How do I calculate the cost of an interest only hard money loan?

18 Replies

David Cs answer is correct as far as it goes (I can't tag him because there are 3 David Cs with no photo, so I don't know which is which) but here is more detail.

To more accurately estimate it:

For 100K, take the principal balance X 12% = $12,000

Divide that by 12 to get the monthly interest, or by 360 to get the daily interest, assuming your lender does not have a clause that says there is a minimum amount, or a prepayment penalty.  So a month's interest would be $1000, and a day's interest would be $33.33

This is further complicated if you take construction draws as you complete the project.  In that case, the daily interest is sometimes calculated on the outstanding principal balance (which will increase with every draw).  In addition, some lenders charge interest on the full amount of the loan, even when they are holding the construction funds pending work done.

Like you said it is often banking standard. 

Started back before calculators and computers to calculate out loan payments and it made for easier computations than 365. Breaks into 12 equal 30 day months. 

Account Closed  we do it because it increases our yield... and looks good on the books.

and we don't get caught in a leap year

@Jay Hinrichs   i used to use 365 because I thought it was the fairer thing to do then I noticed most people were using 360, presumably because of the yield boost, so I changed.  We are of course for the most part talking pennies.  Borrowers never balk at the difference so what the heck.

Account Closed  for me it makes a 29% apr jump to 30.6%  that's huge for me on my deals and for reporting purposes

@Jay Hinrichs   Small percentages on big money is a big deal, small percentages on little money (like myself) is a little deal.  But I get it.  As a business person you can't be cavalier about these things, you have to take every edge you can get, business is unforgiving.  Some would say it's a Trump-esq thing to do but then those are generally the high paid actors and academicians that don't have to work for a living:)

BTW, the only place it comes into play for me is the prorations from loan funding to the end of the month and at the end of the loan from the last payment to payoff.  I get monthly payments in between and that is regardless of the number of days in the month.

I'm impressed that you actually quantify the difference, I'd have to think for a while to figure out how to do that.

Account Closed I have a program that does it automatically as my success to my investor based is ALL based on ROI.. nothing else matters.. and it really satisfies the number crunchers when you can put in your P and L on a project that you made 31.56 % apr.... they love that stuff .

instead of say Hey I think we made about 30%....  as you know early payoffs drive APr's through the roof and I am only as good as my performance.

I had one pay off in 8 days last week.. return was in the 300% range.. or something like that..

@Jay Hinrichs

I see.  You have investors to satisfy, I don't, it's just me, except for two or three investors I have that like me don't really care that much about 1.56% ... hmmm, 1.56% IS quite a lot.  I know you're a smart guy but 360d/y vs 356d/y makes a difference of 1.56% on your portfolio?

I know early payoffs drive yields through the roof when loans are acquired at a discount but my loans go out at par, unless you want to view points and fees as a discount.  Early payoffs drive me crazy ... I now have to spend a month or two trying to find another (good) flipper to lend to thus driving my yield down-down-down:(

I think you and I are doing different things.

Account Closed  deal flow is always an issue.. fortunately its not for me.. I get a payoff and sometimes fund right back out same day.. or next day..but we are as you stated high volume shop

not uncommon to have 10 payoffs and new fundings per week..

Drag on the money is very real..

I look at drag very simply I look at a funding bucket and that bucket has its own checking account I look at average daily balance on a monthly basis. one of my buckets has 6 million in it and the average daily balance is usually under 200k through the year.. I see that as highly efficient.. whether I am correct or not.. I don't really know but it feels right to me.. LOL.. As HML goes we are a small shop that carved a niche in a very particular sector of the market that I identified as under served so we stepped right in.

for many investors though a nice 9% note for say 5 years that has 60 on time payments .. those will out perform the 12% short term because of the lack of drag.. we do a million a month of that paper.

@Jay Hinrichs   I like that work 'drag', I'll have to remember it.  I worked in aerospace for years.  Aeronautic engineers spend a huge amount of time designing to reduce drag, I can see this loan business is the same in that respect.  Also like your method of quantifying drag (daily account balance), it's a twofer as I like to say, you get an accurate bank statement AND a drag measurement all in one.

Account Closed  drag is related to angle of attack.. got to attack these notes  LOL

I just came back to answer the question and @Jay Hinrichs has done a much better job than I could.  I'm a small local lender, so no where near the volume that Jay does.  For me, it's ease of calculation with 30 day months.  

