Should You Pay Off Bank Loans on Investment Property?

should you pay off bank loans on investment property does it make sense to strive for pain down your mortgages faster on rental property through maybe refinancing in from a thirty year to a 15 year mortgage and for that matter if you have the financial wherewithal does it make sense to just pay cash for rental property as opposed to getting a loan we're going to cover all of those questions in great detail I'm going to make it as simple as I can for you and I'm probably going to share with you a couple of tips you've never heard before hi I'm Phil offski with freedom mentor comm I'm a full time real estate investor real estate mentor and coach to many of the most successful real estate investors all across North America best-selling author of two books my first one how to be a real estate investor and then my newest one real estate investing gone bad both are mandatory reading if you're serious about real estate investing and this YouTube channel is number one the most popular it is almost hit 10 million views thank you so much for that in fact these days and I'm at an airport Retta maybe an amusement park somebody will pull me out of a crowd and say then I love your videos so you somewhat may be a celebrity not like a real celebrity but a lot of people know who I am these days so thank you for that well maybe I shouldn't be thanking you and I talked more about the training here as it relates to bank loans versus all cash all right let's get started so to frame this entire discussion we need to talk about the concept of arbitrage don't don't get scared about the word arbitrage you do it every day probably for example if you hire someone to clean your house or to mow your lawn typically you're doing that because you're paying them 10 to 15 dollars an hour in your normal job you might earn 30 to 50 dollars an hour so it makes a whole lot of sense to have them do the work because you can make more money per hour doing what you do best as opposed to what they do best that's arbitrage but what here we're going to talk about is financial arbitrage the idea that you can earn more interest on your money when you invested then the prevailing interest rates for you to borrow money let me show you what that looks like in sort of to frame this particular concept I'm going to talk about paying cash for a house I know you may not be able to do that but it makes the discussion easy for illustration purposes okay so we've got a house and it's going to be three hundred thousand dollars and what I'm going to use for this example is a ten cap I'll explain what a cap rate is in a moment but this is going to have a ten cap rate meaning if you paid three hundred thousand all cash for this house you would get a 10 percent return on your investment after all expenses after management maintenance after taxes everything you would bring in ten percent or thirty thousand dollars a year that would be your return meanwhile you can borrow the money at five percent that's the interest rate on the loan so I asked you this question if you can bring in ten percent and it costs you five percent does that make financial sense the answer is yes you don't have to have a degree in calculus or advanced mathematics to see this you can get a positive five percent arbitrage play here you're getting 10 percent from the investment and you're paying five percent in the form of interest make sense okay so this is the concept and this is why it can make so much sense to have a bank loan when you have a rental property long term investment property I'm not talking about flipping real quick here I'm talking about long term you may have heard me talk about cap rate before let me talk about it one more time so cap rate is this you're you're going to have what's called an N oh I that is your net operating income and that's going to be divided by whatever the purchase price is okay in a why what's that that is your absolute income cash flow after you've paid so it's going to be your income - your taxes and your insurance and your maintenance and your management and all the other expenses that go into owning a piece of real estate but it doesn't include the cost of the mortgage because that's not what we're talking about here we're talking if you pay cash for it what would be all of the income minus all the expenses that's where you get this Noi number and what a cap right number ends up looking like is it's a point zero something or a point one something so a point one zero is a ten cap it's a percentage numbers what it is okay so in this particular example in order for us to get a ten cap on this deal what would have to happen is this I would have to have a you know of course the the purchase price is three hundred thousand but I would have to have an income after all expenses a yearly income of thirty thousand that's how I get to my ten cap financial arbitrage is just the beginning of the benefits of bank loans against rental real estate so the next one is what I'm going to call higher use that as a arrow cash on cash return alright so we'll go back to our example and that is three hundred thousand and a 20% down payment on that would be sixty thousand that's our 20% down so for thinking in terms of cash on cash return that would be this amount of money this is our cash into it how quickly is this come back now we know from our example that we had 30k coming in per year but now we have a loan in place of 240 that's going to change our total amount of income coming in and so I did a quick analysis on Zillow mortgage calculator on a 5% interest rate loan that's about twenty thousand dollars a year goes toward quote debt service so out of this what we end up getting is ten thousand that's our actual cash flow so our cash on cash return is ten into sixty but that is still a lot better than our original remember we had our and cap so if we had a ten cap if this is higher if 10 into 60 is higher than 10% which it is that means that our cash on cash return is higher than it than the cap rate so that means it makes sense if you have a bank loan you're not putting as much money into the property so you're getting a faster cash on cash return and that's not the total return because remember out of those 20,000 some of that's go into principle if I'm moving too fast you're gonna have to watch this again because I'm going to keep flying all right number three one of the things I absolutely love about bank loans is that it allows you to buy more real estate with your