Free and Clear Properties in Real Estate: What Does It Mean?

When most people buy a property, they opt for the common practice of securing a mortgage, a financial tool that enables them to purchase a property with a down payment, while spreading the cost over time. Yet, there exists an alternative route—one that offers the allure of outright ownership, unburdened by loans. This is the realm of buying a property "free and clear."

What does it mean to own a property free and clear, and how can it shape your real estate decisions? In this article, we will uncover not only the advantages but also the potential drawbacks of pursuing this path, providing you with a comprehensive perspective on the journey to property ownership.

What Does Free and Clear Mean?

Put simply, free and clear means that a real estate property is purchased outright without any remaining debt encumbrances. In other words, you simply buy the property and own it without any strings attached. Alternatively, free and clear can also mean that you own your property after paying off your mortgage in full.

Normally, when real estate is bought or sold, the parties involved conduct a title search. This is used to identify if there are any existing liens related to the property title. Liens on real estate aren’t always negative; as an example, if you take out a traditional mortgage, there will be a mortgage lien from the lender plus a property tax lien from the county.

How Does Free and Clear Impact Financing?

Having a property free and clear can significantly impact your financing options and flexibility. After all, you have an asset worth at least several hundred thousand dollars totally under your control, and you can do many different things, like dip into that property's equity, sell it for cash, or use it as collateral for another loan.

For this reason, having a free and clear property is potentially a great idea for residential homeowners, real estate investors, and is often regarded as a significant financial milestone for property owners because it means they have complete equity in the property and do not owe any money to lenders or creditors in relation to it.

What Are the Advantages of Free and Clear Properties in Real Estate?

There are several advantages to owning a free and clear property in the real estate market.

No More Interest Payments

First and foremost, you can continue to own, use, and live in the property without having to make any more interest payments. This is a huge advantage whether you want a property to live in with your family or you want to build up your real estate portfolio. The less interest you pay, the more money you have to use for other purposes and objectives.

Full Ownership of the Properties

However, the real advantage of free and clear properties is that you have full ownership of those properties. Once you have total ownership over a free and clear real estate asset, you can do a variety of different things like:

Use the equity you’ve built up in the property to take out loans, lines of credit, etc.
Use the property as collateral for other loans via cross-collateralization. Your real estate asset will help you qualify for very expensive or high-value loans if you otherwise might not.
You never have to worry about the property being seized or going through the foreclosure process. Again, this provides you with peace of mind, whether it's your residential property that's free and clear or one or several investment properties you use for income.
More earning potential if you decide to sell or rent the property as you would not have to account for paying off an existing mortgage or covering the monthly payment. This also opens up opportunity to reinvest into the house and make improvements to increase the value of the home.

These advantages combined make free and clear real estate ownership an attractive prospect for many in the real estate market.

What Are the Disadvantages of Free and Clear Properties in Real Estate?

It’s important to keep in mind that there are also some key disadvantages or downsides you might encounter in owning a property free and clear, particularly if you decide to buy the property with all-cash.

Limited Liquidity

Making a cash offer on a property ties up your funds and reduces your overall liquidity. This means you have less readily available cash for other investments or financial needs.

Additionally, owning your property free and clear means you lose out on potential tax benefits: The IRS lets you deduct your mortgage interest from your rental income because it's a necessary expense to own a rental property. If you own the property outright, you have to pay the IRS more money, reducing the cash reserves to build your portfolio or invest in a new venture.

Opportunity Cost

By using all your cash for a property, you may miss out on other potentially lucrative investment opportunities that could provide higher returns. In other words, owning real estate free and clear might make it harder to diversify your investment capital or portfolio.

Inefficient Use of Capital

Tying up a large sum of money in a single asset may not be the most efficient use of your capital. In the event the property market in your area experiences a downturn, your investment could be at risk, and you might not have diversified assets to offset potential losses. Diversifying investments across various assets can help manage risk and optimize your portfolio.

Lower ROI

If you own your property free and clear, you lose out on some of your ROI or return on your investment.

Imagine a circumstance where you make a small down payment on a rental property. Then, you leverage or borrow the remaining balance due. Even though you are still making monthly payments to your original lender, you can collect all the monthly rental income from that rental property in the meantime. That’s profit you can put directly into your pocket without having to purchase a property outright.

Through this setup, you only have to pay a little bit of money to start turning a major profit with your rental investments. In essence, not purchasing a rental property outright lets you receive a better ROI compared to if you did purchase it outright.

In other words, if your goal is to make as much money as possible from rental real estate investments, buying the properties outright might counterintuitively not be the best idea. You might be able to purchase more properties and, therefore, collect more rental income more quickly if you take out traditional loans instead.

In the long run, you’ll still want to own the properties free and clear (unless you sell them for the development of your portfolio). But in the short term, it’s clear that limited liquidity might be more of a hassle than an advantage.

If you buy a property all cash or purchase it outright, your ROI will be lower for a long time. You had to make a much larger initial investment to start turning a profit in the first place.

Let’s look at an example by calculating ROI for a property you purchased for $120,000, which is your annual pre-tax cash flow divided by the total cash invested.

With a free and clear ROI:

Your annual pre-tax cash flow = rental income - operating expenses
Say you have $16,000 in rental income and $4,000 in operating expenses. You have $12,000 in annual pre-tax cash flow
Therefore, your ROI = $12000 annual pre-tax cash flow / $120,000 = 10%

Now, let's look at your ROI with a leveraged mortgage or deal:

Your annual pre-tax cash flow = rental income - operating expenses - mortgage payment
Say you have $16,000 in rental income again. You also have $4000 in operating expenses. But you also have a $4,000 mortgage payment. $16,000 - $4,000 - $4,000 = $8,000
Your ROI = $8,000 annual pre-tax cash flow / $30,000 down payment = 26.66%

As you can see from this example, using leverage to purchase the rental property may allow you to see a much higher return on your investment compared to owning the property free and clear.

Who Should Own a Property Free and Clear?

Even with the above potential downsides, owning a property free and clear is still an excellent choice for most homeowners and prospective real estate investors. The enhanced control and greater long-term profits make owning a property in this way an excellent idea.

It's also the natural outcome for any long-term mortgage. If you purchase a residential property with a 30-year fixed-rate mortgage, you'll eventually own the property free and clear at the end of the 30-year term, provided everything goes smoothly.

Don’t be afraid of owning a property free and clear. Instead, make sure you know how this may change your portfolio and investment opportunities.

The Bottom Line

In conclusion, the choice between owning a property free and clear or having a mortgage has its pros and cons. Owning free and clear provides security but ties up capital. Having a mortgage offers leverage but comes with ongoing payments and risks.

Fortunately for investors, there are also private loans such as bridge loans and portfolio loans that offer a middle ground. A private mortgage loan allows you to close as quickly as cash, with funding in as little as 3 business days, while preserving liquidity. This gives savvy investors the ability to strike a balance between speed and leverage.

Connect with a Vaster private loan specialist today to learn more.

Sources:

Free and Clear: Meaning, Overview, Pros and Cons | Investopedia

Equity Definition: What it is, How It Works and How to Calculate It | Investopedia

Publication 936 (2022), Home Mortgage Interest Deduction | Internal Revenue Service

What Is ROI? How to Calculate Return on Investment | Tech Target