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August 27, 2021
Are you eager to gain a passive income from vacation rentals; or do you want to fulfill your dream of living in the Mayan Riviera? For both of them, the first decision to take is choosing the type of property and its location. Once this is done, if you do not plan to pay the entire home’s price by cash, it is time to decide how to finance the part not covered by the down payment: would a personal loan or mortgage be better?
In other words, is it financially appropriate to take a loan putting your personal wealth as collateral for the debt’s repayment, otherwise bringing into play the home you are buying?
This post will try to briefly explain the characteristics of these two types of funding, allowing you to decide for yourself which is the best option for your needs.
The first thing you should take into account is how much money you need.
It is hard to find a banking institution which grants more than $750,000 MXN as personal financing.
Therefore, this type of funding might be more suitable to finance remodeling, repairs and maintenance expenses, which require lower amounts than for purchasing a property.
Unlike a personal loan, where you may get the precise amount you need, usually a mortgage loan will cover 80% of the purchasing price at most; or 50% of your house’s value if you want to get liquidity for other purposes and not to buy a property.
You need to consider it when you do your financial considerations.
Generally, a personal loan is granted for no more than 5 years. Instead, the mortgage duration may be up to 20 years, and sometimes up to 30 years.
A shorter or longer term maturity will affect the interests’ amount and the money to be repaid: the longer the duration, the more interest will be paid, and the money to be repaid will be higher.
On the other hand, the monthly payment will be lower with a mortgage, because the capital outstanding is divided into a greater number of installments.
A personal loan’s interest rates are up to three times higher compared to a mortgage: the Mexican banks charge a 27% interest rate on average on a personal loan, and 9/10% for a mortgage loan.
Usually, personal loans require fixed monthly payments throughout the credit’s life.
Instead, a mortgage can be:
At a fixed annual rate.
At a variable rate , generally with the single installment linked to the Interbank Interest Rate (TIIE), currently in Mexico at 4.25%, with the addition of a margin set by each bank.
In a mixed form.
When the market interest rates are low, as in this period, it would be more appropriate to take advantage of a fixed rate, because there is a higher probability that they will increase in the future as market rates rise.
For this reason, variable rates imply greater risk and require a deeper financial knowledge.
To get an idea, currently the Mexican Interbank Interest Rate (TIIE) is at 4.25%, while in 2019 it was 8.25%.
But any time soon, the monetary authorities might increase that instrument of economic policy in order to fight inflation caused by an improving post-pandemic economic situation.
A mortgage has several expenses that we do not find in a personal loan.
Although the interest rate on a mortgage loan is lower compared to a personal loan and, likewise, its amortization period is longer, we should consider a number of costs related to the loan contract and the formalities for the mortgage establishment and deed:
Application fee: typically range between 1/2% of the financed amount. They are charged by the lender to process your mortgage application.
Property appraisal expenses.
Closing costs: approximately 7/9% of the home’s purchase price. They are related to the origination and underwriting of a mortgage loan, real estate commissions and property taxes, as well as title and record filings.
Homeowner’s insurance policy: to protect the property. In case of damage, fire or destruction of the property, the bank is entitled to the sum paid out by the insurance company for the compensation of the remaining part of its credit.
The annual payments of interest and principal, with the addition of the expenses above mentioned, give the real cost of a loan to a borrower, the APR (Annual Percentage Rate).
For example, with a 9% nominal interest rate on a mortgage, the APR can be approximately 12%.
Do you want to decide whether to finance the purchase with a personal loan or a mortgage loan, and therefore, calculate how much money as down payment you are going to pay?
Let’s suppose, for example, a 645 sq .ft. recently built property in the heart of Playa del Carmen, just steps away from the beach, with the following characteristics:
Based on the use of an appropriate financial model, we can find the funding percentage of a personal loan beyond which the net cash flow from a property turns negative, and the investment is no longer profitable.
This depends on:
If you choose a personal loan to finance your property’s purchase, you need a very high down payment to make your investment profitable, even paying small prices.
In our example, the financial model tells us that, based on 27% interest rate and 5-year amortization period assumptions, your net cash flow turns negative when you finance over 40% of your home’s purchasing price; therefore, you need at least a 60% down payment to get a positive return on your investment.
The higher the property’s purchase price, the higher will be the down payment requested to make your investment positive.
These percentages change much with a mortgage loan, depending on the home’s value.
But, actually, you can purchase a property, gaining a positive return, by funding the 90/95% of your investment through a mortgage loan.
Financing a real estate property’s purchase with a mortgage would be the best option, compared to a personal loan, if you do not have enough capital to invest in a down payment.
Or if you want to improve your returns by using leverage, at various funding levels.
On the other hand, the personal loan is the best choice to finance repairs and maintenance expenses, as well as the extraordinary capital expenses (for instance, a roof repair, or air conditioning units and household appliances replacements) .
You can contact your real estate advisor for the best investments options, and for calculating which is the more profitable funding solution.