Why should we do 30 yr when compared to a 15-yr mortgage ?

Question

Hi

I understand that people advice higher Cash ROIs to evaluate a rental (investment) property so that you will have cashflow. However, I am wondering why is it not a good option to go for short-term loan so that you can close the mortgage soon and have the full rental value as your monthly income. In 15 years from now, wouldnt it help to have the full rental value available to pocket so that I can retire and live on these rental incomes? it will require a couple more hundred dollars a month from my pocket for the next 10 years but it could help for my retirement plans. Agree?

David M. Ward · Answer

Babu Ramadoss, I'm glad you asked your question.  It gives me a reason to examine this a bit more analytically than my usual simplistic response of "debt is bad, pay it off quick" - the reasoning that I've employed with both personal and business debt for the last 30+ years.  Looking solely at the numbers, I may be making a mistake.  But for me, not having debt makes me feel good, is protection against uncertainty, and that's worth several thousand dollars a year.  Again, that’s for me.  Your analysis will depend on how you're wired in addition to how the numbers work out.  Like Jonathan Bombaci said “it depends on your risk profile.”  I agree that certainly makes a difference.

I'm not CPA or financial advisor and I'm curious what others think, but I would think the thing to do is run the numbers over an equal time horizon of 30 years - using that same horizon for both analyses, one for a 15 year and the other for a 30 year amortization period.  Appreciation in the underlying realty is going to be the same over either period.  It would seem clear that you're going to build equity much more rapidly with the 15 year note versus the 30, but if you use the same period for analysis, 30 years, both will have you ultimately owning the property outright.  So you're looking, at least initially, at what the impact of the two different loan periods are going to be on your cash flow and your tax savings (the other two components of wealth building through rental investing in addition to appreciation and equity increase).  Again, this is analyzing both deals over a 30 year time horizon.

You'd also need to consider whether you're in a position to offset your active income with passive losses if your active income is sufficiently low.  Let's assume, for this analysis however, that your modified adjusted gross income is more than $150,000, so you're not in position to deduct any passive losses against active income.  That's a big assumption, I admit, but it wouldn't be that hard to figure the additional benefit you might get if you can offset up to $25K of passive losses against your active income, or some lesser amount if your active income puts you in the phase-out range.  Let’s also assume that you’re not a Real Estate Professional for tax purposes.  See IRS Publication 925.

Let's also assume that your 15 year rate is 2.25% and your 30 year rate is 2.85%.  How realistic these are?  I'm not sure, but safe to say that the 15 year rate will be lower than the 30.  Presuming a $250,000 loan on a piece of some property that has an after renovation value of $300,000, with $50,000 attributable to the land and therefore $250,000 to the depreciable improvement (the structure) and assuming you put down a little more than 10% of the initial purchase price, say $35,000, then you have debt of 250K-35K = $215K.  You can depreciate the structure valued after renovation at $300,000-50K (50K being the presumed value of the land itself) over 27.5 years = 9,090/year using a straight line depreciation method.  $215K over 15 years at 2.25% gives you a principal and interest payment of $1,408.43/month.  $215K over 30 years at 2.85% gives you a P&I payment of $889.15/month.

Let's look for just a second at the fact that to borrow that $215K over 15 years at 2.25% you're going to pay a total of P&I of $1408.43/month x 12months/year x 15 years = 253,517.40, thus your interest cost is 253,517.40 - 215,000 = $38,517.40.  To borrow the $215,000 over 30 years at 2.85% you're going to pay a total of 889.15/month x 12 months/year x 30 years = 320,094 total and thus your interest expense for the privilege of the lower monthly payment and higher cash flow totals 320,094 - 215,00 = $105,094.

