Are You A Money-junkey?


Personal debt in America continues to rise as consumers push off the day of reckoning through the use of multiple credit cards. For many, this debt is ultimately paid off by refinancing their personal residences. On the face of it, being able to pay off high-cost short term non-deductible debt with long-term deductible mortgage debt has some merit on its face, but it ignores the fact that borrowers eventually wind up owing thousands of dollars against their heavily mortgaged property. This can only be repaid by selling their home.


A few months ago I was contacted by a retiree who had sold his large appreciated home to repay debts. Next, he used the remaining sale proceeds to buy a free and clear mobile home in a mobile home community. Over the next following five years, he had borrowed all he could against his new home to keep his credit cards alive.  By the time he contacted me to buy his mortgaged mobile home and lot, he had borrowed out all the equity. Because the market value of his home was dropping rather than appreciating, all that remained to him was debt and payments that he couldn't afford to pay out of his meager income. By the time he called me, he didn't have enough salable equity left to pay a sales commission. By becoming dependent upon refinancing to support his spending “habit”, at an advanced age he had consumed all his equity and was confronting a bleak, homeless future.


Certainly he should have looked ahead to make certain that he would have a place to live before using up all his equity, but he didn't. Before casting stones, ask yourself if you're doing the same. Have you refinanced a house to “pull equity out”; then used the proceeds to pay off debt incurred in support of your lifestyle? That is the same thing he had been doing. It's easy to justify refinancing an equity to reduce the interest rate or to stretch out a mortgage loan to reduce payments, but this can increase the risks of ownership while reducing the benefits.


In another scenario, suppose you had taken title “subject to” a loan, or had been buying a house on a lease/Option or contract; where previously you had had no loan liability, when you refinanced and signed your name to a new loan, you became personally liable for the payments. Spending borrowed money on consumables is rarely a good idea. Even when borrowed funds are used as a down-payment on another house, this is only a good idea when equities are appreciating at a rate considerably higher than the annual cost of the borrowed money. Anytime that prices stabilize, using borrowed money to re-leverage a portfolio does little more than reduce cash flow and increase the risk of loan default if the economy turns down.


Just prior to the down-turn of the 1980s, I owned 33 houses in and around Pascagoula, Mississippi that were about 80% leveraged; then the market slowed to a stop. Fortunately, I had taken title subject to all the loans and had incurred no personal liability on the debt. I survived by selling 22 of these houses at any price I could get, and using the sale proceeds to pay for the others. It's instructive to note that I never used any of the money to pay for my personal bills, and with each sale, I reduced overall debt while increasing the safety of my investment. Eventually, the last houses that I sold repaid all my efforts; not because of appreciation, but solely because their loans had been paid off.


A portfolio of houses assembled by borrowing against one house to buy another are like so many dominos lined up in a row. While they are appreciating, it makes sense to sell one of the dominos now and then and to use the proceeds to support the remaining highly leveraged houses. But if the market slows and sales dry up, a highly leveraged investor can be trapped in a nightmare of dominos that begin to fall, each causing the next domino in line to fall. In past market slow­downs, I've seen investors who were millionaires on paper lose everything this way.



It's natural for the fledgling investor to rely upon institutional lenders for mortgage money with which to buy houses. Banks and mortgage loans abound in good times. Lenders besiege investors with offerings of attractive loans at low interest rates. All people have to do is to arrange a loan or line of credit secured by their personal residence or other assets, then go out and find a house to buy. The problems with this is two-fold:


1. With each new loan, their FICO score drops a little and they become less and less attractive to institutional lenders. One day, they'll find that they can't borrow enough to buy the next house; hence the number of houses they can buy is limited.


2. When hard times come and borrowers can't make payments, the lender can't cut them any slack. This is because their lender has borrowed the money lent to them. It can't make it's own payments without their payments, so it has to be pretty inflexible.


By way of contrast, if investors borrowed from long term private investors who lent their own funds, in difficult periods, private investors would probably be a lot more lenient and understanding. This is primarily due to the fact that they don't want to own — and have to manage — the mortgaged collateral. They aren't beholden to a higher lender, nor hemmed in by regulations that institutional lenders must abide by. Who might these private lenders be?


