Conventional Loans don't make sense to me because...

[Zachary Schimenz]

Ok so I'm reading a lot about loans and trying to figure them out, a couple things I can't figure out for the life of me, was hoping one of y'all could help me understand!

1. Why would a bank loan out money at a 4% interest rate when they could put that money in the stock market and make 10% to 12%? Do the interest rates they get from mortgage payments work differently than interest rates from the stock market (i.e. are they compounded more often or something?)

2. Why does Amortization matter when it comes to the percent interest and percent principal. I understand that at the beginning of your payments you pay mostly interest, and it gradually shifts where towards the end you're paying mostly principal, I just don't understand why it matters. For example, if you take out a $100,000 loan at 5% over 30 years, you're going to have to pay a total of $193,255 (figured this out using an online calculator). Whether I'm paying interest or principal on my payments at the end of the day I still owe the bank a total of $193,255, so why does it matter what "order" the principal and interest are paid off?

3. In most of the articles and books I'm reading on buying rental properties, they use Cash on Cash ROI to calculate if something is a good deal, and typically they compare it to the stock market (makes sense, if I can get a better ROI from the stock market I'd rather put my money there). I don't understand why everyone uses CoCROI and doesn't include loan paydown as part of the ROI. The equity you're building up is still money you're building up, even though it isn't immediate cash on hand, just like if you put money into a 401K, you'd still count the interest you're making even if you can't take it out right away. So wouldn't it make more sense to include loan paydown as part of your ROI calculations so it'd be an apples to apples comparison to the stock market?

Anyway, I'd really appreciate some help on this if you have any answers! I know there are a ton of people much smarter than me on these forums. Thanks!

-Zach

[Ben Nelson]

Interesting questions to be sure.

1) I’m not an expert in the banking system but you could certainly go way down the rabbit hole into how the banking systems work. But banks take in deposits to be able to lend the funds back out. By the way, the lend fractionally which means they don’t lend out the same amount they take in, they lend out many times more than they actually have. So if they have $10 million, while they could invest in the stock market at 12% (which, correct me someone if I’m wrong, but pretty sure they are not allowed to make that type of investment with deposits). However, if they can lend out $100 million on that $10 million - which they can - they are actually making 4 times as much money with 1/3 of the “return”. This is just the tip of the iceberg by the way. Start studying the financial system and banking and you’ll be shocked at how it actually works.

2) Amortization matters a TON because most people sell or refinance every 5-7 years on average. They’ve got the game figured out. Front load interest and you are perpetually paying interest forever. Yes, if you get a loan once and never touch it by selling or refinancing, it doesn’t matter. But who does that? Even as an investor, re-leveraging for more acquisition is typically part of the game. Every time you get a new loan you reset the amortization schedule and are just paying more interest up front.

3) It all depends on what you want to compare it to or how you want to look at it. Different investors want to look at different numbers. I agree, amortization should be taken into account for overall return. But cash on cash does play a purpose, plus it's an easier and quicker way to analyze something initially. Cash on cash is one metric while IRR is another. Just multiple ways to be making an analysis.

Just to touch on another couple factors, especially when comparing to the stock market, leverage is a HUGE piece of return. This is especially true when factoring in appreciation. While a return on a property might be 4% based on appreciation, if you only have 20% equity in the property and 80% as a loan, that return is NOT 4%...it’s 20%. Leverage can massively accelerate returns. Also, return on equity is another calculation you want to be making and paying attention to as you’re paying things down with amortization and as equity increases with appreciation.