Which type of loan makes the most sense to a buy & hold investor

Question

Example... Which would you (you meaning real estate investors out there) prefer,

1) 15 year loan @ X% that yields a $200 a month positive monthly income on a 4-plex, or

2) 30 year loan @ X+% that yields a $900 a month positive monthly income???

Option 1 seems good because the loan pay down alone is 15 years faster, but ob,y produces $200/mo cash flow. On the other hand option 2 is great because of the cash flow you get now + more tax write-offs. Which type of loan would you recommend assuming these are your only 2 options??

Scott Trench · Answer

Aha! So this is how nerdy I am. Business is closing, and I decide, "nope, I'm not going to go home! Instead, I'm going to model out exactly why a 30 year loan is better than a 15 year loan for building long-term wealth!"

Find my spreadsheet  here.

These two graphs show the main points from the model:

Basically, return on equity is higher for more leveraged real estate assuming regular annual appreciation of 3-4% on property prices. Further, because you are producing positive cash flow in the all cash situation, and more cash flow in the 30 year loan scenario than the 15 year scenario, you can invest that cash somewhere else. In this case, we invest in the stock market. Remember, the stock market has historically produced 11-12% returns (although even that is up for debate - feel free to download my model and change all those assumptions).

So you'll notice that because investors can reinvest the cash flow in the 30 year mortgage into things like dividend producing stocks (or other real estate), cash flow at the end of a 20-30 year period will often be greater in the 30 year vs the 15 year scenario.

The takeaway is that if you reinvest the cash flow from your 30 year mortgage scenario in more leveraged real estate or stocks, then even when the 15 year mortgage goes to zero, you are still doing almost as well from an aggregate cash flow position, and you are earning far greater returns on your equity. In fact, you'll notice that the 15 year loan "return on equity" line bends! That's because after year 15 you finally start generating enough cash flow to get into the black (positive cash flow territory, and can begin purchasing stocks, which typically yield higher returns than unleveraged real estate, making your returns INCREASE because less of your holistic financial position is in paid off real estate!

This is a very important point! I suspect that there are many moderately wealthy investors out there with paid off real estate that would be far better off over the long term selling their paid off properties and just putting that money in the stock market! Or, better yet, buying more leveraged real estate!

Finally, to leave you with just one more graph, here is the impact on your net worth between the three choices of buying property all cash, buying with a 15 year note, and buying with a 30 year note:

NOTE: One flaw in this calculation might be the interest rate assumption. The gap may not be as large if interest rates are significantly lower for 15 year loans.

Jeff F. · Answer

Personally, I'd go for the second option. You can always treat it like a 15 yr loan (say, make a year end payment of 8,400) and you'll be in approximately the same spot you would if you did a 15 year, but this will allow you to build up a reserve account for when something goes wrong - and it will.

If you've only got 200/mo cashflow, and you need a new furnace after owning for 6 mos, then you'll be in the red, but fine if you were cashflowing 900/mo

Matt Vogt · Answer

How long do you plan on owning the property? You're going to cash-flow more on the back-end if you go with a 15 year, however you'll be able to scale faster with a 30 year mortgage (higher income, lower monthly debt). How many other properties do you have, and how many do you want? That will likely dictate what works better for your strategy. I would probably do a 30 year fixed, then pre-pay the principle down with your extra cashflow. That way your income will still be inflated, and your DTI will be more impressive allowing you to acquire more properties in the future. It doesn't take too much more than a 15 year mortgage payment to prepay your 30 year down to 15 years, and for that added cost you'll have more flexibility in the event of financial hardship.

Anthony Wienke · Answer

I have to agree with the others in here that the 30 year is the better option. As iv learned from some other members here, you can pay more towards the principal with the extra positive cash and treat it like it was a 15 year. You may pay a little more in interest but with the extra money going towards the loan itself you will get that interest rate down more on each monthly payment.

I think my favorite part of the 30 year loan is what Jeff said. If something goes wrong (AND IT WILL) you can count on that extra positive cash to pick up the bill for repairs and maintenance.

