Trying to Choose The Right Loan? Stop Looking at Just The Rates!

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It is not uncommon for investors to be presented with different loan options when they are securing a loan for a property. Often these options can differ in the required loan to value (LTV), the interest rate or whether or not they allow you to roll in construction costs. I am probably presented options by investors every few weeks that are not sure how to compare the loan options, and it is not uncommon for the banker to falter when asked what the incremental costs is of the additional money. (In fact I may be cheating a little by writing this since I can then reference it to inquiring purchasers at a later date).

Let’s Look at an Example

In this example you can purchase a property valued at $150,000. To simplify the example let’s assume both are offered with equal terms, 30 years. The first loan option will allow you an LTV of 90% at a rate of 6.5% while the second calls for an LTV of 80% at 6%.

The theoretical caller always calls and presents the above option as a great way to get “cheap” funding.  They look at the difference on the rate and are pleased with a .5% interest rate difference that allows them to preserve $15,000! The problem is that the actual cost for this is much greater. To complete the example above you are actually borrowing the $15,000 at a rate of 10.20%. This is found by looking at the difference in payments. Below is my attempt to simplify the process.

Incremental costs pic1-1In practice this means that you borrow the additional funds at 10.20% only IF it is the cheapest option available to you. If you are borrowing just to borrow or because you like having a sizeable cushion in cash you may want to give this a second thought. Is it worth it to keep your savings earning less than 1% to borrow at 10.20%? If instead you are convinced that you can have that extra money work for you and EARN a rate of return greater than 10.20% then this is a great route to go. There is no “right” answer but the cost of the additional $15,000 is rather high even though it seems misleadingly low at .5%. This argument will generally hold since rates are often higher the more you borrow.

Last week I actually had someone come to me with a similar question. They were trying to determine whether it would be wise to purchase a $100,000 property using a conventional loan which required 25% down payment at a rate of 5% or a homestyle loan that required 20% at a rate of 5.5%. What was unique about this option was that the homestyle option allowed this investor to roll in about $20,000 worth of renovation costs. This changes our calculations a little and is one of the few times it may actually be OK to roll the cost in.

Related: For Real Estate Investors, Finding Good Loans Is Tougher Than Finding Good Deals

Incremental costs pic2

This above means that the cost to borrow these funds is 4.52%. If you have money sitting in a cash account earning 1% this may still not be the best option. However, the prospect of this type of program certainly must be considered. Some investors may even argue that borrowing money at this rate is nearly free money when inflation is taken into account.

Related: Investment Property Loans: The Ultimate Guide

Still Reluctant?

For those of you who have your own team of workers that work “under the radar” you may still be reluctant to do even this deal with the cost to borrow at 4.52%. The reason is when funds are supplied by a third party your team must be licensed by the state and the particular city. This may result in you not being able to use your team which would drive the cost on projects up 10-20% more than what you can do “under the radar”. In other words when using your own funds and team you may get the $20,000 job done for $16 – 18,000. This is money saved today which completely skews the results in FAVOR of doing the deal with your own funds. Depending on where you are this may not be an option. However, the conclusion to draw here is that understanding financing and financing costs are more than just comparing rates.

While I didn’t look at it here we could also compare different loan terms in the same fashion. Believe it or not I compare every loan option presented to me for parcels in my own portfolio a similar way until I find the maximum I should borrow for any one given property given my next best use of the funds. I hope this will at least get you thinking about incremental cost and how it impacts your purchase.

…what are your thoughts?

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About Author

David Rodriguez is a professor of finance and a managing real estate broker/owner. As a real estate investor himself, David has been able to leverage the academic and practitioner experience. This shows through the development of his own residential real estate portfolio across three states and his goals to help investors to do the same. David has published courses, chapters and articles in the realm of finance and real estate and is always looking for ways to get information to those that are interested.

11 Comments

  1. Thanks David for nudging us to do the math on the differental on loan choices.

    Like the rest of us I’m looking for lower cost alternatives to bank financing to purchase and hold rentals. Anyone find crowd funding or wall street funders for >5 yr term loans at reasonable total cost?

    A source for unsecured business lines that are at or lower than 10%. Lots of business lines above 13%, which one can use where ever one would use hard money…

  2. Stuart Stevens on

    It appears that you are including the difference in principal along with interest and then comparing the interest on the loan against initial cost of the difference in both principal and interest. This comparison has NO value. This may make more buyers think about the cost of money although I suspect this will only confuse most individuals who read this. I would strongly suggest that this post be removed.