Right there I just hate the idea of paying a bank $105K versus $38K in interest just for the privilege of the lower monthly payment.  Yes, I recognize that I get higher cash flow with the longer term as well as the ability to deduct the interest as an expense against this property.  Of course, I always think the first thing when people say “but it’s 100% deductible.”  Sure, it is an expense that can be used to reduce your ultimate income, but nobody is in a 100% marginal tax bracket.  Thus the amount of the expense actually reduces your tax liability is not the full amount of the expense.  For example, if your income puts you in position where your marginal tax rate is 28% then you pay $28 out of the last $100 you earn.  If you have a $20 fully deductible expense, it doesn’t reduce your tax liability by $20.  Rather it reduces your tax liability by $5.60.  The deductibility helps, but the expense doesn’t magically disappear simply because it is deductible.  The higher your marginal rate, of course, the more value the deductibility.

Now one more side comment - people are right who say "with a simple interest loan you can always pay more each month, but with the shorter (15 year) term, you must pay the higher amount each month."  And they're right.  There is risk - vacancies, structure damage (insurance can protect against this), market hazards, etc., with the shorter term and higher monthly payment, I get it.  However, I once asked for a 5 year note term because I wanted the forced discipline to get the darn thing paid off quickly.  That’s just me, I needed that.  Okay, back to the analysis.

So where are we in wealth terms.  Remember, the appreciation is the same at 15 or 30 years regardless of which loan you took out, so I'm setting that at 0 because it is not relevant because I'm not selling and experiencing a realized gain.  So at the 15 year mark I own a $300,000 ARV structure and land if I financed over 15 years.  Additionally, at the 15 year mark I thereafter have what I would have been paying on the P&I of the 30 year note (889.15/month) added to my monthly cash flow.  For that next 15 years after the 15 year mark I therefore get that $889.15 x 12 x 15 totals = $160,047.  So at 30 years I have $300,000 + future value (FV) of those 15 years of cash flows totaling $160,047 which, of course, will be reduced by taxes if I don't have some offsetting losses in the LLC where I own this property.  I'm going to figure, however, that at the 30 year mark the FV of those 15 years of additional cash flows will have earned me at least what I would have paid in taxes.  (Maybe I put the “extra” cash flow in a tax deferred investment account like a Simple or SEP IRA so I don’t feel the tax bite right away.)  So at that 30 year point, simplistically, I have $460,047.

At 30 years on the 30 year mortgage, I'd own the property outright for the same value of $300,000 since we’re not fooling with appreciation.  (Note that you could just as easily set your appreciation at 2.5% per year if you want, the value is going to be the same at the 30 year mark for both analyses.)  For that entire 30 year period I would have had the surplus cash flow difference between the 1408.43 monthly payment on the 15 year note and the $889.15 on the 30 year note which equals $519.28/month.  Over the 30 years I have $519.28/month x 12 months/year x 30 years = $186,940.80, for a simplistic value at 30 years of $486,940.80.  And this value is low because I would have had that monthly extra cash flow each month starting at year 1, rather than waiting until year 15 on the 15 year note to get the increased cash flow of $889.15 for that final 15 years.  I also would have had the tax benefit of the interest deduction for 30 years rather than just 15 of them, with, of course, most of the interest expense front loaded in the amortization table which is more valuable given the time value of money.  So using this simplistic method of analysis, the 30 year note appears superior.

Now one thing the above analysis doesn’t seem to be taking into consideration is the wealth creation through debt reduction - aka increase in equity that takes place more rapidly with the 15 year financing period versus the 30 year period.  And I may be wrong, but I think this is where I differ from Greg Scott.  I think he’s absolutely right if you’re paying down debt and realizing no increase in equity (like on a credit card).  But with realty, each payment reduces our the total owed on the note and, therefore, has a wealth increasing benefit for us.  (Yes, I recognize this sounds simplistic.)  If our analysis period is 30 years, then the total equity earned is the same - the $300,000 value of the underlying asset.  However, we get that $300K 15 years earlier with the shorter financing period.  That definitely has value - it makes you wealthier more quickly.  The first payment you make on the 15 year note at 2.25% financing $215K goes $1,005.31 toward principal with the balance of $403.13 going towards interest.  Your net wealth, due to debt reduction/increase in equity went up by $1,005.31 that first month.  Compare that to the 30 year note - your first month’s payment (on 30 year note, 2.85%, $215K financed) goes $378.52 to principal and the rest - $510.63 to interest.  So the difference in equity building for that first month is $1,005.31 - $378.52 or $629.79 in favor of the shorter 15 year financing period.  Of course, the cash flow on the longer (30 year) note has the benefit of being $519.28/month higher ($1,408.43 monthly payment on 15 year note - $889.15 monthly payment on 30 year note), all other things being equal.