In last month's newsletter we described lenders who would be attracted by extraordinary yields on fairly short term loans; but there are others who prefer to lend money on a house at competitive rates than to lend it to banks at low rates to be re-loaned to others. Who are these investors? How can they be contacted? When low-rate loans are easy to get at banks, buyers usually prefer to use institutional financing, and sellers prefer being paid in cash. But when the bank loan-window is closed, investors can't buy and sellers can't sell. It is at this point that the most obvious long term motivated lender is the person selling a property.


Speculators who buy and sell houses solely for profit are usually highly leveraged and hard to deal with. Home-owners are quite different. They don't sell their homes capriciously; absent of crushing debt, they usually have a good reason for selling other than merely making money. When the lender is the seller, its primary focus is on selling the house and quickly moving on with its plans. Most home-sellers (and commission brokers) focus on the price they want to get, and less interested in terms; unless they need cash to pay the broker and/or to buy their next home. Once there's enough cash in the deal to pay these necessary costs, often they can be persuaded to carry creative financing for the balance of the money.


This isn't merely supposition; I have been on all sides of this kind of transaction. On more than one occasion, I've been the seller who has been willing to carry financing. I've been the broker looking for a cash commission. I've also been the buyer who needed seller financing in order to buy a house. Here are a few ways in which financial arrangements have been structured to enable each party to reach his or her goals:


1. Sellers who need cash with which to pay the commission, or for personal reasons, place an institutional home-equity loan on their property. Next, they sell it to the buyer subject to all the loans. If they desire, they might lease it back on a break-even basis equal to the first mortgage payments. When they move out, the buyer can rent the property at fair market rental rates. The buyer thus buys with no cash down, but with high leverage and payments for which he is not liable.


2. In a similar situation, instead of borrowing needed cash on a second mortgage from an institutional lender, sellers carry back the financing. The buyer signs a wrap-around Note and mortgage for the entire purchase price. This Note is then sold to a private investor at a discount to make the yield attractive. The seller pays his debts out of his note-sale proceeds and moves on with the remaining funds.



In the foregoing passages, the focus was upon finding a source of cash for the seller; what about sellers who don't need cash as much as they need management and/or debt relief? With these sellers, a major concern will be that their payments will be made on time as will the fact that they are still liable on the existing first mortgage loan. They also may be concerned about a Due-On-Sale clause that might appear in their mortgage or Deed of Trust. This clause gives the lender the right to demand that a new owner qualify for an existing loan. It also permits the lender to adjust the loan terms and interest to reflect the then current mortgage market; or it can foreclose the loan. Let's dispose of this potential problem now:


Practically speaking, the greatest hindrance to being able to take title to a property on which there is Due-on-Sale financing is posed by brokers who fear that sellers will be doing something wrong. They often “kill” deals that would benefit both the seller and the buyer. They don't comprehend that under federal law, it is not illegal for a buyer to take title subject-to an existing loan when a house is purchased; nor to keep an institutional lender in the dark that this is happening. The law merely gives lenders some remedies, if it chooses to use them.


In general, over the 24 years that the Due-On-Sale clause has been used, it has rarely, if ever, been enforced by lenders. Oh, they huff and puff and threaten to blow the house down when they discover that one of their loans has been taken over by someone else. They don't foreclose often unless payments aren't made on time, or their collateral is threatened by neglect and abuse, or inadequate insurance coverage, or failure to pay property taxes. Absent of these mitigating circumstances, the courts have been reluctant to side with lenders when borrowers petition the court for injunctions against foreclosure due to Due-On-Sale clauses.


There are many exceptions to the Due-On-Sale law that lenders must respect when someone takes over a loan without qualifying for it. Exemptions include properties that are given pursuant to a divorce decree and those that are inherited. A lease not containing an Option for up to three years is not a violation, nor is a pure Option without a lease. Any junior lien, or wrap-around mortgage is acceptable. When an entity has signed the loan and subsequently less than 50% of the control and ownership has changed hands, this is not considered to be a violation. Properties are routinely placed into the names of Trustees “upon advice of counsel” for “estate-planning purposes.” A loan can't be foreclosed because of Due-On-Sale violations if it would damage the interests of a junior lien holder. Here's how creative entrepreneurs have by-passed this problem while buying houses:


1. Property is placed into a Trust with the seller named as Trustee. The buyer buys only the beneficial interest on an installment contract. The Trustee continues to make the payments on any existing liens. Even though equitable and legal title is held by the Trustee on behalf of the Trust, ownership of the beneficial interest allows the buyer to get the benefit of all tax write-offs, amortization, interest and tax deductions, rents; as well as the net profit upon sale.


