Real estate debt, explained: Banks, buydowns and DTI in plain English

My mother says “revolving debt makes the world go round,” and she was right in a way that took me 20 years to appreciate.

Banks make money by lending money. The money customers deposit is the foundation they use to stay liquid — don’t know how much interest you’re earning on your CD, but I can guarantee you it’s less than the bank charges when it loans it out to other people.  The Federal Deposit Insurance Corporation (FDIC) calls that spread net interest income, and it remains the banking industry’s largest single source of revenue. 

Banks make money on credit cards and mortgages too.

It is the business model. Commercial and multifamily mortgage debt outstanding in the U.S. runs in the trillions; if we take debt out of the equation, modern real estate stops existing.

Banks are incentivized to lend. That understanding changes how a consumer approaches leverage. You are not begging a bank for money. The question stops being, “Can I afford this debt?” and becomes, “Can I use this debt to build wealth faster than I pay interest?”

There are opportunities available. A  wave of adjustable-rate commercial loans made when rates sat near historic lows is now reaching its adjustment terms. Meaning there’s going to be a lot of units coming on the market which are going to seem like good options for investor and house hacker clients.  

Everything in real estate runs on borrowed capital. Understanding the two kinds of money in a deal, equity and debt, and being able to explain them to clients is going to be key coming into the next cycle.

If you have any questions for me or a topic to recommend, email me.

Question: What is a mortgage, beyond the stack of papers signed at closing?

Answer: A mortgage is a loan secured by real estate. The bank gives you money to buy the property, and the property becomes collateral for the debt. If you stop making payments, the lender can eventually foreclose to protect their investment

The monthly payment, in a perfect world, includes principal, interest, property taxes and insurance. The principal part pays down what you owe. The interest is what the lender charges for using its money. The taxes pay the government, and insurance protects the property, which is the lender’s collateral.

Beyond the paperwork, a mortgage is a leverage tool. You control an asset with a relatively small amount of your own money while the lender supplies the rest. If the property increases in value and the income supports the debt, leverage can build wealth faster than saving for the full purchase price.

Question: Why do investors say a deal ‘doesn’t pencil out’?

Answer: When investors say a deal “doesn’t pencil out,” they mean the numbers do not work on paper.

The property may generate rent, but after the mortgage, taxes, insurance, repairs, vacancy, management, utilities and every other little thing are paid, there is not enough left to justify the purchase price or risk. The cash flow may be negative, the return may be too low, or the projected refinance may not return enough capital.

The property can still be beautiful. The location can still be excellent. But if the income cannot support the debt and expenses, the deal does not work.

Learn how to “pencil” a deal and your life will change.

Question: What is a rate buydown, and when is it worth bringing up to clients?

Answer: A rate buydown is money paid upfront to reduce the buyer’s mortgage rate. It can be temporary, such as a 2-1 buydown that lowers the rate during the first two years, or permanent, where discount points reduce the rate for the life of the loan.

A seller may offer a buydown — or buyer’s agents can ask for one — as a concession instead of cutting the price. It is worth considering when the property needs help attracting buyers, the buyer is qualified but “payment-sensitive” or the seller wants to preserve the sale price. The lender must approve the arrangement, and the credit cannot exceed the buyer’s allowable closing costs. 

Question: Why does a bank care more about debt-to-income ratios than credit scores?

Answer: A bank cares about debt-to-income ratios, credit scores and downpayment/reserves. They combine to answer a larger question: Can you afford to pay it on time if something goes sideways?

Your credit score shows how you have handled borrowed money. Your debt-to-income ratio shows whether your income can support another monthly payment. Your down payment and reserves show how much cash you have invested and whether you can survive an unexpected repair, job loss, vacancy or financial emergency.

A great credit score cannot save an overloaded budget. A large down payment cannot erase a history of missed payments. Mortgage underwriting looks at the whole borrower, not one impressive number.

Each week in America Answers, Inman contributor America Foy answers questions from the industry at large and offers advice on how to handle the situation.