15y vs. 30y strategy - convince me i'm wrong

12 Replies

Hello everyone,

First things first - I'd like to thank all of the contributors to this forum, your advices and inputs taught me *A LOT* - so I'm grateful for that.

TL;DR: For a new RE investor with a good starting point (liquid assets), would it be better to take "x" amount of 15-year mortgages, or "2.5x" amount of 30-year mortgages?

Full version (For the sake of argument, I'll make up some numbers to help explaining my question):

Consider the following case - Individual with $500K and no properties other than residential house.

Let's say residential properties in the area are going for $200K.

Comparing two relatively "conservative" strategies, let's assume individual wants to "cash out" 15 years from now (hence: get as much passive income from said properties once you reach the 15y mark):

Strategy 1. "Bulk up" - put 25% down payment + 30y mortgage, get as many assets as you can (let's assume 400K/50K=8), keep bulking from additional savings. Once you reach the 15y mark, you "cash out" some properties to pay the rest of the mortgages.

Strategy 2. "Sprint" - put 50% down payment + 15y mortgage, get less properties - but pay less interest to the bank as well (lower interest rate + higher equity gain ratio per loan). The properties will be payed in full once you get to that 15y mark, but you will have less properties.

Let's assume that both of the aforementioned strategies yield the exact same monthly payment to the bank, and same cash-flow. Let's assume cash flow is low-to-none.

AFAIK:

The main advantage of bulking up: More properties --> more gain if there's high appreciation

The main advantage of sprinting: Less money spent on interest payments (about 3.5x less), which also means higher equity gaining ratio.

Everywhere I look, people are saying that you should *always* go for the 30y approach. But when I look at the aforementioned strategies, it seems logical to me to try the 15y approach too. It sounds like a classic risk/reward issue, not like an "open-shut" case as depicted from all my research I've been doing so far.

I'm trying to realize if I'm missing something here, will appreciate your inputs.

Please forgive me if this question seems trivial, I tried looking up the answer prior to this post but most of the cases I've seen spoke about different cases (low initial liquid assets / high cash-flow properties + snowballing / etc)

Thanks

@Or Y. I think you're primary point is correct: both loan terms can work, it depends on what you want to get out of the investment in the short term. Many of our clients that are investing for current cash flow like the 30yr term because of the lower PITI, which (all other things being equal) should equate to higher net monthly income.

However, especially for those who don't need the income right now, I often recommend using a shorter loan term. You have to remember that the primary advantage of using leverage in REI (other than stretching your capital further, of course) is that your tenants pay down your note over time, essentially buying you 75-80% of a home (assuming standard dp's). Whether you go 15 or 30, that aspect of financing remains true - your tenants are the ones paying your mortgage. The difference is that more of your monthly income goes to pay down with the 15, whereas the 30 nets you more cash flow but ends up using more of that rental income to pay interest in the long run (for the privilege of paying over twice as many years). Either way, a solid rental investment means the bank is getting its due from your tenants.

One of our favorite strategies that many of our clients employ is a bit of a mix between your Bulk and Sprint. Leverage your capital using 25% dp's and 15 yr loans (assuming they don't need the monthly income right now). Shoot for 6 props or more , which in Birmingham means having about $150k in capital to deploy for dp's (6 * $25k dp each, average price for solid B/B+ cash flow props is about $100k) plus some for reserves, of course. Make minimum payments on all props but one, devote alllll the cash flow from the entire portfolio to paying down that one loan as quickly as possible until it's free and clear, then move onto the next. If you wanted to pull that equity out to keep building your portfolio, great. Often people are closer to retirement and are happy to have zero loan payments, just cash flow and real estate to pass on to their heirs (hello, stepped up tax basis). If the market looks good, you could also sell those paid off props and leapfrog into bigger/better/more via the 1031 exchange. Plenty of options depending on your goals.

It's not quite the Sprint, since we're sticking to 25% dp rather than 50%, but it's definitely faster than Bulk, and you typically end up with a nice little portfolio of free and clear props in 10 years, give or take.

