make now an ideal moment to invest in rental properties. Capital has never been so cheap for the average investor — the numbers would not work nearly so well if rates were 10%, as they were back in 1990. (Update: mortgage rates have risen since the time of writing, but haven’t yet come close to 10%. And even with higher rates, the math of mortgages still makes a lot of sense — further reading on that topic in this article.)

A few things to know about mortgages on rental properties in particular. First, your rate on an investment property loan will always be a bit higher than the prevailing average rates, generally by about one full percentage point. That means a decent rate today for an investment property loan would be 4.25%, compared to the prevailing average rate of 3.26%. For my examples, I’ll be using 5% to stay conservative – this would be easy to get even if mortgage rates rose noticeably from their current levels. (Update: I am intentionally not updating the math in this article’s examples, since they represented a point in time, and will become relevant again if mortgage rates fall again in the future.)

Second, to get that interest rate, you will have to put at least 20% down; with 25% down you can sometimes get a better rate, so I’ve always chosen a down payment of at least 25%.

Finally, there is a limit to how much cheap capital you can access this way. To be more precise: you can have a maximum of TEN mortgages in your name. Once you reach ten (including your primary residence if you have a mortgage on it), banks will no longer offer you the conventional 30-year fixed-rate loan. There are still ways to get additional loans, but it gets more complicated, and those loans will generally have higher rates, higher closing costs, and less favorable terms. (Here is my full article discussing some of the other ways you can finance rental properties.)

So you want to use those ten conventional mortgages – what I like to call your “golden tickets” – first. (If you’re married, you can functionally get 20 mortgages by putting ten in your name, and ten in your spouse’s name, assuming you can both qualify individually.)

With that background knowledge in place, let’s return to my Memphis house, and look at how a mortgage could have dramatically improved my returns vs. buying in cash. We’ll look at the impact of a mortgage on both ways to make money in real estate: cash flow and appreciation.

Mortgages Can Increase Cash Flow

Here was my (faulty) logic at the outset: If you have a mortgage payment each month, that will reduce your cash flow. Therefore, to maximize your cash flow, don’t get a mortgage.

While this logic seems to track, it can actually be VERY wrong. To see why, we need to introduce a new metric to stand alongside Cap Rate, which we’ll call “Cash on Cash returns”. This metric reflects the fact that when you buy with a mortgage, you invest less cash, which means that any cash flow you generate is off a smaller base of dollars invested.

Let’s get a 30-year fixed-rate mortgage on my Memphis house, at a 5% rate, and see what that does to my returns. My monthly payment on that mortgage would be $380.47, which would reduce my monthly cash flow to $267.50:

Notice that the Cap Rate is unchanged at 8.23%, because Cap Rate is a measure of unleveraged ROI (in other words, assuming there is no mortgage).

Even though I’m making less money each month, I invested less money at the outset – I only put down 25% to buy the house, which is $23,625. So when I calculate my Cash Flow on Cash, I divide my annual cash flow by that smaller denominator, like this:

Wowza! I’ve just increased the rate of return on my invested cash from 8.23% to 13.59%! (Note: for the sake of simplicity, I’m ignoring closing costs in these examples, which will always be somewhat higher for leveraged purchases than cash purchases due to origination fees and other loan costs paid at closing.)

You can see the power of this on your annual cash flow if we assume that I use my same $94,500 to buy FOUR houses with mortgages – instead of earning ~$8K in positive cash flow each year, I’m now earning almost $13K:

Bottom line: my original intuition, though it did seem logical, was wrong. By using mortgages, I could actually invest the same number of dollars and INCREASE my cash flow by more than 65%.

An important caveat is needed here: the numbers don’t always work this way. Sometimes a mortgage results in a LOWER cash on cash return. Sometimes a mortgage’s impact to Cash on Cash Return in negligible (neither higher nor lower). How can you tell? There are no hard and fast rules; you have to run the numbers. But in general, the result will depend on two main factors:

Cap Rate: the higher your cap rate is to begin with, the more likely it is that a mortgage will juice your Cash Flow on Cash.
Interest Rate: the higher your loan interest rate, the less likely it is that a mortgage will increase your Cash Flow on Cash.

Still, given today’s low interest rates, and the cap rates of rental properties currently available in many US markets, the numbers frequently work very well — it is quite easy to use mortgages as a means to increase your monthly cash flow. (Update: of course this is less easy as mortgage rates increase, which they have since the time of writing.)

Remarkably, though, this isn’t the whole story! Let’s talk about the other way that mortgages help rental investors – through appreciation.

Mortgages Can Increase Appreciation

To be clear, mortgages don’t actually make the price of a property go up any faster. But a mortgage can still help you capture more appreciation. Let’s explore how that works.

