Negotiate Perfect Seller Finance Terms Every Time - Using Loan Factor Rate to Determine Debt Product

Today's video is a very special video. This is actually a clip from our last mentorship section. We're talking about loan factor rate. If you don't know what that is, it's unique to creative finance. If you want to know if your creative finance deal is going to work, if you're borrowing at the right interest, this is how you choose that interest rate. This is the math behind it. You've probably never seen this before if you haven't followed this channel. This is the single most helpful tool if you're using seller finance or any other form of creative finance where you get to impact your own interest rate. Hope you enjoy.

Can you, can you talk about the loan factor rate again? Is it my understanding, Craig, it's just the difference between cap rate and your interest rate? Is it some—

or a bit more? No, it— no, we won't explain it. So your cap rate is your cash-on-cash return when you pay cash. And I want to focus on this. You pay cash for every deal you buy. It's just not typically all your money. So you have to analyze for the not-your-money part. And that's what we're looking at a factor rate in regards to. Cap rate is your dividend. Factor rate is your cost. The reason we look at a factor rate versus an interest rate is a lot of loans are amortized. So your cost is more than just your interest, it's your principal and your interest. So you want your dividend to be higher than your cost of capital every time. If you do that, you have what's called positive leverage. If it's the other way around and your cost of capital is higher than your dividend as a percentage, you're going to lose money on every dollar you borrow. And that's where you don't want to borrow money. It's a negative leverage position. So the equation you're looking at, your annual payments, your annual debt payments, your principal and your interest times 12, you divide that by however much you borrow. That's your factor rate. So if you borrow like Heiner's deal earlier, I think it was Heiner, 4% interest, 30-year AMM, your total payments times 12 for annual payments divided by the loan amount is going to equal 5.73%. And I rounded up 0.002, but you get the idea. That's your cost. So your dividend, your cap rate would have to be higher than that because you paid cash for the whole deal. You're just borrowing a portion in that portion at 4% amortized over 30 years. Is costing 5.73%. So you need the cap rate to be higher than that. Otherwise that portion of the deal is going to lose money. Okay. Got it.

I think that's okay.

Watch the recording, by the way. That—

so Cody and I over the past 3 years have probably explained loan factor rate at least 100 times and we'll, and we'll keep doing it because it only, it only matters in creative finance, right? Because you It only matters if you get to choose your own interest rate. This doesn't come up in normal real estate classes because why would it? That was the best I've ever heard it explained. And the reason for that is your dividend on the cash. If you really boil down what is a cap rate, it's— people always explain it as, well, it's the return that you'd get if you bought the deal completely in cash. That also means that is your actual dividend on every dollar of cash invested in a deal. It's the same thing. So the reason that it's such a good comparison is your cost of the cash in the deal, your borrowed capital versus the return on the money in the deal, the dividend on the money in the deal. That's all you're doing. It's the same dollars. What is the cost of them? What is the return of them? You're just looking at the spread between the two and your true cost of capital, even though you're paying down the principal. It affects your cash flow. This is the mistake that Cody and I made on the Robinhood where we have this amazing debt paydown. We have an amazing return on a profitable asset, but the principal paydown at the end of the year takes it negative. So while we're making a ton of net worth, we're losing money in cash flow because we have a negative loan factor rate while we have a cash positive deal. You don't want to be in that situation because it's uncomfortable. Kody and I just wrote checks for a lot of money to do the part where we pay it down. And guess what? We're going to pay a little bit of taxes on it too, because it posted a profit. We have an operating profit and we have a cash loss because we had to put cash into paying down the loan. That is why loan factor rate is so important, because you can be making money and increasing your net worth and losing cash. And it's the number one way people lose real estate is they're like, wait a second, I'm out of money to bleed. Game over. That's so very important to understand. But if you look at it as an equation, it's just simply your principal plus your interest divided by the amount borrowed compared to the cap rate. If your cost is less than your dividend, you're going to cash flow on every dollar borrowed.

Okay.