Really, it comes down to what you want to achieve with your investments. If you need the cash flow, the longer term will save more money per month for your wallet. If not, you can build your portfolio faster (and cheaper) with shorter terms and an aggressive paydown strategy.

I like the aggressive pay off strategy, but why not just keep a 30 year loan and toss in some extra $ each month toward the principle?   That way you can pay off quickly and still have the flexibility of a lower payment in the event that your plans change or you come upon harder times when the cash flow would be helpful. 

Thank you for your inputs!

Some updates after checking options with lender - it turns out that mortgages with high down payment are "frowned upon" (from financial perspective), so the bottom line was that a 15y+50%dp get about the same interest as 30y+25%dp(!)

This was super surprising to me, since the loan is way more "secure" for the lender AFAIK.

@Clayton Mobley the problem with 15y+25%dp in my region, is that you will have negative cash flow. I can stand the neg flow by using the additional reserved 25% I didn't put down, but I assume that lenders will not allow too much loans when they see that bad $flow.

@John Koster I like this approach, 30y+25%dp+expedited payments using 25% reserve. What I fail to understand is:
A. how often can you make these payments?
B. what happens when you inject more funds into the principal: does the end date of the loan reduced, or does the monthly payment go down?

On that note I wonder - what happens if someone takes 30y+25%dp, and then a month later pays 25% of principal? (same question of B., except instead of enlarging the monthly payment using these extra 25% you didn't put as dp, you do it once)

Although most investors have a preferred strategy and may try to sell it to others, me being no exception, once you analyse your options, 15 or 30, the choice should be obvious and 9 times in 10 the option to go with 15 or accelerated pay down has nothing to do with making money (the future being entirely unpredictable). It is strictly a risk factor. The most conservative investors will opt to pay off their debts asap with the belief it is a safer bet. Those with a higher risk tolerance, like myself, will opt for the 30yr to maximise growth and long term higher returns. They will never work out the same in the end when one considers the lost opportunity value of cash. Everything about paying down a mortgage and having cash parked in real estate ultimately will cost you more money when investing.  It is not about profit it is about perceived profit and that is what conservative investors seek.

Personally I believe that fluctuating real estate markets makes using a property as a bank is higher risk due to market shifts wiping out your equity but others see high leverage as a higher risk.

The greater the risk the higher potential reward.  

@Or Y.

Most loans will allow you to make additional principle payments as often as you would like.   Most mortgage statements will have an "additional principle" box to add to your regular minimum payment.  In theory, you can pay off your 30 year loan in a year if you would like.  You can call and request what your pay off payment would be at any time.  

Your listed minimum monthly payment will usually not go down, but depending on the loan product and your bank,  you may be off the hook for your next month's payment, if your previous additional principle contribution covers it.   

These are generalizations.  Not all mortgages are alike.  Some have hefty pre-payment penalties and other rules.  Just make sure you ask lots of questions before committing to a loan.

  

@Or Y. well, on the one hand you are correct - higher dp means more secure cash for the bank, but it also means they make less in interest so you can see why their ideal situation is a moderate downpayment with a high loan balance and long term from someone they know can afford to repay the loan plus allllll that interest. You trying to pay more upfront is smart from your perspective (maybe not in terms of the benefits of having tenants pay down your loan, but definitely in terms of minimizing interest payments) but the bank doesn't see it the same way. 

Now, with regard to your comment that 15y +25%dp isn't doable in your region...that would raise some alarms for me, just generally. How tight are your margins with a 30y that a 15y completely kills them and causes you to have to subsidize payments with your reserves?  Of course some properties are still good investments with tight margins, but I would just double check all your other numbers (expenses) to make sure you're estimating your cash flow conservatively, or, if possible, based on actual historical data. 

I should also mention, just as a general disclaimer for all new investors, that you should have a reserve on hand that *isn't* being used for additional loan payments. 

You called the remaining 25% that would have liked to use for a 50% dp a 'reserve', which I understand in the context of this thread, but I just wanted to also note that a pool of money you plan to use to subsidize loan payments shouldn't count as your actual 'reserve'. 

