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Posted over 9 years ago

Hack of Wk of 10/20 - Why Paying Off Debt is NOT Necessarily Smart

Normal 1413820933 Loan Calculator

The "Hack" of this week is NOT the usual technique that you can implement in your real estate business. It's rather a different way to analyze a deal and a different way to look at debt. Before I discuss how to do this analysis, let me first discuss the importance of leverage.

Leverage and 3 Types of Leverage

As landlords, it makes sense to use LEVERAGE - get a bank loan so you use as little of your money as possible. With the low interest environment that we have right now, it makes perfect sense. Why use your own money and pay yourself less than 4% interest rate when you can use the bank's money instead? You can then spread your money over several deals and become wealthier faster.

BUT most investors don't realize that there are 3 types of leverage - positive leverage, neutral leverage and negative leverage. Oh and by the way, negative leverage does NOT necessarily equal negative cashflow. It just means your money is NOT working as hard as it should. But I am jumping ahead of myself.

When investors think of leverage, they think of INTEREST RATE. If the return on investment, say is 10% and the interest rate the bank charges is 4%, the investment should be GOOD, right? The reasoning is that there's a 6% spread and therefore, the investment makes sense. Being an engineer by background and now a private lender, I realized that investors got it wrong. The interest rate is NOT the right number to focus on.

The Right Number

What's the right number? It's the LOAN CONSTANT. What the heck is that you say?

The loan constant is the amount of debt payment you incur per year divided by the loan amount. In an interest-only loan, the loan constant is equal to the interest rate. In a regular loan, the loan constant includes the PRINCIPAL payment and therefore the loan constant is HIGHER than the interest rate.

Let's give an example.

Let's say you want to borrow $10,000 from your 401k and you'll use that as downpayment for a real estate deal. Let's say this deal should give you a 12% return on your investment - so you'll get $1200 a year from the deal. Your 401k provider says you can borrow $10K at an interest of only 2% and the loan is payable in 3 years. You grin and tell yourself - that's awesome - I will make a 10% spread, right? WRONG. Here's why. Your $10K at 2% interest rate is payable in only 3 years. Assuming the loan is not amortizing, the way to calculate the loan constant is as follows:

[$10,000 + ($10,000 x 2% interest/yr x 3 years)] divided by 3 years = $3,533.33/yr debt payment

You then divide that by the $10,000 investment equals 35.33% LOAN CONSTANT.

Given that you only get $1200/yr return on your deal or 12%, when you deduct your loan constant of 35.33%, you get a NEGATIVE leverage of 23.33%! You are actually losing money for the first 3 years of $2,333 per year. If you're expecting positive cashflow, you're in for a surprise. You just have to do the math and you need to calculate your loan constant.

Investors will sometimes choose 15 years to pay off an investment loan, sometimes they want to get it paid off in 10 years. Be careful. Wanting to pay off a debt sooner is not necessarily the smart. Why? Because when you find your real spread, you might be in the negative leverage territory. Let's give a more complicated example (for those of you who hate math, you can go ahead and get your calculator now). 

Let's say you have a property that you can buy for $100,000 and it has a 10% cap rate - meaning it produces a net operating income of $10,000/year. Let's say you can get an FHA loan for 95% of the purchase price at 4% interest rate. You have 3 choices:

Choice A - Pay the Loan in 10 years

Choice B - Pay the Loan in 20 years

Choice C - Interest Only Loan

Which loan makes sense? Let's say your objective is to generate as much positive cashflow as you can. Let's calculate the loan constant.

Choice A - you get a mortgage calculator to do this. Loan amount $95,000, interest 4%, amortization period - 10 years or 120 months. Monthly payment equals $961.83 or an annual payment of $11,541.95 a loan constant of 12.2%.

Choice B - monthly payment equals $575.68 or a loan constant of 7.3%

Choice C - is obviously 4%.

Here's the Summary:

Normal 1413820896 Loan Constant

You will have negative cashflow in Choice A and positive cashflows with Choices B and C. If your objective is to get as much cashflow as possible, Choice C will give you the biggest spread. If you can get the property flipped in 3 years, it makes sense to just stay with Choice C. 

However, if you want to keep the property long term, Choice B makes more sense so you can get the loan paid off and make a lot more cashflow after 20 years. Or, you can stay with Choice C and just pay off the principal by making an extra payment. By doing this, you will protect yourself from the possibility of the rent decreasing or the net operating income of a property becoming lower due to a circumstance outside of your control. For example, what if the property taxes increase all of a sudden and now your cap rate decreases to 6%. Having a 7.3% loan constant with Choice B means you will be in negative cashflow territory. But if you maximize your spread you can still pay the principal during boom times and choose to just pay the interest during lean times.

Ultimately, investing and deciding to pay off your mortgage sooner or later is a personal investment decision. What I have hoped to have done with this blog post is to show you how the real spread is calculated and it begins with a not-so-known number called the LOAN CONSTANT.



Comments (6)

  1. This addresses some questions I had. Thanks Jeff!


  2. Jeff,

    The 3 year loan is payable in 3 years. I guess, I was not clear. I meant the interest was only 2%...I did not mean 2% interest only. My mistake. Sorry.


  3. In your example of the 3 year loan at 2% it was also interest only.  Why did you use the formula there?  I realize that my example is not correct but I don't believe yours was either.  


  4. Jeff, the interest only loan is precisely that - interest ONLY. So it's $95K x 4%/yr = $3,800/yr


  5. It seems you made the error in calculating (not calculating) the loan constant for the interest only loan in the chart above.  If I understand correctly, you need to figure the loan term since this is not amortizing.  Assuming a term of 20 yrs. :  

    [$95K + ($95K x 4% x 20 yr)] divided by 20 yrs = $8,550 yr. debt payment.

    $8,550/95K = 9% Loan Constant.


  6. 1.  NOI is ONLY operating income based on operating expenses at one point in time.

    2.Cap rates are established by the market.  Expenses changing after your purchase have little to do  with the market cap rate at that time.

    3.  Otherwise a more thoughtful approach to leverage than usual.