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When real estate investors seek financing for their projects, understanding the nuances of different loan structures can make a significant impact on their profitability. One crucial distinction is between loans that charge interest on the full loan amount, including both the purchase price and the rehab budget, and non-Dutch loans that only charge interest on the funds as they are used. In this post, we'll delve into these differences, helping you identify them on a term sheet and make an informed decision for your next investment.
Traditional loans often charge interest on the total loan amount from the moment the loan closes. This means that if you receive a loan covering both the purchase price of the property and the anticipated rehab costs, you begin accruing interest on the entire amount right away. For instance, if you secure a $150,000 loan to purchase a property for $100,000 and allocate $50,000 for renovations, interest starts accumulating on the full $150,000 from day one, regardless of when or if you use the rehab funds. This approach can significantly increase your borrowing costs, especially if the rehab process is gradual or if you don't end up needing the entire rehab budget.
In contrast, non-Dutch loans, also known as interest-on-draw loans, offer a more flexible and cost-effective solution for real estate investors. With these loans, interest is only charged on the funds as they are disbursed. Using the same example, you would start by accruing interest on the $100,000 purchase price at closing. The additional $50,000 earmarked for renovations would only begin to incur interest as you draw down those funds.
To illustrate, let's break down the disbursement and interest accrual:
Loan Amount for Purchase: $100,000 at a 10% annual interest rate.
Rehab Budget: $50,000 at the same 10% annual interest rate, disbursed in draws.
Traditional Loan Example
With a traditional loan, the interest on the full $150,000 begins accruing immediately. Here's a simplified payment schedule for the first eight months, assuming interest-only payments:
Month | Balance | Interest | Total Payment |
1 | $150,000 | $1,250.00 | $1,250.00 |
2 | $150,000 | $1,250.00 | $1,250.00 |
3 | $150,000 | $1,250.00 | $1,250.00 |
4 | $150,000 | $1,250.00 | $1,250.00 |
5 | $150,000 | $1,250.00 | $1,250.00 |
6 | $150,000 | $1,250.00 | $1,250.00 |
7 | $150,000 | $1,250.00 | $1,250.00 |
8 | $150,000 | $1,250.00 | $1,250.00 |
Total interest paid by month 8: $10,000.
Non-Dutch Loan Example
In a non-Dutch loan, interest accrues only on the amounts as they are disbursed. Here’s a detailed schedule based on disbursements one month after closing ($10,000), three months after closing ($20,000), and six months after closing ($20,000):
Purchase Loan Amortization Schedule Loan Amount: $100,000 Interest Rate: 10% per annum Monthly Interest: $100,000 * 10% / 12 = $833.33
Month | Purchase Loan Balance | Interest | Total Payment |
1 | $100,000 | $833.33 | $833.33 |
2 | $100,000 | $833.33 | $833.33 |
3 | $100,000 | $833.33 | $833.33 |
4 | $100,000 | $833.33 | $833.33 |
5 | $100,000 | $833.33 | $833.33 |
6 | $100,000 | $833.33 | $833.33 |
7 | $100,000 | $833.33 | $833.33 |
8 | $100,000 | $833.33 | $833.33 |
Draw 1 Amortization ScheduleDraw Amount: $10,000 Interest Rate: 10% per annum Monthly Interest: $10,000 * 10% / 12 = $83.33
Month | Draw 1 Balance | Interest | Total Payment |
2 | $10,000 | $83.33 | $83.33 |
3 | $10,000 | $83.33 | $83.33 |
4 | $10,000 | $83.33 | $83.33 |
5 | $10,000 | $83.33 | $83.33 |
6 | $10,000 | $83.33 | $83.33 |
7 | $10,000 | $83.33 | $83.33 |
8 | $10,000 | $83.33 | $83.33 |
Draw 2 Amortization ScheduleDraw Amount: $20,000 Interest Rate: 10% per annum Monthly Interest: $20,000 * 10% / 12 = $166.67
Month | Draw 2 Balance | Interest | Total Payment |
4 | $20,000 | $166.67 | $166.67 |
5 | $20,000 | $166.67 | $166.67 |
6 | $20,000 | $166.67 | $166.67 |
7 | $20,000 | $166.67 | $166.67 |
8 | $20,000 | $166.67 | $166.67 |
Draw 3 Amortization ScheduleDraw Amount: $20,000 Interest Rate: 10% per annum Monthly Interest: $20,000 * 10% / 12 = $166.67
Month | Draw 3 Balance | Interest | Total Payment |
7 | $20,000 | $166.67 | $166.67 |
8 | $20,000 | $166.67 | $166.67 |
Combined Payment Schedule up to Month 8
Month | Interest on Purchase Loan | Interest on Draw 1 | Interest on Draw 2 | Interest on Draw 3 | Total Interest | Total Payment |
1 | $833.33 | $0 | $0 | $0 | $833.33 | $833.33 |
2 | $833.33 | $83.33 | $0 | $0 | $916.66 | $916.66 |
3 | $833.33 | $83.33 | $0 | $0 | $916.66 | $916.66 |
4 | $833.33 | $83.33 | $166.67 | $0 | $1,083.33 | $1,083.33 |
5 | $833.33 | $83.33 | $166.67 | $0 | $1,083.33 | $1,083.33 |
6 | $833.33 | $83.33 | $166.67 | $0 | $1,083.33 | $1,083.33 |
7 | $833.33 | $83.33 | $166.67 | $166.67 | $1,250.00 | $1,250.00 |
8 | $833.33 | $83.33 | $166.67 | $166.67 | $1,250.00 | $1,250.00 |
Total interest paid by month 8 in a non-Dutch loan: $8,416.64.
Comparing the two scenarios, traditional loans result in higher interest payments because you pay interest on the full amount from the start, regardless of when or if you use the rehab funds. In our example, you would pay $10,000 in interest by month eight with a traditional loan, compared to $8,416.64 with a non-Dutch loan, reflecting significant savings.
Understanding these distinctions is crucial when reviewing term sheets from potential lenders. It's not uncommon for lenders to market their loans as non-Dutch, but the fine print on the term sheet might tell a different story. A true non-Dutch loan will clearly specify that interest is calculated based on the actual disbursed amounts rather than the total loan amount. If the term sheet indicates that interest is calculated on the entire loan amount from the beginning, regardless of the disbursement schedule, then it is not a non-Dutch loan.
To ensure you are getting a non-Dutch loan, closely examine the payment terms and the interest calculation methodology on the term sheet. Look for clauses that outline when and how interest begins to accrue on the loan. If the document states that interest is only charged on funds as they are drawn, you are looking at a non-Dutch loan. This distinction is important as it can save you a significant amount of money in interest payments, particularly if your rehab budget is substantial or if the project timeline extends over several months.
Non-Dutch loans offer a financial advantage by aligning the interest costs with your actual use of the funds, allowing for better cash flow management and potentially higher returns on your investment. By understanding the key differences between these loan types and carefully reviewing the terms offered by lenders, you can make more informed borrowing decisions and optimize the financial outcomes of your real estate projects.
In conclusion, while both loan types provide the capital needed to purchase and renovate properties, non-Dutch loans offer a more flexible and cost-effective structure by charging interest only on the funds as they are utilized. Always scrutinize the term sheet to confirm the interest calculation method, ensuring that the loan structure aligns with your financial strategy and project needs. This understanding can help you avoid unnecessary interest costs and make the most out of your investment.
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