Due Diligence in Tax Lien Investing: Calculating Potential Return on Investment (ROI)

8/8/2024 12:00:00 AM

As an investor, understanding and accurately calculating the potential return on investment (ROI) will do you a lot of good.

ROI serves as a key metric for evaluating the profitability and attractiveness of an investment opportunity. 

By conducting thorough ROI calculations, you can make informed decisions, compare different investment options, and maximize your chances of achieving their desired returns.

Why Understand Interest Rates and Penalties?

Tax lien investments derive their potential returns from the interest rates and penalties associated with delinquent tax payments. 

These rates and penalties can vary significantly depending on the state, county, and local jurisdiction. 

You must thoroughly research and understand the applicable interest rates and penalties, as they directly impact your potential ROI.

Calculating ROI as an Investor

Calculating the potential ROI for your tax lien investment requires following a structured approach:

Step 1: Determine the investment amount (the delinquent tax amount plus any additional costs or fees).

Step 2: Identify the applicable interest rate and any additional penalties or fees.

Step 3: Calculate the total interest and penalties that would accrue over the expected holding period.

Step 4: Divide the total potential return (interest and penalties) by the investment amount to determine the ROI percentage.

For example, if you purchase a tax lien for $5,000 and the applicable interest rate is 18% per annum, with an additional 5% penalty fee, the potential return after one year would be:  

$1,150 = (($5,000 x 0.18) + ($5,000 x 0.05))

The ROI would then be calculated as:

($1,150 / $5,000) x 100% = 23%

Considering exit strategies

When calculating ROI, it is essential to consider various exit strategies and their impact on potential returns. 

For example, if the property owner redeems the tax lien within a short period, your return may be lower due to the limited interest accrual and penalties. 

On the other hand, if the investment leads to a foreclosure auction and property acquisition, your potential ROI may be significantly higher, factoring in the property's market value and any appreciation or rental income.

Accurately calculating the potential ROI is critical to successful tax lien investing. 

By understanding interest rates, penalties, and the impact of various exit strategies, you can make informed decisions and maximize your chances of achieving their desired returns. 

However, it is crucial to remember that ROI calculations should be combined with thorough due diligence and risk assessment to ensure a comprehensive evaluation of each investment opportunity.