The first way is through the gradual pay-down of mortgage principal. Let’s continue the example we started above, in which I had a monthly payment of $380.47 to service my mortgage. Mortgage payments always contain some principal and some interest. For example, my first monthly payment contains $85.16 of principal; after I make that payment, I owe the bank $85.16 less, and I therefore have an additional $85.16 worth of equity in the home.

My favorite part of mortgage pay-down is that it gets better every single month. Loan payments follow an amortization schedule, such that every month’s payment contains a bit more principal (and a bit less interest) than the previous month. For example, my second monthly payment contains $85.51 of principal, 35 cents more than the first month. This continues for the life of the loan, with the rate of change increasing over time. (By the time I pay off the loan in 30 years, things will have changed a lot: my final payment will still be $380.47, but that will consist of $378.89 of principal, and just $1.58 of interest!)

But for the purposes of our model, we’ll use the first month’s principal amount of $85.16. I’m going to add that into my monthly numbers, and calculate a new metric called “Total Return on Cash”, which includes both my cash flow and mortgage pay-down and compares that to my cash invested:

As you can see, the paydown of my mortgage balance has juiced my returns even further – to 17.91%, or more than double the 8.23% I would get paying for the house in cash. My four mortgaged homes are generating nearly $17K in returns annually, consisting of ~$13K in cash flow and ~$4K in mortgage principal reduction.

But wait – there’s MORE! We haven’t even factored in yet that home prices tend to go up over time.

Now, I’m not talking about major increases in prices here. If you’re someone who’s looking for 10-20% annual appreciation, you’re now a different kind of real estate investor: a speculator. You’re looking for the right city, and right neighborhood, that will experience rapid price increases, and since nobody really knows where that will happen, the best you can do is to make a well-informed guess. I like to leave as little to chance as possible when I invest my money, so this isn’t the level of appreciation I look for, or expect. Instead, I focus on maximizing cash flow on my invested dollars — which leads me to favor cash flow markets over “hot markets”.

Still, on average, home prices have historically increased at the rate of inflation. (Not that great – but this makes sense, because if homes appreciated faster than inflation, fewer and fewer people would be able to afford them over time, and that obviously hasn’t happened.) So in our example, we’ll assume that inflation continues at ~2%, and that my Memphis house appreciates right along with inflation.

This ends up being pretty nice, though – because with my mortgage, I’ve only invested 25% of the price of the property. That means that the home’s 2% increase in value is actually returning 8% on the dollars I’ve put in. Or said a different way: since I was able to buy four homes instead of one, I’m now capturing 2% appreciation on four homes. (And though the bank put down 75% of the cash, I get to keep 100% of the appreciation!)

A quick caveat: this impact has the potential to cut both ways. If home prices DECREASE, you will absorb that decrease across all four homes instead of just one. But in the long run, home prices are relatively stable (certainly more so than stocks), so it’s very reasonable to assume inflationary home price increases in your modeling as long as you plan to hold the home for the long term (at least 5 years, but ideally 10 years or longer).

Okay, drumroll please…

Let’s put this all together. In my model, I look at one final metric: the total ROI (Return on Investment) on the cash I’ve invested, which includes cash flow, mortgage pay-down, AND appreciation. Take a look at the final numbers:

There you have it: by using mortgages to buy four homes instead of one, I’ve invested the same amount of money ($94,500), but increased my Total ROI from 10.23% to 25.91% (assuming 2% appreciation). If that isn’t magic, I don’t know what is!

This high rate of total returns compares extremely favorably to all other kinds of investing — and even outpaces the stock market.

There’s even some icing on this money-making cake: in a multi-year model, this ROI gets better and better over time. This is because 1) mortgage paydown accelerates, and 2) while rents and nearly all monthly costs will go up over time, there is one important cost that is fixed – your mortgage, or course! So this Total ROI of 25.91% is actually just the beginning.

Conclusion

Loans are the rocket fuel for rental property investments, particularly the first ten (or twenty) “golden tickets” – those low-cost, conventional 30-year fixed-rate mortgages. These mortgages can dramatically increase your returns on invested capital in three distinct ways:

Increasing your Cash on Cash (depending on mortgage rates);
Mortgage pay-down (which accelerates over time); and
Amplifying the value to you of inflationary home price appreciation

About the Author

Hi, I’m Eric! I used cash-flowing rental properties to leave my corporate career at age 39. I started Rental Income Advisors in 2020 to help other people achieve their own goals through real estate investing.

My blog focuses on learning & education for new investors, and I make numerous tools & resources available for free, including my industry-leading Rental Property Analyzer.

I also now serve as a coach to dozens of private clients starting their own journeys investing in rental properties, and have helped my clients buy millions of dollars (and counting) in real estate. To chat with me about coaching, schedule a free initial consultation.