Scott Trench · Answer

Mathematically, in an appreciating market, you will likely be better off with a 30 year mortgage in almost every case. This is because you take on more leverage over a longer time period.

There tends to be widespread consensus among the investing community that paid off, all cash real estate tends to produce lower average returns than other types of investments (like stocks) dollar for dollar. It is through leverage that real estate investors tend to see larger returns in appreciating markets.

However, not everyone (including me) invests solely for the mathematical output. Some folks like to have paid off properties. Some folks like to manage risk, and some folks don't like debt. Are you willing to sacrifice some return in exchange for being debt free and owning paid off properties?

Personally, if I were looking to be in the most stable possible position 15 years from now, I might try to pay off a ton of rental properties. But, I would acknowledge that in doing so, I might be forgoing substantial amounts of wealth that I could have generated by maintaining a leverage position.

Of course, if you go with the 30 year loan, make sure that you DO use the extra initial cash flow to build up a reserve like @Jeff Fruhwirth  says. No or little cash and lots of leverage can spell disaster.

Gabe G. · Answer

I am sure you will get opinions on both sides of this question.

However, get as many 30 yr fixed mortgages as you can get. Eventually you won't be able to get anymore, that are a full 30 year AM.  It provides the most flexibility and cash flow for emergencies.

Mark S. · Answer

@Cam Jimmy I feel like the main reason to do a 15 year mortgage is if you have a plan to use the full rental income in 15 years.  For example, if you have a child who is going to be going to college in 15 years you could use the income to pay for tuition or your might retire.  Otherwise I think the 30 year is a great option.  The interest over the life of the loan will be a lot higher but there is a good chance you will sell the property before the mortgage has been paid off.

best of luck!

Michael Lee · Answer

Hello again!  Thanks for responding to me.  It all depends on your goals and criteria.  It is getting easier to borrow money now-a-days.  I have no direct information to give you because of my lack of experience but it is best to have equity and cash flow.  Save as much money as you can.  What you do with that money is to pay capital expenses and buy other properties or refinance your property that has overly appreciated and use the equity made to put into savings or buy more property.  You have to live cheaper when first starting out.  Stick to your criteria and goals.  Keep your emotion out of your deals and learn how to walk away. Know what your market will support.  See you later!

Michael Lee · Answer

Hello and welcome to BP!  What you do or try to do depends on your goals.  Save as much money as yu can and try to pay off properties to use the equity cash to buy more properties.  When you can't get owner financing get loans that are as short as you can afford but try to avoid Hard Money short. 20 or 25 year amortization is what I am talking about.  Try to save money as much as you can and put off some of your wants for later in life.  Separate your wants from your needs.  At first just spend your money on the have to haves and not on the needs until later.

I am now reading a book that has good lessons to follow,  it made me realize that leads are basically in two categories, some are ad answers and some you allready know and have to communicate with on a regular basis.  Keep track of all your leads so when you know they need a communication.  Doing a little extra goes a long way.  Show your respect by giving them something extra from you.  Spend some time everyday to communicate with them and it will pay off.

Always remember to do a math analysis on your projects and try to look at them before you make an offer or at least have a clause in the sales contract that will allow you some time (about 15 days) to make a detailed inspection and possibly back out of the deal without a penalty that is greater than your earnest money deposit.  As soon as you close get an insurance policy that will protect you in case of a loss.

I am 59 years old and would like to help you whenever possible and I found BP about 11 months ago and I am still deciding what to do while I medically recover.  I also went to college and got a business degree, not that it is mandatory, and it emphasized real estate.  Since I was in Texas and planned on staying there I found out if I was qualified to take a broker test and I was so I took the test and got a license.  I kept that license for about 30 years but never did that full time.  Regardless of what I had I felt more comfortable in the construction business.  I have been in the construction-related business since I was 17 including those college years.  If you think that I can help you on anything please contact me through BP at any time.  Good luck to you!

Which type of loan makes the most sense to a buy & hold investor

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