Mortgage, loan, equity, debt, principal, and interest are often spoken but rarely understood... like the lyrics from a Bob Dylan song. But unlike Dylan’s lyrics, you will need to know these words, because in CRE investing, they’re commonplace. When you put them to work in the real world, they have incredible power. These devices and concepts enable companies, families, and individuals to live a higher quality of life. They will allow you to become a commercial real estate investor without the risk of losing all your hard-earned dollars.
We’ll break down each of the aforementioned “buzzwords” and show you how they tie together in the world of commercial real estate investing. By the end of this article, you should feel comfortable explaining what each of these words means, understand how they create value for CRE investors, and know most of the words to “Blowin’ in the Wind”...No one actually knows all the words to “Blowin’ in the Wind,” not even Bob.
It’s a word we hear, read, and say all the time, but there’s no shame in admitting that the first time you saw that word, you pronounced it “Mort Gage.” There is also no shame in admitting that the concept – as basic as it may seem – might still be somewhat obscure.
A mortgage is a debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments.
When entering into a mortgage, the borrower (you) is making a legally binding contract with a financial lending institution (such as a bank or some other creditor) for the loan of money. In exchange, the borrower (you) repays the said monies in installment payments with interest applied to the lending institution over a predetermined amount of time. Upon completion of all scheduled payments, you will no longer owe the financial institution any money and become the sole owner of the property.
Equity is the amount of cash required to make your real estate investment. It’s your ownership stake in an asset, or put another way, it’s how many shells you’re putting in the game.
Debt is the amount of money you borrowed to fund the remainder of the purchase.
Putting it all together
The majority of real estate investors use a combination of both equity and debt to purchase real estate assets. By using both, investors can buy more property with less of their own cash and transfer some of the risks of their investment to the financial institutions who make the loan. A double win for you, right? Keep reading.
Since the financial institution is taking on some risk by providing you with a loan, you can bet your yolk that they expect something in return for their generosity - that something is interest.
The original money borrowed is referred to as principal, and the charge to borrow the money is called interest. Interest is often expressed in loan documents as the annual percentage rate (APR). APR is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction but does not account for compounding. Compounding is the concept of interest earned or paid on interest. Principal and interest are paid back to the lender on a predetermined schedule over the life of the loan.