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As a healthcare entrepreneur, you'll need to leverage your capital to purchase property to operate your business. That leverage will come in the form of debt financing. How you pay back the debt can affect your cash flow and profitability. Let's look at three (3) common debt financing designs for property and the (dis)advantages of each.
Three (3) types of mortgage designs
Purchasing property to operate your business is a big and often necessary investment in your venture. How likely you are to get a loan for that purchase will depend on the underwriting process your lender executes (learn about the LTV in underwriting here). Once you've cleared that hurdle and have a lender's commitment, you'll have one of three options from which to choose how you pay back the loan:
Interest-only loans,
constant-payment loans, or
constant-amortized loans
A loan request and pertinent terms
Each loan design has its own pros/cons and applicability, depending on your circumstance. Let's look at the following loan request and terms for our healthcare entrepreneur.
Constant-payment mortgages/loans (CPM)
Most entrepreneurs are familiar with constant-payment mortgages/loans (CPMs). Many residential properties (i.e., homes) are purchased using this loan design. CPMs are characterized by a constant period (usually monthly) payment. Based on a pre-determined schedule, a predictable portion of each payment will satisfy the cost of the loan (i.e., interest expense) and the principal. Using our loan request above, a sample payment schedule (a/k/a amortization table) would be:
Notice that the payment per period (monthly in our entrepreneur's case) is constant: $1819.91 per month. As the loan (slowly) progresses toward maturity (t = month 120), the proportion of the payment that goes towards interest decreases while that for the amortized principal increases. Slowly and predictably, our healthcare entrepreneur pays off the $150,000 outstanding loan balance (OLB).
Payment schedule at the start (left) and end (top) of the loan
Interest-only loans
As the name suggests, interest-only loans require the bare minimum payment each period. Each month our entrepreneur pays only the interest expense. S/he never touches the principal amount, and thus the outstanding loan balance (OLB) remains fixed at $150,000.
Notice that just like the CPM design, the monthly payment is fixed and predictable. The OLB remains unchanged until the very last period of the loan (at maturity) when another interest payment ($1000) plus the original loan amount ($150,000) are paid in one *balloon* payment.
Payment schedule at the start (left) and end (top) of the loan
Constant-amortized mortage/loan (CAM)
CAMs are an underutilized mortgage design because of the lack of constancy in payments. The loan is divided (amortized) over the maturity period (120 periods). Add the first tranche of the principal (in our case, the first tranche of amortized principal = $150,000 ÷ 120 = $1250) to the interest on the OLB (which, at period t = 1, is 0.67% of $150,000 = $1000). Thus, the first payment (at t = 1) is $1250 + $1000 = $2250.
The second payment (at t = 2) will be different than the payment at t = 1. Now, the OLB is $150,000 less $1250 = $148,750. There are now 119 payments remaining, so the amortized principal is now $148,750 ÷ 119 = $1250 (this is the constant-amortized portion of CAM). The interest payment for t = 2 is 0.67% of the OLB (0.67% x $148,750 = $991.67). Thus, your total payment at t = 2 is $1250 + $991.67 = $2241.67.
The table below shows the first few payments under the CAM design.
Notice that the amortized principal is constant - hence a constant-amortized mortgage design. However, the payment made each period is different. While it is predictable, it is different and requires that the entrepreneur monitor the monthly payments to avoid under- or over-payments.
Payment schedule at the start (left) and end (top) of the loan
(Dis)advantages of each mortgage design
Shown below is a graphical representation of the per-period payments based on loan design. When would each design be favorable for an entrepreneur?
Constant-payment mortgages (CPM)
The biggest advantage is the predictability and constancy of the per-period payments. As a busy entrepreneur, you could set up an automatic pay with your bank so that you don't have to worry about under- or over-payments. And forecasting cash flows over any horizon becomes a bit easier because your payments remain constant throughout the length of the loan.
A disadvantage is that the portion of the payment that satisfies the OLB starts off small and slowly increases. In our example, the 50-50 point, where 50% of the payment goes towards interest and an equal amount goes towards the OLB, happens between periods 16 and 17 (see table above). After that, more of your payment goes toward the OLB than the cost of the debt (interest), but not by much.
Interest-only loans
In this mortgage design, the per-period payment is the lowest. For cash-deficient entrepreneurs, having a low monthly payment may be beneficial. Cash-deficiency is not always a bad thing, as some healthcare ventures are actively growing and need capital to fuel that growth. Lowering one's monthly payment to the bare minimum releases capital for growth-related activities.
The biggest disadvantage, as you will see below, is the lack of lowering the principal. Not only does this feature increase your total payments, interest-only loans increase your risk of default (see LTV for details on how lenders quantify your default risk as a loan progresses toward maturity).
There's also one huge *balloon* payment at maturity. This balloon payment isn't easy to pay unless you sell the property, which isn't what healthcare entrepreneurs generally do.
Constant-amortized mortgages (CAM)
CAMs offer the quickest path towards paying down the OLB. Unfortunately, the monthly payments aren't constant, so unless your on-top of your payments, there's a risk of under- or over-payments. Under-payments will result in a penalty that does *not* reduce your interest or outstanding loan balance. Over-payments are equally bad because that capital is no longer available for you to use in operating/growing your venture.
Cost of each mortgage design
Each mortgage design has a cost associated - it's not just a matter of convenience. The cost is measured by the total interest paid over the life of the loan, as shown in the table.
Interest-only loans result in the lowest per-period payment ($1000 per month). For that benefit, an entrepreneur will pay a total of $120,000 in interest - nearly double the other loan designs.
Constant-amortized mortgages (CAMs) require the most attention-to-detail, but for that effort, an entrepreneur pays the least amount in interest.
Let us know how you structured debt financing in your venture. What parameters of your loan design did you find useful and was it worth the cost you paid (in total interest).
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