15 yr vs. 30 yr affect on cash flow

18 Replies

So imagine I have a generic property in a vacuum that I could finance in one of three ways (approximately):

30 yr loan => +$1000 cash flow per year

20 yr loan => Basically break even on cash flow

15 yr loan => negative $2000 cash flow per year

(all would be 20% down)

So I'm not a big time real estate investor that's always doing deals....I'm looking to own a small handful (1 to ~3) of properties to build long term wealth and generate some income to fund a potential early retirement in early 50's (maybe) and bridge the gap until I can tap into my 401k and IRA at 59.5 yrs old. So there's an incentive for me to have the property paid off when I'm 45-50 years old (15 or 20 yr loan), as opposed to financing for 30 years and then not owning it outright until I'm 60 (when I can access my 401k anyways).

BUT - I always hear about the dangers of negative cash flow. Does this still hold if the negative cash flow is due to aggressive financing, not the property itself?

Which option would you go with?

You need to work your numbers--on the surface these all look horrible to me even if you need a write off.  If you only need a few deals make them "good to great" deals not just "average or poor".  Real estate is harder than stocks and bonds you should be making more money with RE than you do in the stock market.  Cash on cash return? depreciation tax savings, etc?  If you borrow the money at 4% and are making a 15% return then use that money for 30 years but if your return is low then look for another property. Answer:  If you have a 30 year loan there is no penalty for paying it off in 15 years if you choose but you have the option to use the money for the full time as life conditions will change.

Looks like a bad deal or it should have a very good appreciation potential Usually rental should have break even or positive cashflow with 15 y mortgage
Originally posted by @Carl Fischer :

You need to work your numbers--on the surface these all look horrible to me even if you need a write off.  If you only need a few deals make them "good to great" deals not just "average or poor".  Real estate is harder than stocks and bonds you should be making more money with RE than you do in the stock market.  Cash on cash return? depreciation tax savings, etc?  If you borrow the money at 4% and are making a 15% return then use that money for 30 years but if your return is low then look for another property. Answer:  If you have a 30 year loan there is no penalty for paying it off in 15 years if you choose but you have the option to use the money for the full time as life conditions will change.

I know you were kind of just throwing out a return of 15% just as a rough figure, but could you expand on which "return" you might have been referring to? IRR, Cash-on-Cash with Equity, Modified IRR etc, before-tax or after-tax etc? All of these numbers could be very different from each other. I guess the most realistic return figure would be the Modified IRR assuming a reinvestment rate for whatever you would do with your positive cash flow...?

Michael E

My father told me early on "use the Keep It Simple Stupid (KISS)principle"--My personal goal is to get a minimum of 15% "cash on cash" return for any real estate that I "buy and hold". Appreciation, tax savings, debt reduction if leveraging, depreciation tax savings, etc should all be included. However I watch the COC --the rest is gravy. I do not usually count appreciation until it occurs and is never a discriminator in purchases. I am an investor not a speculator.

I will take the positive cash flow dollars and do short term private lending or buy some distressed notes like Dave Van Horn talks about. I do not do less than 10% interest,cash on cash, return with notes but again I target 15% COC just to keep it simple. I do most of this in IRAs and I am a big believer in Roths or tax free returns. This Makes the numbers a little simpler. I must confess that I do let some money sit around in case I come across a great deal I can act quickly. I have sources that do overnight loans or transactional funding as well that keeps the lazy money working some while it is sitting around. Each investment stands on its own and is reviewed annually. I hope this answers your questions.

Originally posted by @Jane A. :
Looks like a bad deal or it should have a very good appreciation potential Usually rental should have break even or positive cashflow with 15 y mortgage

So I'm still pretty new to real estate investing, but from screening online listings, it's just about impossible to find a property that will break even on cash flow with a 15 yr mortgage (and the standard 20% down....you can make anything cash flow positive with a large enough down payment, of course). I'm assuming operating expenses of 50% of gross rental income, ~3.8% interest rate on the loan.

With these parameters, monthly rent needs to be about 1.2% of the purchase price. So a $100,000 property needs to rent for $1200/month.

Gross Income/mo = $1200

Expenses/mo (50% of rent assumption) = $600

Net Operating Income = $600/month

Debt Service (15 yrs at 3.8%) = $580/month 

I have a hard time imaging that I'll be able to find a property for $100k that rents for 1200/month in my area (about an hour west of Baltimore). That kind of property is probably more in the 800-900/month range and in the seedy neighborhoods, in my area, which would be basically breaking even on a 30 yr mortgage. 

Just curious - in order to find deals that you are willing to do, are they always foreclosures/distressed sellers etc? I understand that great deals aren't just "out there" waiting for anyone to stroll on by, that you have to dig to find them, but I'm curious to hear how much research time you put in and/or # of properties looked at before you find a property worth investing in.

Thanks for the help!

