Topic 04 · 6 min read
Mortgages and What Interest Really Costs
Borrowed money magnifies both the good and the bad.
A mortgage lets you control a whole building with a fraction of its price. Each payment splits into interest, which is the cost of the loan, and principal, which reduces what you owe. Early on the payment is mostly interest; late in the loan it is mostly principal.
What to know
- Principal and interest
- Only the interest portion is a cost of doing business. The principal portion is you buying more of the building.
- Fixed versus adjustable
- A fixed rate keeps the payment steady for the life of the loan. An adjustable rate can rise later, which can turn positive cash flow negative.
- Leverage cuts both ways
- Borrowing raises your return when values rise and deepens the hole when they fall or rents stall.
- The lender's cushion test
- Lenders check whether the property's income comfortably covers the payment. If it barely does, so should you.
The tax benefit
Mortgage interest on a rental is generally deductible against the rental income, while the principal portion of the payment is not — it is simply repayment of what you borrowed.
Worked example
Where the payment goes
On a $200,000 loan early in its life, a $1,200 monthly payment might be about $950 interest and $250 principal. The interest is a cost; the $250 quietly grows your ownership.
Watch out for
- Refinancing resets the clock and the fees.
- A payment that only works at full occupancy is a payment that does not work.
- Personal guarantees mean the lender can look past the property to you.
Terms from this topic
PrincipalInterestLeverageAmortization
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