    Difference in interest rate = rate1 – rate2 !!!!!!!!!!

    • David Rodriguez on

      Stuart,

      Looking at the difference between two rates is not looking at the entire picture. That would not provide you the incremental cost which is the cost of the additional funds borrowed.

      This post is looking at “incremental cost” of the additional funds borrowed. The difference in payments as a result of the 50 basis points is applied to the entire loan balance, not just the additional funds borrowed.

      Not to complicate it anymore but I did a quick search to see if I could find you some more detail. These first few slides address the need of looking at this issue.

      http://business.auburn.edu/~hollalh/refin/Incremental.pdf

    • Stuart Stevens on

      David

      Upon further reflection, the numbers are correct, I was incorrect. Getting an additional $15,000 for only .5% loan interest increase results in over 10% increase on the additional funds.

      Thanks

  3. I honestly can’t figure out if you are advocating the bigger down and lower rate or the other way.
    The mumbo jumbo with fictitious interest rates, that as pointed out above don’t seem to be real measures of anything, seem needlessly complicated.
    If you are arguing that a bigger down with lower interest will be far cheaper falls well into the “duh” territory.
    This also assumes essentially unlimited funds to be able to double your down or fully fund an extensive construction project with no other consequences.

    • David Rodriguez on

      Shaun,

      You are correct that this is only looking at financing cost and more specifically the cost of borrowing that “next dollar” (termed marginal or incremental cost) . This is not advocating one way or another. I do this analysis for every property and loan option presented to me since it is not always obvious.

      In fact with the second example above which was pulled from an investor I worked with just last week, with real numbers, shows that it is not necessarily a “duh” moment. In that example, with homestyle, the cost of additional funds was low enough that one can justify rolling it in. However, that is not always the case which is why I choose to incorporate the additional detail into my personal analysis.

      • Still very academic and needlessly complicated.
        Get an online mortgage calculator and pull up the amortization table for both and compare how much interest you are paying if you want to figure out what costs what.

        This analysis again also assume limitless options to the investor.
        What if:
        a) He can only afford a small down and little extra for the fix up. Then the high LTV loan is the only option and the rehab money is being borrowed someplace. Then it is just a matter of finding the least expensive option.
        b) Maybe there is enough free cash to put in the bigger down and self fund the construction but not much extra liquidity. If the project goes bad they are wiped. Or less pessimistic another good deal comes along and there are no funds around to even do a really high LTV loan. Opportunity costs could be huge.
        c) Say the option was a higher rate lower down seller financed loan. This could cost less up front, in both down payment and transaction costs, even if the interest is higher. However this is more flexible and you can say deed the property to an entity and not have it in your name thus making you DTI look much better for future conventional loans and not take up one of your 4-10 conventional slots. Intangible benefit there, which would be very difficult to quantify with any precision.

        Lots of things that need to be considered in anyone’s particular situation.
        This feels like a much more trouble then it is worth analysis to me.

        • David Rodriguez on

          Shaun,

          Thanks for the reply. I agree entirely that a fair amount of scenarios and factors must be taken into account. I also agree that an amortization table would help in determining the total interest paid between two alternatives. It will not give you the cost of those additional funds but it will certainly shed light. Truthfully, if all investors even just took that step it would prove valuable. I was just presented this question in more than one instance and thought it would be good to toss it around.

          Thanks again for your comments

  4. very confusing article which would only be interesting if it showed that the higher interest rate was advantageous to the investor.

    • David Rodriguez on

      Michael,

      The point here is more to determine how best to finance. Each situation is different. A deal you are working on may have an incremental cost of 8%. In other words to borrow an additional 10% (for example) would cost you 8%. If you have an alternative investment that can earn more than 8% you would borrow the funds at the price of 8% and invest your money in the alternative.

      On the other hand if you could not earn a minimum of 8% in alternative investments you would be better off just putting your money down on the property and NOT borrowing the extra 10%.

      This goes back to you wouldn’t borrow at 8% to make 5% logic. However, the bank does not break it down this way so you will have to do this yourself. The bank simply states that to borrow more will cost more but that is not useful in an analysis.

      If you are interested feel free to reach out through BP. My intent was to make a concept more usable and to shed light on why we can’t just look at offers at face value but I am not sure I succeeded.

      I hope this adds some level of clarity.

      Thanks for the read

  5. Good article David, the high cost of the extra $15k is not immediately apparent by looking at the 0.5% interest rate difference. Good reminder to fully “run the numbers” when making financial decisions.

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