There is the "math" answer and the "life" answer. On a math basis, if your cost of borrowed money is less than the return, you should theoretically never pay off the loan. Of course, only the government can really do that because it has an infinite lifespan. And it ignores risk. You unfortunately do not have the luxury of either.. If your gal is to have rentals paid off by age 50, then set it up for that. Don't worry about cash flow. Cash flow is a meaningless number. You can manipulate it by down payment, length of loan etc etc. It doesn't tell you anything about the quality of the investment. The IRR or CoC or ROE all are better indicators of quality of the investment and how it compares with other options. Get a good IRR investment (I would not bother with rentals for less than 15% CoC per year after all reserves) but that threshold is for you to decide on your own.

@Michael E.

I like what @Carl Fischer said about borrowing at 30 and repaying as if it were at 15-year amortization, except when you don't want to. That gives you built-in flexibility to cope with changes in your circumstances, as you might sometimes need extra cash. Very creative.

Also what @Anish Tolia contributed makes eminent sense to me. You can set it up to do what you want it to. 

So I work a lot in Maryland, and am wondering what part of central Maryland you are working in. If you are trying to work a deal in Montgomery County, for example, I'm sure you've found it's very hard to make rental numbers work due to the very high cost of acquisition. In the real estate kingdoms of Montgomery, Howard and most of Anne Arundel Counties (all in central MD), appreciation rules. 

But you can achieve decent numbers in many other parts of the state where you are able to acquire for less and rent at a sensible rate.

High-appreciation markets like the Washington DC area attract already-wealthy investors, who do not need the cash flow (see: everything written about Southern California, in any of the gazillion forums on BP). So a high-appreciation market is not a fruitful arena for the rest of us not-already-wealthy investors. We need high cash-flow markets where we can start with modest investments and build. Look around, there are plenty in Maryland!

Good luck,

Nancy Roth

An hour west of Baltimore . Sounds like the Frederick area.  The thing about here in Maryland , there are few " cheap " areas  that are nice and even fewer nice areas that are cheap .  Finding good deals on decent houses that will cash flow isnt easy and it takes time .  ( excluding Balto city ) .   I have rentals in Pasadena Md , first you can find a house for $100 K its a total gut or tear down .  A  two bed 1 bath rents for between 1100 to 1300 , a 3 bed  runs on average 1500 to  2500 depending on the area of Pasadena . You are looking at buying a 2 bed for around $180K on the low side and $ 250K for a 3 bed on the low end in a decent area . Numbers are tight .  You just have to keep looking . I looked for 2 years and nothing , then 2 dropped in my lap in 6 months .

15% COCR would be a worthy goal and reasonable when compared with peer-to-peer lending which is making 8% returns ridiculously easy. When I factor COCR return though I don't factor in appreciation, tax benefits, depreciation, principal pay down, just straight cash flow before tax.

@Michael E.  you articulated your goals pretty clearly: 1-3 properties paid off by the time you are 50.  We don't know your financial position, but this should be doable as planned. 

In your plan, the tenants will be buying your investment for you, and you want as little of their money going to the bank as possible. Get the 15-year loan - which should come at a decent interest rate discount over the 30-year loan - and work your well-articulated plan. Don't forget that paying a 4% rate on a 15-year loan vs 4.5% rate on a 30-year loan is 10% less interest per year to the bank. You don't get that advantage when paying a 30-year loan on a 15-year schedule. Your spread may differ from this example, and might result in even more savings. 

You plan is, however, capital-intensive. You will need substantial down payments to purchase these 1-3 SFHs, and you will have to generate all of the down payment through income other than the rental cash flow, since you are giving that up by taking the 15-year loan. You will also need to generate and set aside your reserves from other income sources, for the same reason. Lastly, you need to plan for annual income taxes. On this plan, if there is little-to-no cash flow, your (cash flow + loan pay down) - (depreciation taken) is going to be greater than zero, and will result in taxes due. That money needs to come from somewhere, too. 

As for properties, isn't Maryland one of the most expensive and highly-(property) taxed states in the country?  Have you considered buying turnkey in a lower-cost, lower-tax state?  Sounds like you are more interested in buying a future yield than actually operating a rental business (nothing wrong with that).  But don't buy too little property if you are counting on this funding your retirement at 50. Three paid-off houses in flyover states may or may not give you the wealth and income you are striving for by then....especially if you will remain in a high-cost state after retiring. 

Within Maryland, I've heard grumblings from family there that the "second wave" of foreclosures is about to hit. People whose unsustainable loans were modified during the crisis are again finding them to be unsustainable. This is Montgomery County. Check it out for yourself; I have no market knowledge there, but agree with the principle. 

Good luck, and find a way to work your plan - or make an educated decision not to - before the BP mantra of cash-flow-is-King changes your mind for you. 

@Michael E. , I do almost exclusively 15 year loans.  I normally would not buy a property that will not break even with a 15 year note.  I have made an exception or 2 for B+ or better neighborhoods. Your market might not work like mine so it is hard to give good advice.

