Re: Interest vs. Principal - Posted by Dave T
Posted by Dave T on September 27, 2001 at 17:21:00:
To answer your first question, you do NOT pay taxes on either principal or interest payments that you make. Since I suspect this was not your real question, let me say that generally speaking, mortgage interest you pay is deductible but the principal payments you make are never deductible.
Now, your second question relates to the drawbacks of this deal. You don’t tell us what you will do with the property if you buy it, so I can’t get too specific.
Let’s assume that you intend to hold the property for rental income. Let’s also assume that you agree to give the seller a 30% premium over market value for his property, but he has to agree to 100% owner financing at 0% interest for 30 years.
For the sake of illustration, let’s say the property is worth $100K but the seller wants $130K. If you agree to the inflated price and if the seller agrees to your financing terms, then your monthly payment on this property is only $361.11 per month (130000/360). If you can rent this property for $650 per month, do you think your cash flow would be about $150 each month after operating expenses and mortgage payment?
After seven years, you will have paid the loan balance down to $100K while pocketing $12600 in cash flow. If you also assume that the property appreciates at a constant rate of 5% per year, at the end of seven years your property will be worth over $140K.
Now let’s also assume that you sell the property for $140K and net $130K after selling expenses. You pay off your private mortgage and have $30K left in your pocket. That gives you $12600 in cash flow, plus a $30K payday when the property is sold, for a total return of $42600 on your investment (before taxes of course). Not bad for no money down.
On the other hand, if you agree to the inflated price and also agree to a 4% interest rate, your 100% financing will cost you about $611 every month. Your monthly cash flow practically disappears, and your back end profit on the sale drops to around $19K.
While I usually don’t look at properties that are overpriced, great terms on the sale could still make the deal work for you. I realize that I make some optimistic assumptions here too. After all, the rents might not rise as fast as the taxes and insurance increases, operating costs might be higher is later years as major repairs are required, and high tenant turnover could introduce an intolerable vacancy rate to the mix.