Acting like I knew what I was talking about, I made a flat statement about mortgage loans and was immediately challenged to prove it. And right then, I couldn’t do it, I just didn’t have the words.
What I said was that at today’s never-happen-again interest rates, having a fixed-rate mortgage for 20 or 30 years was money in the bank, all by itself. I said that using a long-term, fixed rate loan at today’s interest rates actually added monetary value to income property or houses because of the terms of the mortgage.
“I don’t think you’re right, so I don’t believe you can explain it or demonstrate it,” my challenger said, “I think a house or office is worth what it’s worth and how it’s financed has nothing to do with that.”
I figured I was right, I just didn’t know how to explain it in little tiny words, so my buddy could understand it. So I retreated to the office to figure it out, especially since a small wager was made on the outcome. I hate to lose a bet. (So don’t make one, dummy,” my wife might say.)
A mortgage with a payment fixed for the life of the mortgage is money in the bank for both the owner of a home and the owner of income property, something like a small office, although for slightly different reasons.
Earlier this week, interest on a fixed rate conventional mortgage for 30 years was quoted at 4.875 percent, slightly less for a 15-year term. I’ve never seen interest rates this low. I’ve seen interest rates almost four times higher in the early ‘80’s, but I’ve never seen them this low and don’t expect to again, either. It’s a rare and beautiful time to borrow money, if done wisely and with some financial education, and to use it to invest in real estate.
Borrowing $100,000 to buy property at 4.875 percent and 30-years fixed results in a payment of $529.21 monthly, fixed for the life of the mortgage. At the end of five years, the mortgage balance will be $91,664.58 and at the end of 10 year, the balance will be $81,033.69.
If the interest rate were to increase by two points, to 6.875, the monthly payment would increase to $656.93 – or almost $128 higher per month. After five years, the loan balance would be $2,340 higher than at 4.875 percent – at ten years, the balance would be $4,524 higher.
I feel safe calling that “money in the bank”. The lower interest rate supports a mortgage of $100,000, with payments of $529.21 monthly. Leave that payment the same, but add two points to the interest rate and the same payment will only support a mortgage of $80, 558.20. That means the lower rate is worth over $19,000 to how much house a borrower can buy. Sounds like money in the bank.
Moving to offices, it’s hard to find a good one for only $100,000 or even $150,000 to $175,000, although I know of several, but the math is easier staying with $100,000 – and I like easy math. It’s harder to find a fixed-rate loan for investment or business property than for a house, commercial lenders like adjustable rate mortgages. But they’re around, including loans from the SBA (Small Business Administration), which has become a recent player because of economic stimulus efforts. Like home mortgages, SBA rates have also dipped under five percent, so we’ll stay with the same 4.875 percent interest rate for the office.
But because the loan is ten years shorter, the payment is higher at $653.07. Adding two interest points pushes it higher still to $767.81 – a $114.74 difference. Mortgages differences at five and ten years out at the higher rate are $2,823.94 and $4,569.56 higher than balances at the lower rate, which means the lower rate is worth almost $7,400 to the borrower, over 10 years. Money in the bank.
Home values are largely based on recent sales of comparable homes, plus what the market will pay for them. Business/investment property is largely based on the relationship between what it cost to buy and the income it produces. Because the higher interest rate cut the net income by almost $115, it also reduced what an astute investor would be willing to pay for it.
This is usually true even if a smallish insurance broker, a one or two man attorney firm or (almost as bad) a real estate broker is buying it for their business’s own use. Many times, for tax purposes, the business owner will hold title himself as an individual and rent it to his corporation, charging market rent. For those who like to live dangerously, title is often held in the wife’s name. You want to talk about landlords and big rent increases? Wait until after a spousal quarrel and you might see rent increase records being set. (Just kidding, honey. Really.)
No matter what interest rates do in the future, knowing your fixed-rate mortgage will carry the same interest rate for the whole length of the mortgage and that your payment won’t change is worth something all by itself, even if only peace of mind.
Unfortunately, there’s not room left to go deeper into how an aggressive adjustable rate mortgage could possibly change the value of income property, although running out of room may be a blessing, if you’ve managed to slog through the numbers this far. Hard to liven things up with jokes about numbers, they don’t lend themselves to humor. “Ha, Ha, look at the way that three looks. And the seven, what a bad haircut, flattops went out of fashion years ago. And the zero, there’s just nothing there and hasn’t the eight gained weight?”
There’s one thing true about all real estate. If you’re patient and keep making payments, then one fine day the payments will end. For an independent insurance broker, lawyer, real estate broker, dentist and hundreds of other types of small business owners, it’s probably the best retirement plan possible.
When we retire and walk through the door for the last time, the business often goes with us. It’s hard to sell a real estate company, for instance, people can go broke without the bother of buying one. But if the front door key stays in your pocket when you leave because you own the building, you’ve got something to sell.
Or rent it. Let somebody pay you, for a change. I know a guy with a small rental property he calls his “boat house” because the rent makes payments on his boat – if there were ever a good reason to justify raising the rent, it would be a boat, often described as a hole in the water into which you pour money.
Mike Hill has been in the real estate business in Valdosta since 1976, when boats were still being made out of wood, not plastic, and has never admitted to owning a “boat” house.