The Real Estate Finance Roadmap: Navigating Loans, Markets, and More

Money is what we use to exchange with one another so we don’t have to trade goods and services directly. It allows us to avoid the awkward situation of offering things like corn to the dry cleaner as a means of payment. Odd, but true. Money is our primary means of exchange and we use it to purchase real estate. The issue we run into is that purchasing real estate requires large sums of money we rarely have, and therefore we need to borrow money. This falls under our current topic, financing real estate. 

There are many ways to finance a property purchase, and there are also important governmental regulations that control real estate finance. Before we discuss these, let’s first establish what the market for money is and how it’s created.

Supply of Money

Just like many other goods and services, there is supply and demand for money. The demand for money is driven by how many people need and want dollars. Dollars are needed for capital purchases, such as equipment or plant construction; even foreign companies require dollars so they can pay US-based companies for goods and services. Homebuyers and commercial property buyers also require dollars so they can pay for their purchases.

The supply of money is controlled by the United States government through the operations of the Federal Reserve and the Treasury Department. The Treasury Department is in charge of minting (creating) money, and acts as the country's money manager, paying employees of the government and collecting taxes. The Federal Reserve controls the credit in the economy. Because the Federal Reserve controls the credit in the economy, they have a larger role in determining the amount of money available.

The Federal Reserve System ("The Fed") is the central banking system of the United States. The Fed was created by an act of Congress and operates independently. The Federal Reserve is tasked with the goal of maximum employment, stable prices, and moderate long-term interest rates. It does this through monetary policy, which it implements to control the cost of credit in the country. While this is done in a number of ways, it is primarily influenced by the federal funds rate, the interest rate banks charge each other for short term loans. When you hear on TV that the Fed has raised or lowered rates, it is the federal funds rate they are talking about. It is vital as it relates to real estate since the cost of credit ends up affecting mortgage rates and the economy. There are various economic reasons behind the Federal Reserve's decision to raise or lower rates, in keeping with meeting their obligations of full employment, stable prices, and moderate long-term interest rates, but these are outside the focus of this course.

Interest rates are affected not only by the action of the Federal Reserve but also by acts of Congress and the President through tax and spending policies. The federal budget and taxation are known as fiscal policy. Fiscal policy has an effect on employment, economic growth, and the size of our deficit. Interest rates are affected by fiscal policy through its debt management, spending, and economic effects. It is typically assumed by economists that fiscal policy affects the economy but does so on a much slower timeline than monetary policy. The effects of tax increases or decreases are not immediate and any structural shift Congress enacts is likely to take quite a while to take hold and even longer to evaluate. Fiscal spending can go to a number of areas so the legislative and executive branches have an opportunity to target specific industries and geographic locations to help stimulate the economy.

Cost of Money (Interest Rates)

Money has a cost. It costs money to borrow from others because lenders charge interest as a condition of lending. Interest is paid by the borrowing party because finance follows a basic principle: money now is worth more than money later. The lender wants to receive more money in the future, since they are giving up the opportunity to use that money in the meantime. Conversely, the borrower pays extra to enjoy someone else's money today. Because the US economy is so large, interest rates are ultimately whatever the market will bear through the supply and demand for return.

Simple Interest (No Compounding)

The nominal interest rate is an annual rate quoted as a percentage. The simple interest method does not consider the effects of compounding. Instead, it calculates interest as the product of the original balance, the nominal interest rate, and the time period expressed in years.

Example

Consider a $5,000 savings account balance with a 12% nominal interest rate, calculated using the simple interest method. In one year, the interest earned is $5,000 x 12% = $600, bringing the total account balance to $5,600.

Now suppose interest is paid at the halfway point, after six months. The balance at that point would be $5,000 x (1 + 12% x 0.5) = $5,300. Notice that under the simple interest method, the full-year interest of $600 is exactly double the six-month interest of $300. The relationship is perfectly proportional.

To generalize, simple interest can be calculated once you know three things:

1. The balance of the loan or savings account (P)
2. The annual nominal interest rate (r)
3. The time in years (t)

The general formula is:

Balance after t years = P * (1 + r t)

Compounding Interest

Compound interest is calculated much like simple interest, with one important difference: it accounts for the fact that the balance changes each time interest is paid out. Returning to the earlier example, after six months the balance under simple interest is $5,300. Simple interest then calculates the second half of the year's interest using the original $5,000 balance, producing another $300 and a year-end total of $5,600. Compound interest treats that six-month balance of $5,300 as the new starting point, so the interest for the second half of the year is calculated on $5,300 rather than $5,000, producing a slightly larger result.

Compound interest uses the same variables as simple interest, plus one additional piece of information:

1. The balance of the loan or savings account (P)
2. The annual nominal interest rate (i)
3. The time in years (t)
4. The frequency of compounding within one year (n)

The compound interest formula differs from the simple interest formula in one key way: interest is compounded on top of what has already been paid. The exponent in the formula handles this by multiplying the number of compounding periods per year (n) by the number of years (t), which converts everything into a total number of periods.

Example

Consider a $5,000 savings account with a 12% interest rate, compounded semi-annually. What is the account balance after one year?

For the first half of the year, no interest has been paid yet, so the compound method and the simple method produce the same result:

$5,300 = $5,000 x (1 + .12 * .5)

Here is where the two methods part ways. For the second half of the year, interest is computed on top of the interest already accumulated. The calculation now uses the $5,300 balance rather than the original $5,000. After one full year, the ending balance is:

$5,618 = $5,300 x (1 + .12 * .5)

That $5,618 is slightly higher than the $5,600 produced by the simple interest method. The difference is small here, but the gap widens as balances grow, rates rise, or compounding periods multiply. The compound interest formula shown earlier allows you to reach that same result in a single calculation.