Should I only be paying interest on land I purchased?

May 22, 2008 11:17 PM

Bought a piece of land and only paying interest. Why would I do that?

This is for my mother actually. She bought a piece of land (13 acres) and under the advice of her financial advisor/ stock broker she's paying only interest. She doesn't understand why.

I know she should ask him why, and will, but I'd like to get independent advice. I'm guessing the theory is that he can continue making money in the stock market (more than the interest she's paying) if she doesn't take money out to pay for the land. But this is a bit over my head.

What are the advantages and possible downfalls doing this? A few more details: She's retired, well off but not rich, and has no plans to sell the land (it's family land she's attached to).

Thanks for any advice/suggestions/information.

posted by anonymous to work & money (11 comments total)

A less charitable theory is that the stock broker can make more money for himself if he keeps her cash in the stock market and actively trades it, generating fees.
posted by bsdfish at 11:40 PM on May 22

Lots of people do that here in Aus, because the interest-only loan minimises your current repayments (at the expense of the requirement to pay the balance or refinance at the end of the term). This, combined with our stupid negative-gearing laws, mean that it's a fairly sound strategy as a sort of tax-subsidised savings plan (being that you gain all the capital growth as equity).

Don't know if you're in Aus, obviously, but as you say, minimising the current repayments may allow your mother to invest that elsewhere, if she believes the growth on the land parcel suboptimal.
posted by pompomtom at 11:42 PM on May 22

...or what bsdfish said.
posted by pompomtom at 11:44 PM on May 22

We did it. The idea is to get some property on a short-term (three year), interest-only loan; build on it during this time and then refinance the property or sell it. Pay off the note in full with those proceeds and, hopefully, have a bit of profit after the bills are paid.
posted by wsg at 12:06 AM on May 23

Normally, IMO, paying down principal is a form of savings and not an 'investment' use of the money. What with the tax deduction of mortgage interest it's quite easy to beat the ~4% pa [per-annum] cost of money of not paying down the loan (heck, I made 4% last week on SDS ;)

(the difference between savings and investments is risk premium of the latter)
posted by tachikaze at 12:52 AM on May 23

The advice your mother's financial adviser has given her is probably perfectly financially sound, provided that (a) she really can make higher returns on the principal she's not repaying than the loan interest is costing her, and (b) land values continue to increase, so she'll realize more than the outstanding principal when she sells at the end of the loan period. You'll most likely find that both parts of (b) are just taken as givens by the financial advisor. Financial advisors are not life advisors, generally see land as Just Another Investment, and never really believe that financial gains won't always motivate people to sell.
posted by flabdablet at 1:20 AM on May 23

Wow, in general you should never invest in something if you don't have a basic understanding of what you're doing. It sounds like she's building a retirement portfolio for someone else.
posted by blue_beetle at 6:18 AM on May 23

I do this for my house. I couldn't afford the monthly payments of a 30 year mortgage (at least while my kids are in day care). But with an interest only ARM, I can easily afford to make payments and write off the interest expense on my taxes (effectively shaving about 30% off the cost). Also, in theory at least, I can make additional principal payments when more money becomes available to me. There is also the theory that the property value will increase, and so even if I'm not paying down the principal, I'll still come out ahead, say in 30 years.
posted by indigo4963 at 6:44 AM on May 23

A lot of the answers above are perfect illustrations of why the U.S. housing market is in the dumps: people buying property as investment vehicles assuming the value of the property/investment will always increase. It doesn't. No "investment" does (except a passbook savings account). What she's doing is no different than buying stocks on margin; she's just substituted land for the stocks. What goes up must come down.

The problem with this approach is that the "cost" of owning the land is not just the purchase price (as it is with stocks); you've got to add in real estate taxes, insurance, maintenance, etc..., so the real cost of owning the property is probably substantially in excess of whatever the property increase is.

I agree with blue_beetle: if you/she doesn't understand what she's doing, she shouldn't be investing it it. I've yet to see an investment adviser who can earn more than the average return of the market - in fact, most of their portfolios earn substantially less than the average market rate of return.

Finally, indigio4963 may have legitimate current reasons for doing what he/she's doing (day care expenses, etc...) short term, but remember that (in the U.S.) the interest expense deduction is not a 1:1 reduction in your taxes. Every dollar you pay in interest only equates to about a 20-30% reduction in your taxes, depending on your bracket. In other words, the money that you SPEND in interest is LESS than the amount your taxes are reduced by. So, it's a net loss to you. Just something to think about.
posted by webhund at 7:35 AM on May 23

I'm guessing the theory is that he can continue making money in the stock market (more than the interest she's paying) if she doesn't take money out to pay for the land.

Does she have significant capital gains in her stock portfolio? She may want to keep deferring a taxable sale in that case.

The problem with this approach is that the "cost" of owning the land is not just the purchase price (as it is with stocks); you've got to add in real estate taxes, insurance, maintenance, etc..., so the real cost of owning the property is probably substantially in excess of whatever the property increase is.

The OP said his/her mother "has no plans to sell the land (it's family land she's attached to)", so this isn't a question of whether or not it makes sense incur carrying cost for an investment, it's a question of how to best finance an asset.

I'd sit down with the advisor and clarify the long-term plan for financing this land. I suspect it's a tax-planning exercise.
posted by mullacc at 8:02 AM on May 23

What goes up must come down

? Looking back over the past 100 years there appears to be more "up" than "down" in home & land prices.

The value of land is generally the net present value of its rental value, and since land is fixed in supply (and the "good" land is all taken) rents are generally based on wages, and wages, while stagnant, certainly haven't been going "down", at least in my lifetime.

I'm the biggest bubble-head around (ie. thought the 2006 prices were unsustainable) yet will gladly & fearlessly step into the market if/when valuations get back to 2001-2002 levels.
posted by tachikaze at 9:37 AM on May 23