Summary: When buying a rental property, is it best to get a 15 or 30-year loan? In this post, we cover the benefits of each type. We also explain why we favor using 30-year loans when investing in real estate.
When people buy small multifamily rental properties (and primary residences too) they often debate whether to use a longer or shorter-term loan. For most, it often comes down to a 15 vs. a 30-year loan.
But which one is best?
In this post, we cover the arguments for and against shorter and longer-term loans and explain why we believe a 30-year loan is always the best choice when buying a rental.
Reasons to get a 15-year loan
People purchasing their primary residences often prefer 15-year loans, but a significant number of investors also consider shorter-term loans on their properties.
The main argument for a 15-year loan is that it will lower the total cost of the loan. When you have a 15-year loan, you pay less interest to the bank compared to a 30-year loan on the same property. Because there is also less risk to the bank, a 15-year loan will also often have a lower interest rate, lowering the total interest paid even more. The result: less “wasted” money going to the bank.
People who choose shorter-term loans often argue that they can pay off the loan quickly, reducing their debt. This is the second benefit of the 15-year loan: forced savings. If you have to make a higher payment per month, you are forced to save more of your money to pay off your mortgage. It’s building up your savings. Emotionally this can be extremely rewarding, especially to people who are risk-averse and who do not like owing money.
Reasons to get a 30-year loan
There are four main reasons to get 30-year loans for rental properties: increased flexibility, cashflow, liability protection, and borrowing ability.
Increased flexibility
Longer-term loans lead to increased flexibility because the lower monthly payment enables you to get through challenging times with less chance of financial hardship. Prolonged vacancies are hard enough to weather as it is. With higher monthly payments with a 15-year loan, you will be coming out of pocket for a much larger chunk of cash than you would with a 30-year loan. If you have a number of properties in that situation or you’ve lost your job or other W2 sources of income, you can imagine getting into trouble and, perhaps, even potentially defaulting on your rentals.
No one ever said you can’t get a 30-year loan and pay it off faster. In fact, you can make additional payments on top of the ones that are required ones on a 30-year loan and then recast the mortgage. This is a way to lower your monthly payments even more whenever you pay down your mortgage. That is the flexibility you get with a 30-year loan. You can pay it off in 15 years or not, you get to choose.
Cashflow
When you finance a property using a 30-year loan, you have a smaller monthly payment going to the bank, so you have increased cashflow. More money in your pocket today equals more money that you can use to further invest in rental properties, and grow your portfolio and wealth in the long term. When you add in the value of compounding, even small amounts of extra cashflow reinvested today, can pay big dividends in 10 or 15 years.
Liability protection
There is safety in having a loan on a rental property. A property with a loan on it is a far less attractive a target than one that is fully paid off. With a 15-year loan, you are going to pay down the mortgage faster and build up equity more quickly. More equity means a bigger target for lawyers to go after. Therefore, having a loan on your property is a form of liability protection.
Borrowing ability
A longer-term loan offers you greater borrowing ability. When you have a 15-year loan, you have a larger monthly payment, so your monthly outflow increases and your ability to qualify for the next loan (and loan payment) decreases. To maximize growth, then, choosing the longer-term loan makes more financial sense to the investor.
What about other loan options?
Beyond the traditional 15 or 30-year terms, there is a multitude of other loan options. Some of the most popular ones are loans with a short-term fixed-rate, followed by an adjustable rate, aka ARM. Often these are in the form of 5 or 7-year ARMs, which means that an investor will have a fixed rate for the first 5 years (and cashflow well). After the fixed-rate period, the rate starts adjusting (likely upwards) based on what is going on in the market. These types of loans are commonly used in commercial loans for properties five units and above.
The risk of these types of loans is that your mortgage payment can go up significantly after the fixed-rate period. When this happens, people often look to refinance these loans into a 30-year fixed loan. However, if there is a downturn, it’s likely that you won’t be able to refinance because lending has tightened up or your property doesn’t appraise well enough to refinance the loan. This is exactly how so many people got underwater on their loans during the 2008 recession.
Therefore, consistent with our advice on the 15 vs 30-year loans, we advise always choosing the longest term possible to have the increased flexibility, cashflow, liability protection and borrowing ability associated with a longer-term loan.
So which one do we use?
Kenji and I have financed all of our rentals with 30-year loans (excepting our mixed-use and commercial-sized properties – commercial lenders typically use ARMS and shorter terms). The flexibility of having 30-year loans, especially during downturns when there may be an increased vacancy, appeals to us because we tend to be relatively risk-averse. At the same time, though, the ability to grow our portfolio faster by getting more cashflow using longer-term loans appeals to our more aggressive side too. It’s the right fit for us.
So, which one will you choose?