And that has nothing to do with your, your deposit, like what you've actually physically put in, like your—

So let's play that out.

Yeah.

Can I, can I share my screen?

I suppose I can give the power.

Allow it.

Done.

You got the power. All right. So we're going to do I don't need that. I'm going to do Excel. All right. So you bought a 12-plex because you thought that would be a good investment and you bought it for $1,000,000. Oh, well, you got ripped off. That is a Darren move. All right. So you're going to put $100,000 down. So this is your down payment. I'm going to put DP right there. Then you're going to have your loan for $900,000. And let's just say we're going to amortize the loan. So let's do payment. And you don't have to understand this portion. We're going to do it at 5%. You don't have to understand Excel because we make an Excel spreadsheet for you. We're going to have payment, 5% interest. We have the current value of that debt is $900,000.

It's divided by 12 months. I thought you said it was multiplied by 12 months.

Well, I'm just putting in the calculator here. That should be correct. Yeah. This is just an amortization calculator for Excel. This is how it works. This is for a payment calculation. I guess we don't need it though, because I can just do an annual basis. All right. I don't think that's correct, though. I think the actual formula is this. Yeah. All right. So this is the actual payment. If I want to fact-check that really quick, I could go to a mortgage calc. I could put in $900,000 just to make sure that we're not being lied to and we could put in 5%. We put in 5 right there. $4,831 is your amortized payment and that's what comes up here. So if we go back to the equation, we want to look at our annual debt costs. We're just going to take This amount times 12. This is just a quick math lesson, even though we did math last week. $57,976. If we want to figure out our factor rate, which number do we divide into which number? Someone give me the answer. $58,000 divided by $900,000. Yeah, you got it. So our interest rate's 5%. However, our factor rate is 6.44. So the way this would work, let's just assume we're going to do a cap rate of 7%, which means that our NOI is $70,000 on a $1 million purchase. And this is recorded. So if this is like, what the heck are you talking about? That's okay, because you can watch it again. The way that the math works out every single time you paid cash for how much of this deal? 10%, which is how much money?

Yeah, $100,000.

Okay, so our down payment return, we put that here. We're going to have— I'll put the money here. We're going to earn 7% on our $100,000, which is $7,000. Then we're going to have our spread between our cap rate, which is our dividend, and our cost of capital and the money we borrow. So if we look at return on debt, all we're looking at here is we're going to take the 7%. We're basically doing the sum of these two to figure out the spread, and we're going to multiply that spread by however much we borrow. So we're actually cash flowing the 0.56% on $900,000, which comes out to $5,023. So we made a spread on the loan and we earned our cash-on-cash return when you pay cash on the portion of the deal that we paid cash. So what would our return be? We would take the sum of this number plus this number and we would divide that by our down payment. And that's how these calculations work. We get $12,000 in cash flow, $100,000 investment is a 12% return. If for some reason this cost went up, now all of a sudden we're losing money.

So the cost of—

so I went from 5% interest to 6% interest.

Okay.

Yeah. Now our factor rate, 7.19, we lose money. Money because our dividend is less than our cost. So we're losing money on this. Our cash-on-cash return is not higher than the cap rate, it's now lower than the cap rate because we're losing money on borrowed money. This is why in markets like California, Seattle, Portland, you have to put a ton of money down because you're actually losing money when you go and, uh, buy these deals because the cap rate is less than your cost of capital. So they make you put more money down because your return is going to be lower, your debt coverage is going to be lower because you're losing money when you borrow money. So you want to always make sure that you get your cap rate higher than your factor rate. And if you do that, you will always make money because you're paying cash for a portion of it. You're going to earn a cash flow on it, and if you make spread on the debt, you cash flow positive. So you can either reduce your cost of capital or you can get your dividends up. Those, those are the main ways to improve your, uh, improve your net cash-on-cash return. You can always borrow less money, but if you're in a negative leverage position where your fact rate's less than your cap rate, you will still lose money on the borrowed capital. You've got to make sure that one is higher than the other. If you do that, you'll do pretty good in real estate.