If you’re thinking about buying a rental property, you’ve probably looked up current mortgage interest rates. Banks all over the country set their mortgage interest rates based on a number of factors, including central bank interest rates set by the Federal Reserve. Depending on current economic conditions, the interest rate for a primary residence mortgage could be less than 3 percent, greater than 20 percent, or somewhere in between.
Over the past decade or so, interest rates have been historically very low. However, these rates are beginning to rise, making rental property buyers and other real estate experts hesitate before closing deals.
Just how important is your mortgage interest rate when buying a rental property?
Buying a Rental Property: Factors to Consider
According to Green Residential, there are many different factors you’ll need to consider when buying a rental property. While it is important, and can influence many variables by itself, it’s not everything.
You’ll also need to consider things like:
- Neighborhood and demand. If the neighborhood is excellent and rental properties in this area are in high demand, you can afford to spend much more on the home. You’ll have no problem attracting tenants and you might be able to charge a high amount of rent as well. Conversely, if demand is insufficient, even a great mortgage deal won’t save you.
- Future potential. Most rental property investors think in the long term. It’s not enough to think about how this property functions today; you need to think about how it’s going to function in several years. Is this neighborhood growing? Is the home going to remain in good condition?
- Current condition. Speaking of condition, you’ll need to think about the current condition of the property before buying it. You might be able to score a great deal at a low interest rate, but if you also have to do major renovations, it could compromise your profitability.
- Asking price. Don’t forget about asking price. If you can find a great deal in a good neighborhood, interest rate might barely factor into the equation. On the other end of the spectrum, a ridiculously overpriced property might still be a bad purchase even if interest rates are near zero.
- Your portfolio. Also think about the nature of your current rental property portfolio and overall investment portfolio. It’s important to diversify and minimize your risks.
The Role of Mortgage Interest
Now let’s take a look at mortgage interest rates exclusively. Each year, you’ll pay a certain amount of interest on the principal of the loan you take out to purchase this property. Obviously, this influences the price you pay each month, but there are many discrete effects that mortgage interest rates can have.
- Monthly payments and cash flow/profitability. The most apparent effect of mortgage interest is on your monthly payments, and by extension, your cash flow and profitability. The higher the interest rate is, the more you’ll pay in interest each month, and the less money you’ll make (assuming you charge the same amount of rent).
- Lifetime interest payments. It’s also a good idea to look at the lifetime interest payments you’ll make for a given mortgage. In some ways, your interest payments are a “waste,” since they don’t help you build equity; they simply go to the bank. Over the course of 30 years, even a difference of 1 percent in your interest rate can lead to you paying $75,000 more on a $330,000 loan.
- Home prices. As we all experienced over the last few years, interest rates can influence the prices of homes. Many consumers look at their monthly mortgage payments as an indication of whether they can afford a property, so lower interest rates mean they can afford bigger, more expensive homes. In a highly competitive environment, it also means they can afford to bid higher than their peers. Collectively, these influential forces push home prices higher, which can sometimes negate the benefits of lower interest rate payments.
- Competition. Lower mortgage interest rates mean more people are able to enter the housing market in a bid to buy a home. That means increased competition, and more layers of complexity when you’re searching for properties to buy.
Is a Lower Interest Rate Always Better?
Most property investors will tell you that lower interest rates are favorable, but the truth is a bit more complex. Because lower interest rates are associated with higher home prices, more competition, and other tricky variables, high interest rates do come with some advantages. On top of that, it’s possible to find great deals on rental properties regardless of the current interest rate.
What’s important is that you understand the environment you’re entering, so you can make the best strategic decision.
Managing a Low Interest Rate
When buying in a low interest rate environment:
- Be prepared for competition. You’re going to have many people trying to outbid you, so be prepared to exit if the deal doesn’t make sense.
- Don’t shy away from borrowing. You don’t want to run the risk of over-leveraging yourself, but a low interest environment means you can borrow more with fewer costs associated with your borrowing.
- Understand the risks of high prices. Low interest rates usually push prices higher. That’s not always a bad thing, but it could leave you underwater on your loan if you’re not careful.
Managing a High Interest Rate
When buying in a high interest rate environment:
- Prepare a larger down payment. Borrowing doesn’t make as much sense in a high interest rate environment. Accordingly, consider preparing a larger down payment for the properties you buy – or buy them all in cash.
- Be choosy. Competition is low and the environment typically favors buyers, so you can afford to be choosier when selecting properties to add to your portfolio.
- Consider refinancing. Mortgage interest rates may be high now, but that doesn’t mean they’ll remain high in the future. If interest rates drop, you can always refinance and take advantage of the new rates.
- Consider selling. Higher interest rates typically mean lower prices, so if it works for your strategy, you can buy a house in a high interest rate environment, sell it in a low interest rate environment, and cash in on the pricing difference when it comes.
So just how important is the mortgage interest rate when buying a rental property? While it’s not as important as other factors, like the location of the property and the total price you pay, it’s a very important consideration. Make sure you understand the current interest rate environment before planning your purchase, and strategize accordingly.