2. Property is leased for 3 years by one party (possibly a Limited Liability Company who could sub-lease it to an occupant). Next, an Option is purchased by another individual or Trust, and credit is given against the Option price for each on-time rent payment. The Option can be sold at any time.


3. Instead of buying the property, the buyer lends the seller an amount equal to the equity at a negotiated price. Loan terms are documented on a non­recourse wrap-around demand note. It calls for no payments, but has a high interest rate. It is secured by a wrap-around mortgage or All Inclusive Deed of Trust that includes the existing mortgage loan. A deed to the property together with all documents needed to transfer the property are signed, notarized and placed into escrow with a Title Company or Closing Attorney. The seller moves out without making payments, and, pursuant to standard mortgage terms, the lender – owner takes over the property and applies rents toward interest accruing on the loan.


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Every loan has a built-in feature that has the power to transfer equity between seller and buyer invisibly. When a series of payments are being made to buy a house, payment terms can be “above” or “below” comparable loan terms that are available in the institutional loan markets for similar loans and comparable properties and buyers. This is reflected in “Present Value” (PV). This is calculated by entering the number of monthly payments and monthly payment amount. Instead of entering the interest stated on the loan documents, the monthly rate of comparable institutional loan interest is entered. By pushing the Present Value (PV) button on the calculator, the Present Value arrived at is the market value of the equity being purchased. This plus the down payment is the PV of the price paid.


Here's an example. Suppose the seller of a free and clear house, after a $20,000 down payment, agreed to provide $100,000 financing with monthly payments of principal and interest of $599.65. The loan would be for 30 years. Annual interest would be 6% even though banks were charging investors 8%; how much equity will have been transferred simply by mortgage loan terms? The present value of this loan, discounted at 8% would be $81,709. Over the loan term, the seller would have unknowingly transferred $18,291 to the buyer. Rarely would a seller hold the financing for so long, and rarely would the buyer hold the property thirty years, but you can see how equity could thus be transferred from seller to buyer via terms.


Now, suppose we shortened the time period for buyer and seller down to 10 years with the same payments, but at zero interest: With the same payments, $71,946 would have been paid on the $100,000 loan, leaving only $28,054 to be paid Now, the plot thickens: Let's say we immediately sold the house at the same price we bought it for, we charge 8% interest-only with a balloon payment at the end of 120 months; what would be the result? We'd receive $666.67 each month and at the end of 10 years, we'd receive $100,000. We'd have to use $28,054 of this to pay off our loan. We'd have made $67.67 per month for 120 months, or $8,120 plus $71,946; or $80,066 profit on the sale. The foregoing isn't intended to represent an actual transaction; it's meant to point out how private financing can create profit in a market where institutional financing isn't available at a price that makes sense.


A chronic complaint of long-term investors is that the rental market won't support the price one must pay for a decent house in a decent neighborhood. Thus far, my focus has been on debt carried back by a seller for a borrower; but suppose the seller were to become a co-investor with the buyer? Let's double the price of the foregoing $120,000 free and clear house to $240,000, but let's only buy one half of it. Here's how that would work:


In return for 50% share of the equity, we'd agree to pay the same $20,000 down with 6% interest-only payments, or $500 per month. When we sold the house, we'd divide the net proceeds into two equal parts. Out of my share, I'd pay the seller the remaining unpaid loan balance. In most areas, the house should net $1000 per month from rent. It might be reasonable to expect that the house would appreciate at 6% per year over the holding period. At the end of 10 years, let's say it would net about $400,000 on sale after all expenses. The seller would have received $60,000 in monthly payments plus $60,000 in net rents, plus $200,000, plus $100,000, or a total of $420,000. We'd net $100,000 with no negative cash flow.


There's real magic in being able to buy houses without negative cash flow; you can buy as many houses as you can manage. In the foregoing illustrations, the yields and profit would have been even more pronounced with a house on which an existing loan could have been “wrapped” with a lower interest rate loan. Very few people retire rich by making mega-profits on just a few deals. Most people get rich by making smaller profits on more transactions. You can too!


Copyright © Sunjon Trust All Rights Reserved, (888) 282-1882
Quotation not permitted.  Material may not be reproduced in whole or part in any form whatsoever.

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