Selecting terms for a loan

[Kevin Larson]

I just had an offer accepted on two duplexes.  This is my first purchase.  I am now talking with a mortgage broker who is presenting me several different loan packages. I am putting 25% down each duplex, looking at a 30 year fixed.  I would prefer to try and cash flow as much as I can on these properties.  Is it better to spend money on points ( the way I understand it a higher closing price ) to get a lower interest rate say 4.75%?  Or should I take a a higher interest rate and pay less in closing costs?

Ex:

4.75% P&I - $245  Points cost $1172

5.00% P&I - $252  Points cost $703

5.25% P&I - $259  Ponts cost  $176

Thank you for your advice and time in advance.

[Jonathan West]

Originally posted by @Jay Helms:

@Kevin Larson - if you're goal is cash flow, then anything you can do to lower your monthly payments & expenses will help that. Go with the more points and lower interest rate. 

Jay - respectfully disagree.  Your statement is correct if the goal is cash flow *on this one property*, but there are other ways the cash could be deployed that could help the original poster make additional money.

The most financially pure way to evaluate this decision would be to build a cashflow projection and calculate the internal rate of return on your different options, which would be a function of how fast you expect rents/expenses to grow, how long you'll hold the property, the amount you'll sell it for, etc.  That's more complex than what you probably need though, so here are some other heuristics.

Going from 5.25% to 4.75% will cost you just under $1,000 and will save you $14/month in payments.  It'll take ~70 months or 6 years for you to break even ($14 * 70 ~ $1,000) and save money by paying points to reduce the monthly payment.  If you will be selling the property sooner than that you're better off holding onto the cash.

The above heuristic assumes you can make 0% return on your $1,000 today or your $14/month ongoing.  The breakeven point extends out if you think you can invest the money in something that will pay any sort of return, even if it's just a liquid savings account.  The higher the alternative rate of return the further out the breakeven period extends.  For simplicity sake, assume you could find a mythical 20% bank CD for your $1,000: you'd definitely keep the higher monthly mortgage payment because you'd be earning more in CD interest.

Finally, holding onto $1000 could accelerate to the next down payment for a new property or could be put aside a a reserve fund. I calculate your mortgage will be something like $48k which means at 75% LTV your down payment is $16k: if you don't buy the points then you're ~7% towards your next property, which isn't a lot but isn't nothing.

Contra to all of these points, if you don't trust yourself to wisely manage the $1,000 and you need the extra breathing room that the $14 adjustment in payments will grant you then psychologically you may be better off marginally increasing your cashflow, regardless of the numbers.  However you should take a really hard look at your choices if a $14 swing will make or break you.

This may seem like a lot of calculation for not a ton of money, so mentally I added a few zeroes to the calculations: those at a much larger scale should similarly be worried about whether paying an extra $1mm is worth reducing monthly payments by $14k: math is exactly the same but I bet we all feel different emotions about those bigger numbers.