When is 8% Better Than 12%

Question

I have this conversation frequently with investors investing in mortgage notes and private lending. Many people will look at the interest rate or even the yield to determine which is a better deal. But what many forget is when using yield it assumes you are reinvesting the money you receive every month back at the same rate, which when lending we know this is not the case. Here is a great example:

Investor A does a $25k private loan at 8% interest only for 4 years. They collect $2,000 per year interest and the balance at end of 4 years so they collected $33,000.

Investor B does a $25,000 loan amortized over 4 years. This pays $658.35/mo = $7900/yr but over the course of the loan only $6600 in interest. This then has them collecting $31,600 total after 4 years. Now some of you may say well yes they can reinvest that $7900 every year, but in real estate its difficult to invest $650/mo including the time you are spending on it.

Why share this? The reason being I see a lot of people again just looking at one specific number and not understanding everything behind it.

Chris Seveney · Answer

Thanks. Just trying to educate people on financial literacy as many only look at the "sticker price" and do not think of alternatives for comparative purposes. For example with seller financing doing interest only if you can is a bigger win, especially if you get a big down payment as the risk typically in I/O is price declines, but if you put I/O vs/ Amortization side by side it would blow your mind the $ difference.

Sam Yin · Answer

I'll chime in... Chris may have a different opinion...

For me, I used to think similar to you. As I grew my portfolio, it was always done with PITI and I even started off with the idea to pay them off quickly to get higher returns at the end of the road. Over time, I was exposed to more people in the industry. Specifically, I was exposed to those who live off their rental income and grew their wealth while doing so. By asking questions, the concept of I/O became more clear to me and it opened my eyes to the great benefits of I/O.  Obviously, not everyone will agree or will totally comprehend because they are in different situations in life.

To sum it up: I/O will get you better cash flow, into more deals, and will allow you to grow faster and leave the W2 sooner.

Here is what it means: Better cash flow equals higher purchasing power in future deals. That means you can grow faster with larger deals/more units. That will ultimately put you in a better position to leave your W2.

The most frequent fear of leaving the W2 is the loss of benefits. Take a moment, breathe, and analyze what those benefits are that your employer is providing. Quantify it. Now reverse engineer the math and figure out what REI investment needs to be made... or returns needed... to cover that quantified cost. Do it. check that off your list and move on with your life. You just got your benefits package covered, and it is no longer a hurdle.

In my case, I did exactly what I just described. My benefits package was roughly 60K-80K/year. That included medical, dental, disability, 457B, pension, etc... I made sure there was a return that accounted for that benefit package. Then I looked to invest to make enough to cover my lifestyle... roughly another $60-$80K per year, for a family of 5 to live comfortably.

That is the magical power of I/O. Reread if you need to.  When given the choice, I chose I/O, as I did so on my last few purchases. Thus, my tax return will reflect the higher income in order for me to make purchases without the need for a W2. For example, I am currently looking at a $4.5M apt complex, but I do not have a W2 as of last year. However, the income from rentals, some being higher due to I/O notes, allowed me to qualify for the purchase. It was a tremendous fear, but after a few conversations with lenders and brokers ahead of time, I figured my initial fears were just that... fear.

You might ask: why? or when will the property be paid down/paid off. The answer is most often, NEVER. Because the underwriting has the tenants paying the I/O note and the tenants also pay for any Refi, Cash out, HELOC, etc. And when it is sold, its at a higher price, thus there is profit created.

This might not work for everyone. Because everyone's goals are different.

James Wise · Answer

MF's always forgetting about the details.

Sam Yin · Answer

@Nathan Harden

The last 2 I/O deals are: 10 yr fix, due in 15 with a local Credit union at about 4.5% with PPP of 3, 2, 1,1,1. The other is a 5 yr fix, by the Seller, with possible extension, due in 5 or 10, AT 7.5% with separation clause and no PPP. This was end of July 2022. Current cash flow is about $60k/yr. DP was almost 600K, from 1031x funds.

The first was qualified with PITI, but the I/O was an option. It took about 25% down at slight discount from market price.. The Seller financed one took 20% down at market price. This was end of Sept 2023. Casf flow is about $40k/yr. DP was $280k from funds saved from recent cash flow.

Hope that sheds some light.

Nathan Harden · Answer

@Sam Yin

Hey, I love it. Different strokes for different folks.

I would love to hear how you structured your I/O deals. How long was the I/O, did you get a better rate with I/O, did your numbers work with PITI initially or did you choose I/O to get a smaller payment upfront to get the asset up and running?

Nathan Harden · Answer

Chris, always posting great content!

I got one for you because I am in a similar negotiation as we speak. The seller wants to do a 3 year Interest Only but I told him that I am not his buyer if that is the case because my goal is to always attack principle on day 1.

There are times that I/O can be beneficial to all parties but with mt particular case, the units are turnkey, renting at market value so there is no need for me not to attack principle.

If you're a seller, I/O is the way to go but as a buyer, I never want to get into any I/O for more than 1 year, tops.

What are your thoughts?

Sam Yin · Answer

Chris,

This is some cool insight that some may not be thinking about. I am going to dabble in mortgage notes. I recently listed several apartments and I would consider carrying paper. I wanted to see if this was another avenue to increase passivity. I figure carrying a few notes on I/O would allow for stable income and using a few to 1031 can still help me grow. I am excited to see where 2024 will go.

Thanks!

When is 8% Better Than 12%

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