If your end goal is to "only" own 1-3 SFH to use as an early retirement I would suggest taking the 15 year version. This means you will need to save a potential of 3 down payments over the next five years if you wish to pay the houses off on schedule by the time you're 50, assuming you're 30 now. This shouldn't be difficult with a good income and having a goal in mind. You can be very picky since you will only be buying 3 times in 5 years. I would be surprised if you landed on break even with a 15 year mortgage if you did your research before buying. I believe you will end up with a small cash flow number, but the good news if you don't need cash flow in your situation. Don't forget when doing your numbers that once the first house is paid off you'll be able to snowball that money to pay off the second and then the third.

I would create a nice rainy day fund to help support these units. The main way you can get into trouble with these houses is not having money saved to help with larger expenses. If you are able to save 3 down payments in 5 years, saving for a rainy day fund shouldn't be a problem.

Good Luck with your plan!

Originally posted by @Ken Martinez :

15% COCR would be a worthy goal and reasonable when compared with peer-to-peer lending which is making 8% returns ridiculously easy. When I factor COCR return though I don't factor in appreciation, tax benefits, depreciation, principal pay down, just straight cash flow before tax.

Thanks Ken. Do you mean 15% COCR is a) the bare minimum that you need to even consider a property, b) a good working number that if you can hit, you'll feel pretty solid about it, or c) that's your "ideal" figure that you shoot for and may only hit once or twice in a lifetime, but it's an ideal number so if you fall short of it then it's not too much of a problem?

In order to get 15% COCR, I assume you're financing for 30 years?

Also, what are your operating expenses as a percentage of the gross rental income? I've been assuming 50% to cover all expenses (vacancies, taxes, insurance, maintenance, repairs, management, etc). Is that in line with your experience, or too conservative? Are you managing the property yourself and excluding the cost of your time, or do you have professional management? How much are you budgeting for variable costs such as repairs and maintenance?

In order to hit 15% COCR, I'm calculating that monthly rent has to be 1.4% of the purchase price (e.g. $1400/month for 100k contract). Outside of a foreclosure or distressed seller, I have a hard time imagining many properties will even come close to that. Conversely, using what seems like a more reasonable but still-not-easy-to-find rent of 1% of the value, to hit a 15% COCR suggests operating expenses of around 30% of gross rental income. I have very limited experience but the research I've done suggests that that is way too low, so I'd be really interested in seeing a detailed breakdown from your own experience.

Bottom line - I'm not sure if my numbers aren't working out because I just haven't identified good properties yet, or if because my assumptions are way too conservative, or both.

Originally posted by @Anish Tolia :

There is the "math" answer and the "life" answer. On a math basis, if your cost of borrowed money is less than the return, you should theoretically never pay off the loan. Of course, only the government can really do that because it has an infinite lifespan. And it ignores risk. You unfortunately  do not have the luxury of either.. If your gal is to have rentals paid off by age 50, then set it up for that. Don't worry about cash flow. Cash flow is a meaningless number. You can manipulate it by down payment, length of loan etc etc. It doesn't tell you anything about the quality of the investment. The IRR or CoC or ROE all are better indicators of quality of the investment and how it compares with other options. Get a good IRR investment (I would not bother with rentals for less than 15% CoC per year after all reserves) but that threshold is for you to decide on your own.

Thanks Anish. What do you mean by "after all reserves"? Also, I'm confused why on one hand you say not to worry about cash flow (that part by itself I can understand....IRR, ROE, etc are probably better metrics) but then later you say that Cash-on-Cash return is one of the better indicators, and to shoot for 15% CoC. In order to hit 15% CoC, don't I need the cash flow in the first place? Is your calculation of CoC ignoring debt service? Maybe I'm just misunderstanding how you're calculating CoC. I'm assuming that CoC = Before Tax Cash Flow / (Down Payment + Closing Costs) or alternatively = (Gross Rental Income - Operating Expenses - Debt Service) / (Down Payment + Closing Costs).

Also, since rents will rise over time and the initial investment will stay fixed, the CoC will rise over time. So when you say 15% CoC, do you mean in year 1, or projecting out to year 20+?

Could you elaborate on that a bit more? Thank you!

Michael, because of the ease and low risk of peer-to-peer lending, earning less than 10% doesn't make as much sense anymore for real estate.  So for me, 10% would be the minimum with 15% ideal but that's just me with no right or wrong answer.   And yes, I am more in favor of a low interest 30 fixed.  For example, on my personal residence I have a 30-year fixed 3.25% that I am NEVER going to pay off, even if I move.

One of the note legends, Napier or Fortunato probably, said always lend as high as possible and get your money back as soon as possible, and borrow as low as possible and pay back as long as possible.  I agree with that philosophy.

I like the idea of outsourcing property management, but again just my opinion.  Paying someone 8% for their time and experience is an expense I pay with a smile.

It would be best if you grab a spreadsheet with all of the numbers so you can see the effect of modifying one input and how that affects your COCR.

I prefer lower payments in a 30yrs loan. You have the option to make additional payments toward principal, and pay it sooner. You can can use the cash flow to reinvest in other properties.