Real Estate 029: Financing Rentals with 15 vs 30 year mortgages?

There are a lot of nuances when it comes to real estate investing, and one important decision is financing. Once you have decided that you are going to use good debt to leverage other people's money and scale your portfolio, you must also decide the terms. Investors typically finance their properties through conventional loans (secondary mortgages with Fannie Mae, Freddie Mac guidelines), as such, they decide between 20% or more in downpayment, or 15 or 30 year mortgage terms.

In simplistic terms, 15 year mortgages will generally have better interest rates as they are being amortized over a shorter period of time and seen as less risk to the bank. To the borrower, it may seem beneficial because you have a smaller interest rate, and less interest paid during the 15 years vs the 30 years. However, once you step back and look at the bigger picture, you may want to take into consideration other intangible factors such as flexibility, potential for interest rates to increase, and the ability to use good debt when your returns are expected to far exceed the debt service (Note: if your property is not covering the debt and leaving you with a healthy amount of cash flow each month, you are taking on a big risk as the property may not be self-sustaining from day 1).

Lets take a look at some of the savings on a rental property with a 15 year vs 30 year mortgage:

Purchase price: $100,000

Down payment: 20%

Scenario A: 15 year mortgage with 5.5% interest

This will leave you with a monthly payment of principal and interest of $653. Over the course of 15 years, the total amount disbursed will be as follows:

Total payment: $117,725.95

Principal: $80,000.00

Interest: $37,725.95

Scenario B:  30 year mortgage with 6% interest

This will leave you with a monthly payment of principal and interest of $479. Over the course of 30 years, the total amount disbursed will be as follows:

Total payment: $173,083.40

Principal: $80,000.00

Interest: $93,083.40

This results in additional interest of $55,357.45 ($93,083.40 - $37,725.95).

Looking at $55,000 of interest savings may make you think this decision between scenario A and B is a no brainer, however if we take a closer look there are various factors to consider:

  • Additional interest can be converted into tax savings across rental portfolio

  • Opportunity cost of fast loan paydown vs re-investing the difference

For example, the monthly PI of scenario A is $653 - scenario B of $479 results in a monthly PI delta of $179 that could be used to reinvest for a higher return or used as additional payments as conventional loans typically do not have pre-payment penalties. Lets take a look at how interest payments would change if we used the $179 to make additional payments toward the 30 year loan:

Total payment: $123,515.78

Principal: $80,000.00

Interest: $43,518.13

Now the difference in interest is only $5,792.18 ($43,518.13 - $37,725.95) all the while maintaining flexibility to change directions if you wanted to, instead of locking yourself into a decision for 15 years. In addition, the $179 in savings in scenario B may come in handy when other rentals in your portfolio are not performing or may be negative $200. The extra cash flow from a 30 year mortgage may be used to offset these fluctuations.

Lets take another example and say that you use your monthly $179 PI difference from a 15 year vs 30 year and combine it with savings to purchase a turnkey rental property with a cash on cash return of 12% (These are actual deals I am seeing in the midwest for a C class neighborhood).

With a $179 starting balance and contributing $179 monthly at 12% returns, you will end up with $632,034 after 30 years when you will have paid off your home in scenario B. Without even calculating, the difference is clear. Although this is just an example, investors must understand these variables and opportunity costs when they decide to forego one for another.  There is not real benefit to paying off your mortgage from a numbers perspective. 

I do believe that risk needs to be managed and am not looking to maximize the debt across all of my rental properties, however, depending on what season you are at life: 20-30s "grow", 40-50s "maintain", 60s+ "enjoy", you may find yourself wanting to lower risk and have peace of mind. 

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!