money so you can buy more now that also means is that's pretty obvious you can buy more this is critical depreciation depreciation is something that exists in the United States and it's for tax purposes it allows you to pay less in income taxes because it's an expense although it's not really an expense out of your bank account it's just an expense for tax purposes and for single family homes anyways it is 27 and a half years what you do is you do what's called the cost basis which is going to be the cost to purchase the property minus the land value because land doesn't depreciate based on the IRS rules and so you have cost faces divided by that twenty-seven and a half years so we go back to this example let's say that the value of the land was the 60,000 so really we had a cost basis of 240 and then that was divided by the twenty-seven and a half years round numbers this is 8,700 okay so that means that all the of the 10,000 this is considered an expense so you're only paying taxes on 1,700 bucks a year but but you but you earn 10,000 see that well it's a little bit more than that because some of this is going toward principle but just showing you for simple illustration purposes so by using a bank loan you not only play the arbitrage game and you get a higher cash-on-cash return and obviously you can buy more real estate because you're not putting as much cash in but you also get the power of depreciation whereas let me show you this if you paid cash for the property right and you have this 8700 is still what your depreciation amount is but you're bringing in your 30,000 you see how now you're paying tax on what amounts to twenty one thousand seven hundred so you're paying more in taxes how is that possible it's because depreciation is based on the cost basis so the more you pay for a property the more your depreciation is going to be and that's what bank loans allow you to do powerful stuff isn't it ah but with much power comes much responsibility and there are some drawbacks of bank loans the first is going to be a personal guarantee if you're dealing with residential real estate that is four units in below without exception personal guarantees are pretty much required if you're going to get good interest rates so personal guarantee first big problem and that means if something goes wrong and the loan doesn't get paid back well you are personally liable your to pay for it um this is pretty much obvious but I'm just going to point it out anyways and that is the ability to get a loan right so you may have a difficulty getting a loan all together because there are certain requirements for getting a loan so there's a drawback right um but alongside the ability to get a loan is something even more important that is loan terms so you're going to have to get low interest rate um but this is another big one it's not just the interest rate it's going to be this amortization leave ooh big word amortization is typically thirty years or fifteen if you're doing with commercial real estate you can almost never get 30 years it's usually fifteen or twenty or twenty-five so if you have to go with a fifteen year because that's what the lender is requiring you to do that could really hurt your overall profitability and the plans you have in place because the 15 year puts so much money toward paying it off we're going back to the subject is even good idea to pay it off right so amortization length is important and then fixed rate length all this is big if you're from the United States you probably don't know that in Canada they don't have 30-year fixed-rate loans they have 30-year amortization or or a refinance the loan that you didn't know that and most most commercial lenders are the same way they may do a 15 year or a 20 year amortized loan but it's not going to stay fixed for 20 years it's going to stay fixed for maybe five years and then it's going to go back to whatever the prevailing interest rates are at that time five years from now that's a big deal and that's a huge drawback so when you're planning all this stuff out it might make sense for those first five years but then all of a sudden after five years you don't know what's going to happen with the interest rates so drawbacks there so that's what's so exciting in the United States with residential real estate when you can get a 30-year fixed-rate loan that's incredible because that's fixed for 30 years 30 years from now probably your rental rates are going to be higher probably and probably there's going to have been inflation on the dollar or whatever the currency is that you're dealing with and so what happens is it's so nice when you can lock it in for 30 years but that's really rare outside of the United States all right so that's a big drawback this is a huge drawback for me and for others and that is I'm going to call it lack of anonymity anonymity when you get alone especially when you're talking about residential loans they want you as the person to be the buyer so it's going to show you as the owner on record now you could try to transfer that into an LLC F you close but then you would be breaking the data of deed of trust or mortgage due on sale clause and you might can get away with it but there's problem there it also avoids your title policy and it's still on public records that at some point you are the owner so there's not much anonymity when you're getting a bank loan and if you are high-profile or you don't want people to know what kind of assets you have and everything in between this is a problem with getting a bank loan write these down these are my two commandments of bank loans number one 30% in equity I know most banks are only going to require 20% down for many of your investment loans I'm not saying you just put 20% down what I'm saying is you put 20% down but you also buy it 10% below value that's where you get to 30% equity always have some room in the deal why because if things go wrong and you need to sell that investment property quickly you can drop the price loan up to get rid of it quickly and still make a couple of bucks and definitely pay off that loan so have equity in the property don't be doing 100 percent financing where you have absolutely no equity in the deal and it's all alone that will put you in a potential bind number two is you need reserves I have in your four months of of debt service payments for mortgage payments worth of reserves at least have some money saved up in case something goes wrong you have the ability to make those mortgage payments while you