REAL STORY: How to Lose Money on A Low Interest Loan

[Wendell De Guzman]

When you invest in real estate, borrowing money makes sense because the right loan on a good deal will help you make money faster and with higher return vs. using all-cash.

One of the things that people look at when borrowing money is the INTEREST RATE.

A low interest rate loan is usually better than a high interest rate loan.

With the advent of crowdfunding and peer to peer lending, low interest rate loans is now a reality and if used correctly, can be used in real estate investing. Hard money lenders that charge 12-14% interest is charging way higher than P2P lenders who charge 8-10%. But are HMLs going out of business soon because of P2P lenders? Not necessarily.

The TRUE TO LIFE story below shows that there's more to a loan than the interest rate and if you're not careful, you can lose money on a low-interest loan. How? Here's the story:

This newbie investor approached me right here on Biggerpockets (thanks @Brandon Turner and @Joshua Dorkin!) . She told me she can invest $120,000 cash and she told me about this investor she's supposed to partner that "disappeared" with no deal after almost one month of waiting - and that one month of waiting is costing her money (because she borrowed the money).

I told her about our rent to own deal in Oak Lawn and I told her that unlike the average investor who does this part time, we have 7 full time employees backed by 22 years of cumulative real estate experience and $20 Million worth of real estate transactions. Unlike that investor she's supposed to partner with who now can't get her a property, I told her to come to the office so I can show her 8 deals that we have- 3 of which she can potentially invest in.

She got excited, I showed her the numbers, we agreed on a profit split and we even signed a JV Agreement. The next day, she sent me this email with the different lenders that lent her the money, and she said after sleeping on it, she realized that we need to figure out how to pay HER cost of money. One of her lenders - lendingclub lent her money at a low interest rate of 9.16% (which is a pretty good rate) and payable over 3 years. BUT, her payment is over $800/month. This is an example of a low interest rate loan but with a high loan constant (but I am jumping ahead of my story).

She added all the payments from her different lenders and I was shocked to find out it's a whopping $3900+/month on total loan amount of $140,000 (she also paid 10 POINTS to get all these loans approved)!

Ouch!

After looking at the numbers, I asked her:

HAVE YOU HEARD ABOUT THE CONCEPT CALLED THE "LOAN CONSTANT"?

She said "NO".

I explained to her that the loan constant is your annual loan payment divided by the loan amount. Interest rate is closely related to the loan constant but loan constant covers the principal paydown in addition to the interest payment. An interest only loan will have the loan constant equal to the interest rate.

I can't believe this supposed to be experienced investor did not explain this concept to her.

One of my mentors said that A LOT OF REAL ESTATE INVESTORS lose money and even lose properties when they fail to understand and use a SIMPLE concept called the LOAN CONSTANT. So, maybe this supposed to be experienced investor has not even heard or really understood what a Loan Constant is.

Let me explain it here with an example:

Let's say you have a friend Joe who said that he has a 401K - and he can borrow money from his 401K for a mere 2%. Joe told you that he will charge you 5% so he can earn a 3% spread. He is willing to lend you $200,000.

It's very tempting because, as I said in the beginning of my post, the typical hard money lender lends money at 12%-14%...so 5% as your cost of money is a NO-BRAINER, right? You are excited because you can use this money to buy and fix a 4-unit building and it will produce cashflow of $2,000/month or a cap rate of 10%.

Cap rate of 10% is higher than 5% interest so this is a deal, right?

Well...not so fast. You have to calculate the LOAN CONSTANT.

The typical 401k loan is payable over 3 years or 5 years.  Let's average it out and choose 4 years or 48 months as your loan term. This means your monthly payment is:

$200,000 x (1+5%/yr x 4 yrs)/48 payments =$5,000/month

The Loan Constant is equal to (Payments x 12)/ Loan Amount  x 100(%)

Loan Constant = $60,000/ $200,000 = 30%!

Even though the interest rate is only 5% but since your loan constant is 30%, you will run out of money pretty soon if you can't invest that money at a return higher than 30%!

And a return higher than 30% is NOT easy to accomplish. Warren Buffet's long term average is about 20-25% so...it's not very easy.

Every month in this example, you are going to be out of pocket $3,000 ($2,000 cashflow less $5,000 loan payment). If you can't pay up, you will have to deed the house to your friend Joe and pretty soon, you will likely be no longer friends anymore.

So there you have it - it's a simple concept - LOAN CONSTANT. Before you borrow money - calculate it first and be aware that a low interest rate loan is NOT necessarily a good thing.