March 1980
Vol 2 No 6
Recently we have been inundated by people who want to borrow money. The key to profitable money lending in a tight money market lies in one’s ability to borrow on better terms than those offered to borrowers. Many people pay way too much when they borrow because they don’t seem to understand the basics of lending and borrowing money.
Money is a commodity like houses or land which commands a rent based o the ratio of supply and demand. There are different sources of supply for money: banks, pawnshops, unsophisticated investors who leave money in savings accounts, and venture capitalists. Before you borrow money, it is important to recognize that it is less expensive to borrow larger amounts for a long term, than smaller sums for the short term. For example, the prime rate today is 15 ¼%. Most people would have to pay at least ½% over that for a short term loan. The same borrower can borrow against his house at 12% – 13% over a term of 20 to 30 years, tying down the long term rate.
Why does this happen? Is it the SECURITY? Not necessarily! Even small secured loans command high interest rates. Cost is directly related to the profitability of the loan to the Lender. Suppose you were offered a $1,000 note due in one year for a price of $600 today. The security for this note is a $5,000 property in Australia. Would you be interested? Probably not. It’s not a question of yield on your investment or the risk; the fact is that it’s just too much trouble to worry about something going wrong in Australia for a $400 profit. Add two more zeroes and we would all be interested in the transaction.
The second factor is time. At first sight, it doesn’t seem to make sense that one can borrow long range at a lower cost than short range. Each time a loan is made, a certain amount of judgment, time, and paperwork is involved. A single loan over many years can be made at a cost which is lower than a series of shorter term loans – and at less risk.
Therefore, the next time you borrow money, borrow long-term; and borrow as much as you can each time. Now, let’s consider the sources. Banks and other institutions have to be the WORST places to borrow money under ordinary circumstances! One the other hand, in the event you already owe them money, you may be in the driver’s seat. Last month, we received a letter from a Florida S&L hinting that they would offer a discount for loans that were paid off early. The loan in question had about 10 years left to run at 6.75% interest. Their initial offer was a $5,000 discount on a $23,000 balance in the event it was paid off. With this offer in hand, we agreed to pay off the loan provided they loaned us 80% of the value of the house at current rates to provide the funds.
Banks to whom you owe low interest rate loans are your best source of funds when you need to borrow. Often the same Mortgage or Trust Deed can be retained, with a new note drawn in the amount of the new loan. This eliminates the need and expense for title work and recording fees. The PRIVATE SECTOR is an optimum source of borrowed funds! When we have equity in real property, we can usually sell all or part of it to an investor and pay him a yield that would be less than comparable costs at a bank. For example, one might sell a free and clear house worth about $50,000 to an investor for $40,000, retaining a lease-hold and an option interest.
The investor is offered a 6% cash return in the form of $200 per month rent sheltered by depreciation. The Option could provide for a 10% annual increase to him in the form of long term capital gains over a long term. Although this totals 16%, the out-of-pocket cash flow is only $200 per month which is well below fair-market rents for the house. This kind of transaction yields $40,000 for investment as well as a positive cash flow from rents over the entire holding period to both parties.
As an alternative approach which would avoid any income taxes, one might acquire a sale-able house with a purchase money note secured by another house one owns, and then sell that house for tax-free cash. For this example, suppose I acquired a $30,000 equity in a house offered for sale with a $30,000 ten year note secured by my own house. My basis in the new house is $30,000 over any existing mortgages, so if I sold it for the same amount in cash, there will be no gain, and no tax to pay. Of course, I still owe the borrowed $30,000 which must be repaid over the next 10 years, but I have cash for investment in my pocket at relatively low cost.
In effect, $30,000 has been raised against an asset which would not have normally been refinanced because of high loan costs. The “lender” was the anxious seller who gladly accepted my created mortgage in order to unload his house. Even if the sales price had been discounted $5,000 for a quick resale, the overall loan costs would have been less than from a bank, and the low interest rate on my original note will remain in effect.
Thanks to Rich Brady in Utah for this next idea. He raises cash by borrowing against OTHER PEOPLE’S equity. Rich found an investor who had been sold a house as an investment. The investor quickly discovered he didn’t like management and wanted out – but at a profit. He had over paid $54,000 in cash for the house and it was rented for $250 per month. Brady offered to “guarantee” the $250 per month for 5 years in return for an option to purchase the house for the asking price PROVIDED the investor loaned him $20,000 to invest. The investor borrowed $20,000 against the house and the loan was repaid by the rent that Brady guaranteed. Brady used the $20,000 to buy another house which he will own with the investor, splitting the net profits at point of sale.
The investor is happy because he not only solved his management problem, but effectively bought another investment with nothing down. His monthly cost is only $250 per month. Brady is delirious. He has a 5 year option for which he effectively paid nothing. He also has $20,000 to invest in another house plus a motivated investor to work with. Who says these guys from Utah aren’t too bright?
WHAT’S GOOD ABOUT CORPORATE PENSION PLANS?
They’re terrific tax shelters for those in higher tax brackets. First, form a one-man corporation, and establish a pension plan program. With you as the sole employee, the corporation can contribute up to 25% of your salary (up to $25,000) each year into a pension fund and deduct this from corporate earnings. Neither this money, nor the earnings of the fund are taxable to the employee until distributed upon retirement.
