Cash or Debt - Example #2

Purchase Price is $400,000

It will cost $50,000 to fix up and make it ready for re-sale.

She could pay all cash or finance.  She talked to a Hard Money Lender who has provided a “future value appraisal” of $675,000.  If financed, she can get 100% loan to value and the rate will be at 10% interest only and will cost 4% in points (the Buyer will pay the points out of pocket).

The holding term is 3 years.  What will give her a better rate of return?

The Solution:

Step 1 – Solve for the all cash scenario rate of appreciation.  $450,000 is the Present Value, 3 year term and $675,000 is the Future Value = 14.47% rate of return for all cash purchase.

Step 2 – Solve for the Future Value loan payoff – the loan payoff is $450,000 because it was an interest only loan.

Step 3 – Future Value minus Loan Pay off = $225,000.  To solve for the rate of the financed purchase, you’ll take the $225,000 and enter as future value in your calculator and then you’ll take your amount of points you paid of $18,000 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 = 132.08%.

What This All Means:

If she pays all cash, she will make a 14.47% return on investment (provided it’s able to sell for $675,000).

If she finances with the Hard Money Lender, even though she is paying 4% in points and 10% interest, her return on investment will be 132.08%.

What would you do?  Pay all cash and tie up your funds for 3 years for a 14.47% return on your cash or finance the property and get a 132.08% return in 3 years?