fix the problem whether it's a tenant that moves out whether you have some problem with the actual property or anything in between so have equity have reserves and now you have the ability to take full advantage of the power of bank loans so you can benefit from it and not put yourself into a potential financial bind because you are using the power of leverage with all the benefits of a bank loan is there any benefit to owning rental property all cash let's talk about the first and by far the most important one is anonymity if it's anonymity when you buy when you first purchase the property if you pay all cash you can buy it at LLC you can buy the trust you can buy it in such a way where basically no one even knows you bought it so this is huge for those that don't want anyone to know what kind of assets they're really dealing with and I may know somebody personally like that well also what if you're in a situation where maybe you just gone through a divorce and you run into some money and you don't want the the ex spouse to know about that and take you back to the court and change the whole rules on on the alimony or child support well that might be good for anonymity or maybe you're a drug dealer or that sort of thing and I'm not that I'm supporting that kind of economic behavior but if you want to have anonymity you can do that with all cash purchases so that's a benefit and obviously another benefit is no interest you're not paying bank interest but as we discussed just a moment ago that's not a bad thing so long as your cap rate is a lot higher than your interest rate right but on the other side of the coin if it's about the same or it's just slightly different well then maybe there is a benefit to go with with no interest because if you can't get any more money on your money than then prevailing interest rates I mean there was a time when interest rates for double digits well then it makes sense to just pay it off does that make sense oh but there are myths surrounding owning rental property without a bank loan and here's the big one that you own the property ha let me ask you a question if you don't pay your property taxes and you own the property free and clear what happens the government takes your property may ask you this if it's in an HOA or a homeowner's association or a condo association and you own the property free and clear and you don't pay their bill what happens that's right they take your property another to a smaller extent if you uh if you own a property free and clear and you get insurance that insurance lapses is there anybody they even tell you that your insurance lapse not always tap it to me before it sucks your insurance lapses and all of a sudden you own a home free and clear you don't have any property insurance on it so the idea that you own the property that's a myth the government owns property the HOA owns our property well before you do so don't get thinking that somehow because you own it free and clear you own the property that's not true you're still renting the property from a higher authority there's been a whole lot of talk but what's the verdict loan versus payoff / cash all right well if you're following the commandments you're winning the arbitrage game and if the interest rate is fixed or at least fixed for a long period of time no question loan will always win now on the other side of the coin if the cap rate is really high 15 20 % and that's more than you could invest your money anywhere else in the marketplace it can make sense to pay it off even if you're winning the arbitrage game because there's no other place to put your mind to get that high of a return on investment make sense or if you can't get a fixed rate loan for any length of time and meanwhile you also want to own that property forever for generations and generations you buy some castle in France and you want to own it for forever well maybe you do need to pay cash because that way it's least there's one less thing you have to worry about stuff we're about taxes we don't have to worry about making sure the interest rates don't go crazy and haywire all right also if you need anonymity we've talked about that that if you need an animal you have to pay cash up front to get that anonymity but either way what you see here is paying off makes sense when the cap rates huge if you don't ever would have to worry about that fixed interest rate ever being an issue maybe five years down the road if you're in Canada you deal with the commercial property total run being an enemy pay cash and if you're like me you like to have your cake and eat it too so what is the best of both worlds what's the best of a bank loan in the best of all cash creative financing you guessed it what I specialize in with creative financing whether it be I'm going to give you two examples subject 2 and I have extensive videos on these subjects or owner financing you can get the anonymity you can buy the property and whatever entity LLC trusts you want to buy it in you wouldn't have a personal guarantee on this and most of the time with owner financing you can structure it so your entity as the guarantee not you personally so you avoid those problems you get the benefits of having a bank loan so if you really want to take it to the next level with real estate investing discover how to use creative financing and then you get the best of both worlds you get the best of bank loans and you get the best of cash and you get it both without all the hassles and headaches but you got to know how to find the deals how to structure the deals I got great videos on that in fact there's one video called how to turn a little into a lot part 2 that's probably the best video I have of all of them on the subject of creative finance and how to structure these things all right well I hope you learned some new things here if you've got questions and things that you want to share with me put them in the comments down below to learn more about what we're doing head over to freedom mentor com subscribe to this YouTube channel if you want to get access to these videos before anybody else also grab my 2 books if you haven't already how to be a real estate investor in real estate investing gone bad thanks so much for watching them fill pussy-ass ki I'll see on the next video

Channel: Phil Pustejovsky

Views: 171,510

Rating: 4.8823142 out of 5

Keywords: Bank Loans, Rental Property, Real Estate Finance, Pay Off Mortgage, Mortgages

Id: SyZuh9eh0JI

Length: 20min 58sec (1258 seconds)

Published: Wed Jun 08 2016