So this illustrates that with the shorter 15 year note you sacrifice $519.28 of cash flow to get $629.79 of equity, at least for that 1st month.  So let’s look at a later period in to the financing.  In the first month of year 10 (payment number 120) your cash flow differential is the same $519.28/month because the payment is fixed given our presumed stable interest rate, but the equity increase differential is $503.18 for the 30 year note and $1,258.70 for the 15 year note.  So at this point, 10 years into the financing period, you’re sacrificing $519.28 of cash flow with the 15 year financing period to get an equity increase on that 120th payment of (1258.70-503.18) $755.52.  This illustrates how when it comes to wealth building you have to factor in the benefit that shorter financing periods have toward increasing your debt reduction (equity) compared to longer periods and the trade off of cash flow versus equity.

Even though I’m a fan of equity, I also want to point out that equity should never be seen as equal to cash in hand.  Positive cash flow, cash in your hand each month, is always more valuable than equity.  How much more valuable depends upon a number of factors, but they include transaction costs - accessing equity takes time, selling or borrowing against realty costs money; whereas cash in hand can be spent immediately and has no transaction costs.  You also have to consider what you can do with that cash in hand - what you can earn on investments you can make with that cash flow.

Finally, since my head is starting to hurt, when lose your interest expense deduction after year 15 on the shorter financing period, you’ll still have the depreciation expense (and likely some higher repair expenses due to the increased age of the property), but your taxable income from the property is going to increase because of the lack of interest expense.  But remember, that interest expense deduction is only worth whatever the amount is multiplied by your marginal rate and it only has value if you don’t have other expenses such as depreciation, repairs, etc., or carried forward losses that can offset your revenue from the property.

There really ought to be a calculator for this stuff.  I’m kinda new to BP, so if there is or if my thinking is off, somebody please square me away.

Thanks in advance and Merry Christmas!

David

Kyle J. · Answer

@Babu Ramadoss This question comes up all the time, and often the best choice just comes down to a personal one based on things like: your individual goals, your level of comfort with debt, where you are in your investing career, etc.

What I can tell you though is, if you're new to investing and are just getting started acquiring properties (and plan to keep acquiring them), having the larger payments associated with 15-year mortgages is going to impact your DTI ratio a lot more than the smaller payments of the 30-year mortgages. So you could find yourself with the ability to borrow less if all your mortgages are 15-year mortgages, especially early on when you're trying to fix-up/stabilize your properties and maybe there's not as much cash flow coming in. The larger debt payments are going to even further reduce that cash flow, and your borrowing power towards future properties.

If you're really dead-set on having your mortgages paid off in 15 years though, perhaps a good compromise would be to put them on 30-year mortgages but make extra principal payments as if they're 15-year mortgages. Those extra payments wouldn't be required, so you could stop anytime you needed/wanted to, and they wouldn't count towards your DTI ratio for future lending calculations.

Just something to consider.

Theresa Harris · Answer

Another advantage is right now the interest rates are really low, so it is good to lock those in.  Getting the longer term mortgage, your monthly payments are lower.  You  cash flow more now even though you will be paying your mortgage longer...well your tenants will.  It also gives you more flexibility-go ahead and pay it down faster it you want.

Run your numbers looking at the difference between a 15 and 30 year mortgage both from the paying it off early (15 years with a mortgage, vs 30 years with a mortgage) adding in the extra cash flow that you get in the 15 vs 30 years.

$200K mortgage:

monthly payments 30 year term $752/month, 15 years $1300/month over 15 years the difference in payments is $98,640.

total over the lifetime of the mortgage: 30 year mortgage you pay (or the tenants pay) $270.7K in total vs 15 year mortgage $234K.

Jonathan Bombaci · Answer

Hi @Babu Ramadoss good question I think it all depends on what your goals are and what your risk profile is.

