As I wrote in the Investment Roadmap for the Risk Averse and Cautious Working Class Investor, Real Estate is definitely a need-to-have asset. This is partially due to the potential tax benefits. There is also the potential for price appreciation and rental income. And of course, it is a place to live when it is your primary residence.
New York is the center of the world, so there is no difficulty finding tenants for an apartment. Recently I spotted a good opportunity to purchase a co-op apartment on the Upper East Side for what I believe is a good price. The property is located in the heart of – Manhattan in the highly desirable neighborhood. It is in a convenient location near shopping, restaurants and public transportation so it is even better. Additionally, this apartment came with a relatively low price, meaning a potential capital gain from the initial investment. To purchase this co-op, I need to take out a loan. Here come some quite pragmatic questions.
- Will it be profitable and if so, what is the estimated ROI (return on investment)?
- Should I take a 15-year or 30- year mortgage?
- In the future, should I try to pay back the principal as soon as possible or should I delay?
Everybody knows there is potential tax saving to take advantage of. Even though we don’t like paying interest we may have to. So the decision has to be made by calculating the net cost for the buyer when both factors are taken into account. I’ve laid out the mortgage amortization table and conducted scenario analysis as in the following.
Let’s assume the following parameters commonly practiced in this industry. The loan amount is $300,000, annual borrowing rate is 5.00%, which is equivalent to a monthly mortgage payment of 0.42%.
If I take a 30-year loan with 5% interest rate the return I could generate from other investment opportunities (opportunity cost) is also 5%. The actual total dollar amount I will spend on this property is $579,767.35, meaning, I will have to pay the bank $279,767.35 in interest over the full term of the loan. However, the key feature of this co-op is that it has a liberal leasing policy so I can sublet it out with a monthly rental rate of ~$2000. After deducting the monthly maintenance fee of ~$800, my net income would be ~$1200. Accumulating this to a 30 year period would be translated to $430,000; hence, I earn $152,232.65.
What’s more, there are tax benefits on the interest I pay. Assuming a 10% tax bracket (it is low but in my calculation, I intentionally do so to ensure the final output represents the most unfavorable scenario), the face value of tax saving is $27,976.74. Plugging in a 5% return assumption, the tax saving on this investment is $76,614.06.
Over a 30 year time frame, my net return rate is $228,846.71/($579,767.35+$80000 down payment) = 35%, translating to 1.01% return. If we relax the parameter a little bit, I deem the real yield can be ~2%. It’s not a big return, but taking into account the secure feeling of possessing an apartment, the add-on psychological value is significant.
The next question, should I take a 30-year loan or a 15-year loan?
Following the same set of assumptions on a 15-year loan, the actual total dollar amount I will spend on this property is $427,028.56. This means I will have to pay the bank $127,028.56 in interest. However, the key feature of this co-op is that it has a liberal leasing policy, so I can sublet it out with a monthly income of ~$2000, deducting the maintenance fee of ~$800, my net income would be ~$1200. Accumulating this to a 15 year period would be translated to $216,000.00, hence, I earn $88,971.44.
Similarly, there are tax benefits on the interest I pay. Assuming a 10% tax bracket, the face value of tax saving is $12,702.86. Plugging in a 5% return assumption, the tax saving investments are $20,972.48.
Over a 15 year time frame, my net return rate is $109,943.92/($427,028.56+$80000 down payment) = 22%, translating to 2.02% return. If we relax the parameter a little bit, I deem the real yield can be ~3.5%.
After this comparison analysis, I conclude that it is better to take the 15-year loan if I could stay in the low tax rate bracket and I do not have other channels to invest the money with greater than 5% potential return.
Now the third question, should I consider paying back the principal sooner?
The answer is apparent now. Yes, if you don’t have other channels to generate a greater than the mortgage rate return and you are already in a low tax bracket. On the other hand, if your tax rate is rising and you do have opportunities to get a better return on your money, you do not necessary to rush repay the loan.