Cash or Debt - Example #1

Purchase Price is $200,000

Anticipated Future Value – Buyer believes that the price will appreciate 3% per year for 3 years.

He could pay all cash or finance.  If he financed it would be at 70% loan to value.  The rate would be 4.25% amortized over 30 years.

What will give him a better rate of return – paying all cash or financing?

The Solution:

Step 1 – Future Value is estimated at $218,545.40 (3% appreciation per year).

Step 2 – Loan Amount would be $140,000, which would be $688.72 a month.  The Future Value payoff for the loan would be $132,608.07 in 3 years.

Step 3 – Future Value minus Loan Pay off = $85,937.33.  To solve for the rate of the financed purchase, you’ll take the $85,937.33 and enter as future value in your calculator and then you’ll take your down payment of $60,000 and enter that as the loan amount and then add the 3 years as the term and you’ll solve for the interest rate which = 12.72%

What This All Means:

The Buyer assumed a rate of appreciation of 3% per year.  That’s the rate of return he would have received if he paid all cash – 3%.

BUT … Leveraged appreciation occurs on the whole asset.  In other words … the entire $200,000 is appreciating.

SO … the rate of return with leverage is 12.72%.

BECAUSE … if you can control the whole asset with less money (i.e. leverage), then your overall rate of return will be increased vs. paying all cash.  This also works in reverse too – if it goes down in value, your negative rate of return also accelerates.