In the context of REI, the term 'reserve' is generally reserved (see what i did there?) for the extra cash you keep for maintenance and capex issues that might come up unexpectedly. It's always a good idea to have a little cash buffer so that if something comes up that requires cash right away, you're not stuck trying to rob peter to pay paul.

My general rule is that you should have about $5-7k on hand for the first prop and another $3-5k for each additional. Of course, these numbers are based on our average prop value of approx $100k, so you may need to adjust accordingly for the prop values you're considering.

Many new investors leverage their last penny to get into REI and then are stuck with no buffer. It's annoying to hold back capital that could be 'working for you', but honestly it pays you back tenfold in peace of mind.

It depends on what your goals are - buy a few rental properties and then retire from cash flow?  Or buy rental properties for cash flow and build as much as you can and keep growing even if you achieved a comfortable life style?

If it's the latter, look at it from a different perspective.

You must vision it as a business and run it like a business. Take down pay, 15 year vs 30 year, etc, all that aside. What is your cash on cash ROI for different scenarios with different terms for the property? Typically, to achieve the highest ROI via cash flow, you want to put the least amount down, incur least amount of monthly expenses (including debt) and achieve the highest income. I tell alot of folks not to bank on market appreciation because you have no control or crystal ball. Forced appreciation thru rehab or management works because you have some control on appreciation. Mainly talking about SFH since that's what it sounds like you are looking at. MF is a different ballgame.

Originally posted by @Thomas S. :

Although most investors have a preferred strategy and may try to sell it to others, me being no exception, once you analyse your options, 15 or 30, the choice should be obvious and 9 times in 10 the option to go with 15 or accelerated pay down has nothing to do with making money (the future being entirely unpredictable). It is strictly a risk factor. The most conservative investors will opt to pay off their debts asap with the belief it is a safer bet. Those with a higher risk tolerance, like myself, will opt for the 30yr to maximise growth and long term higher returns. They will never work out the same in the end when one considers the lost opportunity value of cash. Everything about paying down a mortgage and having cash parked in real estate ultimately will cost you more money when investing.  It is not about profit it is about perceived profit and that is what conservative investors seek.

Personally I believe that fluctuating real estate markets makes using a property as a bank is higher risk due to market shifts wiping out your equity but others see high leverage as a higher risk.

The greater the risk the higher potential reward.  

Loan term and payment schedule don't have to be one in the same. The 30 year gives you the added flexibility (and safety) of choosing your payment schedule as you go, at the expense of a slightly higher interest rate. You can turn a 15 into a 30, but you can't turn a 30 into a 15.

The safest, but most expensive option would be to take out a 30 year and pay, or attempt to pay it down in 15 years.

The cheapest but riskiest option is to take out a 15 year.

The middle ground would be to take out a 30 year and pay it off in 30.

Thanks again for your inputs, I've learned a bunch of thing.

I'm going to stick to the 30y, and perhaps 'tinker' with the payment schedule to expedite equity gains (and interest payment reduction).


@Clayton Mobley regarding your comment regarding reserve - you are 100% correct, of course. The way I operate with my household (and future rentals) is using multiple "micro savings" (--> MS), each with its own designation (e.g. yearly expenses / vacation expenses / general savings etc). Each MS got a monthly deposit, and withdraws got to stay inside the MS's boundaries - this way even if I have $10K "laying around" in my savings account, it doesn't mean I can "afford" going to a $10K vacation - it depends on how these $10K are spread across the MSs.

So same goes with rentals - the rent comes in, but some of it will go into the "vacancy MS", some into the "maintenance MS", some into the "cap MS" and so on and so forth.

My current couple of investments are not $flow+, they're a "break-even" properties that bank on appreciation. But I'm planning to diversify the portfolio towards $flow+ in the near future, since appreciation is just another type of gamble (calculated risk, but still).

@Or Y. I love that system! Sounds like you've already got a good plan in place. I agree, moving into more cash flow props is a good idea if your current investments are appreciation plays - all investing is a gamble, so it's could to play both red and black ;)

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