And deal flow is always an issue.  I've never run out of money, but I've definitely been looking for more dealflow to compensate for the early payoffs for sure, David.

Originally posted by @Natalie Kolodij :

Like you said it is often banking standard. 

Started back before calculators and computers to calculate out loan payments and it made for easier computations than 365. Breaks into 12 equal 30 day months. 

 Even when they had early mechanical computers, doing 360 day years meant you could do 12 months times 30 days. And for 30 year mortgages, 12 months times 30 years. 360 payment periods either way. So you wouldn't have to shuffle punch cards around and whatnot, you could just leave the number 360 hard-coded calculating 30 year loans, or calculating pro-rated interest. 

I think the 360 day Banker's Year was actually created by the ancient Romans. Are you guys also doing your calculations by hand?

A bankers year makes a huge difference for amortized loans, which is why the banks still use it, even though I think even they are sophisticated enough to handle a 365 day year at this point. Here, 365/360 = 1.0139, or a 1.39% increase, which does juice up a return on a multi-decade amortized loan.

It's negligible for a 6-month simple interest loan. Note that 12% x (365/360) is only 12.17%. Also,  29% x (365/360) = 29.4% not 30.6%.  You don’t add the percentages.

Strangely, there are many ways to prorate simple interest and I actually had to have a conversation with my attorney about it. February was making me crazy, as were the title companies who seem to have minds of their own when applying per diem rates. Now we just use actual days and life has been much easier.

For full months, which comprise the majority the duration for most loans, we divide the interest rate by 12 and multiply by the principal balance for that month. This makes the banker's year irrelevant. Same as David's example:

Monthly Payment = 12%/12 months in a year x $100000 = $1000/month

I suppose you could also multiply by 365/360 to take advantage, or claim you don't know any other way to do it, but we don't. I don't want any borrower asking why we agreed to X% and are now charging even a few tenths of a percent more. The first and last months are trickier and there are many ways to prorate the daily interest.

We prorate the monthly payment calculation for the first and last month. Using David's example, assuming we got paid back on Oct 14th, the interest for that month would be:

Interest Payment = 12%/12 months x $100000 x (14/31) = $451.61 or $14.57/day

If this were for funding on Oct 14th (18 days, inclusive of funding day) the interest would be

12%/12 x $10000 x (18/31) = $580.65 or $18.73/day

For a 30-day month, we'd divide by 30 instead of 31.

This is super easy to program into a spreadsheet. If you then want to multiply by 365/360 for the first or last month, that extra amount will literally add only a few dollars. Considering what our borrower probably paid in total points and interest (typically in the tens of thousands for a multi-hundred thousand dollar loan over 6 months), I'm not going to piss them off by asking for an additional $15 at the back end of a loan. It's only a few hundredths of a percent of the total, not 1.39%. This adds no value for the borrower. You might disagree, but I consider this the same as a junk fee.

Also, since we never know the exact payoff date, we specify a daily rate to title. My experience is they will always use the actual number of days in the month to pay us back no matter how skilled I word and re-word our payoff demand.

If you always prorate over a 30-day banker's month, as we used to, and payoff is on the 31st, your borrower will be overcharged. What about February 28th or 29th? You will lose money that month with a strict 30-day calculation and/or your spreadsheet will be horrifically complicated – as was ours. Forget all that. We use actual days elapsed, actual days in the month, and a 365 day year. Many fewer headaches and let the borrower keep his $15 for the $25k we might earn. Even over 100 loans, please don't tell me this is a lot of money.

FYI, if you loan in CA and use a banker's year, you must disclose your method of calculating interest in your note and also state that a 360 day year results in a greater interest payment. We specifically state that we use a 365 day year and the actual number of days elapsed.

@Steve S. , so if it's a 2 year loan, for each $100k you borrow at (say) 12% interest-only, you pay $12k in the first year (plus any fiddly compounding or other fee that would indicate that 12% was a lie), then the SAME $12k(+) amount is paid again during the following year. THEN, you'd need to come up with the full amount borrowed as well, at the end of that second year. Good luck...

@Brent Coombs

That's pretty much correct except there is no compounding and the only fees are origination fees, but you're right about it being $12k/yr.  And you are correct about having to pay back the principal amount.

I would say however that if you are a flipper that takes two years to do a flip I would not lend to you, there is definitely something wrong with your business model.  The flippers I work with take 4 to six months and make much more money than I do.

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