A 30 year fixed is the “gold standard” especially with interest rates as low as they are right now. To @Greg Scott’s point you’ll print $ just by holding it at 3% interest for 30 years. That being said you would save interest $ paid by doing a15 year fixed since into a lower interest rate. There are multiple loan options since there are tons of strategies and peoples risk profiles differ.

Most of my properties are on 30 year fixed loans (when they’re not commercial) since I primarily invest for Cashflow. If I can pay less per month on my mortgage (P&I) than my annual Cashflow will be better and I can use that to buy more properties.  That being said I am looking at condos to fund my 1 year olds college in 17 years. My goal there is to buy a $150k condo with a 15 year fixed loan that is slightly Cashflow positive or at least Cashflow neutral. That way when she is ready for school we have a fully paid off property for her to either sell or refinance to pay for school. Or if she doesn’t go to college she has a real asset that she can decide what to do with.

If your goal is to maximize annual Cashflow and use that to buy more properties, which is what most people’s long term strategy is, then the 30 year fixed is probably the way to go. But also consider I have 30+ years until the typical retirement age. If your goal is having a few fully paid off investment properties in 15 years for retirement, then that’s your goal.

I hope that helps. best,

Jon

Mike Dymski · Answer

That's a fair question.  You will find different answers for that on the forums.  Some investors use index funds and earn ~8% (will vary widely).  Another option is tax free muni-bond funds at 5%.  I've seen BP posts mention hard money lending funds that provide monthly liquidity (definitely worth checking out).  I know a bunch of investors who put excess liquidity in the CAZ Liquid Income Fund an earn ~3.5% but that's typically for short-term funds vs five years (and the investor has to be a Qualified Purchaser).

Michael Ablan · Answer

@Babu Ramadoss  - Simple.  Velocity of money.

a 30 year mortgage allows you to keep more cash on hand which you can invest with.  If done right, this should allow you to dramatically increase your ROI.

If your goals change, then you can begin paying your 30 year mortgage like a 15 year.  You can't do this in reverse though (pay a 15 year like a 30yr).

Just be very aware of "effective interest rate".  Yes, your interest rate on a 30yr mortgage is 2.3%, but if you sell that house 3-5 years in then your interest was really around 90-95%.

Know your goals and stick to them the best you possibly can

Babu Ramadoss · Answer

@Buyan Thyagarajan : FYI

Sunil Garg · Answer

@David M WardI used to think exactly like you.  Debt is bad.  But not all debt is bad.  In this case the debt is tied to an asset that is generating you revenue and you are having a tenant pay your equity through the mortgage.

If your goal is to hold the property for thirty years either way, then you are better off having the increased cash flow as you can actually use the money and re-invest it and scale.  Paying off this type of debt faster doesn’t help you unless you plan to build equity and then re leverage it for another property.You are better off with two properties paid slowly at 30 years than one paid quickly at 15 and collecting for 15.

Just my two cents.  If you haven’t read rich dad, poor dad it might help you.Happy Holidays.

SG

Babu Ramadoss · Answer

Thanks @Mike Dymski. I agree with your suggestion.

"Option 2: Invest those funds and earn ~15+%"- The one thing I am trying hard  to understand is how do i put the 300-500$ per month difference into investment again? I have to accrue them for atleast 5 years to make a substantial down payment investment. Am i missing something?

Greg Scott · Answer

Babu:

I have $1.

Let's say I have only two choices with what I can do with that $1.

One option is to invest it.  What rate of return can you make?  People who get good at real estate investing can easily make more than 10% on any investment.

Another option is to pay off debt.  In the example you provided, you were choosing to pay off a mortgage payment at a faster rate than you needed to.  What rate of return do you make?   Paying off a loan earns you no money.  All it does is save you money.  What kind of money does it save you?  It saves you the interest payment.  So, if you have a mortgage at 3% interest and apply that $1 to your principal, what happens?  Congratulations, you are now making 3% on that $1.

By paying off the mortgage you earn 3 cents every year.  I earn 10+ cents every year.  Which is the better choice?

Why should we do 30 yr when compared to a 15-yr mortgage ?

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