I’m purchasing a $100k property, $20k down payment, $8K gross rent, and I can choose between a 15 year amortized loan at 5.5% or an interest only loan at 6%. I plan to hold the property for 5 years and then sell.
After running the numbers, I’m getting a negative cash flow of $2,600 with a -13.2% ROI on the 15 year loan scenario and a positive cash flow of $400 with a 2.1% ROI on the interest only scenario.
However, shouldn’t I take into consideration that I’m paying down principle with the 15 year mortgage and I’m paying less interest on it, so the numbers work out better taking out a 15 year loan, as long as I’m willing to exchange some cash for equity.
For example, I would be paying off around $3k of principle each year if I get a 15 year mortgage and I’d be saving around $900 in interest, so although I am losing $2,600 a year in cash, I’m gaining $3,000 in equity, with a net gain of $1,300 ($900 + $3,000 - $2,600), versus a gain of $410 in cash on the interest only loan.
I understand I would still be negative cash with the 15 year loan, but to me, it seems an overall better investment when equity gain is considered.
Am I going about this the right way, or am I missing something?
Don't do this deal, your numbers don't work and there's no cash on cash return or vacancy, management, repairs, advertising, or upkeep included in this, don't do it!!!
GR
An interest only 15 year loan and an interest only 30 year loan will have the same out of pocket cost each month. Over your holding period, a 15 year amortizing loan will have a higher out of pocket cost than a 30 year amortizing loan. To figure out which is better, use your spreadsheet software to run a cash flow analysis for each loan and compute the after-tax internal rate of return. The interest rates will be different for each loan.
Let’s use $100K as the loan amount for each loan. Let’s say that you have your choice of:
a hybrid ARM at 6% that will allow you to pay interest only for the first ten years. The monthly loan payment will be $500.- a 15 year amortizing loan at 4% with a monthly payment of $739.69, and, - a 30 year amortizing loan at 5% with a monthly payment of $636.82.
Now, let’s use the cash flow analysis spreadsheet you can download from this site at www.reiclub.com/forms/cashflowanalysis.xls to do a cash flow analysis for each loan and to compute the internal rate of return for each. Let’s assume that at the end of eight years, you are only able to sell the property for what you paid for it, $125K. During your holding period, you had the property rented continuously and generated a net operating income of $6000 each year, or $500 per month. Let’s also assume that you are in the 25% tax bracket. For the sake of simplicity, let’s also assume that the depreciation basis is $100K, and that over an eight year holding period, you took $29091 in total depreciation expense that will be recaptured when you sell the property.
At the end of eight years:
The interest only loan gives you an internal rate of return of 0% after taxes.- The 15 year amortizing loan gives you an internal rate of return of 5.322% after taxes. - The 30 year amortizing loan gives you an internal rate of return of 3.59% after taxes.
From the cash flow analysis, it would appear that the 15 year amortizing loan gives you the best return on your invested capital. Your returns may differ if you shorten the holding period to five years.
Although, the 15 year loan gives you the best internal rate of return, you do have a negative cash flow until the property is sold. The question you have to answer for yourself is whether you can afford to wait for your payoff until the property is sold.
Given these choices, I would rather put my investment capital into 30 year Treasuries at 4.5% and collect the positive cash flow each year.
wow 2600/mo negative cash flow and you are thinking of doing it? :banghead
2600 x 12=31,200 per yr. In three years you could have bought the entire thing and you are going to spend 20,000 to do this? :shocked
This is probably the best example of what not to do that I have seen. Gold River is right , run away fast and do not look back or you will turn into a pillar of salt. :bobble
Redhawk
Thanks so much for the link and explanation. I tried to recreate your results but was not able to.
I’m getting an IRR of 1.9% for a 30 year, 5% loan, and an IRR of 4% for a 15 year, 4% loan.
A minor issue I have with the worksheet is that it calculates a tax benefit for negative taxable income but it does not calculate a tax load under a situation where Taxable Income > $0.
I used $1000 monthly rent and filled in $6000 for the net operating income. Purchase price $125K, $100K financed, with land value equal to $25K.
If the Taxable Income on line 22 is positive, then line 23 (the tax load you are looking for) subtracts the income tax liability (computed using your tax bracket rate). Line 23 is subtracted from line 22, giving the net taxable income after taxes on line 24.
If the Taxable Income on line 22 is negative, then the Tax Benefit on line 26 will be a positve number equal to the savings you will realize on your income tax bill.
Because the depreciation expense reduced taxable income, but did not really take any money out of your pocket, your true cash flow is the net taxable income on line 24 plus the depreciation expense (line 25), minus the amount paid toward loan reduction (line 28). This total is reflected at line 35. If you had a tax benefit (line 26) due to a net taxable loss, then this amount is also included in the net after tax cash flow total.
Even if you don’t replicate my example exactly, your results parallel mine. You just have to decide whether this investment is worth the low return you get only after the property is sold and the negative cash flow every year until you sell.