Now for the good part! The fund can lend you money at a reasonable rate of interest, (i.e. 18% secured by a mortgage on your house). You can deduct the 18% interest paid while the fund receives it tax-free. Taxes must be paid ONLY when the contributors and their earnings are distributed. In the event that the corporation contributed $20,000 to the pension fund, then the fund loaned it out to the employee (you) at 18%, a good return to the fund for a safe loan, it would mean an $11,800 tax savings for one in the 50% bracket: (18% of $20M is $3600, or $1800 in the 50% bracket. There would be half of the $20,000 contribution saved for a total of $11,800 in that one year alone).
Many so-called tax gimmicks sound neat but leave the tax payer cash poor. Let’s look at the cash flow. If we accepted the $20,000 above as salary, we would net $10,000 after paying 50% in taxes. By letting our corporation contribute it to the pension fund, then borrowing it back out at 18%, we would have $16,400 net cash after we paid the $3600 interest back to OUR fund. This could of course be loaned to us again if we want.
ONE NOTE OF CAUTION: ALL employees must be included in the corporate pension plan, so establish your pension fund in a corporation in which YOU are the sole stockholder and employee.
RETIREES HAVE SPECIAL NEEDS FOR SECURITY AND INCOME
This month’s Dear John letter deals with the situation of the elderly couple who owns their house free and clear and want to sell it now, while continuing to live there the remainder of their lives. Extreme care must be taken not to jeopardize the security of the retirees! Schemes in which property is deeded to an investor, who subsequently borrows against the property after agreeing to pay a private annuity to the owners for life, are hazardous. The “investor” could well lose the loan proceeds and be faced with high loan payments plus annuity payments on a house occupied by the former owners who hold a life estate. If the investor defaults on the payments, the retirees will lose everything. There’s a solution to this.
Consider this approach. An elderly widow has a fixed Social Security and pension income of $800 per month plus total savings of $15,000. She is willing to use a third of her income and all her savings to secure a nice home for the rest of her ambulatory days. Here’s a formula which provides her with comfort and security while giving the investor high yield. Suppose a house or apartment could be purchased for $10,000 down with a value in the $50,000 – $60,000 range and the balance payable at about $425 per month. The widow would put up the money for the down payment and the investor would agree to make the payments for as long as she resided in the property. Meanwhile, she could lease the premises for $300 per month during that period. The investor would pay for all repairs and taxes plus insurance as long as she lived there. After she has vacated the property, it could be sold and the investor would pocket the proceeds.
The first year this venture might cost as much as $250 per month ($425 payment less $300 income plus $125 reserve for taxes, repairs and insurance). Assuming these expenses increase at 20% per year, they could add up to some $500 per month in 10 years. At the same time, the house would be appreciating considerably during this same period. Obviously, this is a better investment when one is in a high tax bracket. In the 50% bracket, after-tax-costs of this house would be $650 the first year after deductions for interest, taxes, maintenance, insurance, and depreciation (20 year straight line on improvements equal to 80% of value) as offset by the $3600 income received from rent.
The key to this program lies in the fact that rising costs of housing, whether in the form of rents, taxes, insurance, repairs, or from high interest charges, threaten millions of retirees. They are less concerned with loss of profits from their estates than with loss of the fruits of their labor represented in a comfortable, secure lifestyle. By responding to that need, the investor can earn far above average yields.
There are many variations to this type of plan which will make it more or less desirable to the individual investor or retiree. For instance, an active retiree might prefer to do some of the maintenance in the early years of the plan and pay less monthly rent. For those with less pension payments, inclusion of utilities could be arranged in return for a higher amount invested initially. On the other hand, the investor might be able to purchase suitable quarters for LESS than the full amount that the retiree was willing to invest. In this event, the residue could be allocated by the investor toward reducing the negative cash flow.
The investor might decide to syndicate his interest in the plan by allowing another party to provide for all negative cash flow in return for the tax deductions. This could be done through a master lease. Of he might sell ½ interest in the property subject to the retiree’s lease hold interest for a $10,000 note with $125 payments. This would offset the negative cash flow while providing another investor with a nothing down deal in addition to a fantastic return.
What about the couple who owns a house free and clear and wants an income stream? Why not have them borrow (i.e.) $40,000 against their $60,000 home and allow them to pocket the proceeds? You might even co-sign with them on the Note to assist them in getting the loan. Now, you buy the house with the consideration being a lease at a rate you agree upon for the rest of their lives in the house. They can invest the loan proceeds to give them a monthly income for their own use. Perhaps you will be able to invest it for them, guaranteeing them a 12% return in seasoned first mortgages which you can purchase at discount.
BE WARY OF INDEXING ON CONTRACTS AND LEASES!
The C.P. Index is under attack. Our Congressional leaders have discovered that each time the CPI goes up one point; it triggers a $1.5 Billion increase in Government expenditures in the form of indexed pensions and contracts. Although the Bureau of Labor Statistics, the keeper of the index, has valiantly defended the index as the best price measure in the world, my bet is that it will be changed to “more accurately reflect” the spending habits of the consumer. The one factor that receives the most criticism is the cost of housing which now constitutes 29.7% of the index. As a “vast majority of Americans DID NOT buy a house last year” and “a house is an investment, not an expense”, why should housing be part of the index? That kind of reasoning is the start of a re-jiggering of the index which is aimed at depriving millions of Americans of adjustments in their income as a result of cost of living increases based upon the CPI. By eliminating a major element in the CPI, the Government will save BILLIONS, and we don’t believe they will be able to resist the temptation.
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