Real Estate Investment Articles

Hi! Lucy the Mortgage Broker here, with the latest in Mortgage Planning Technology to increase your wealth….

I recently met with a couple, in their late fifties, who are in the same boat with many Americans. Namely, they are house rich but cash poor. Although they have thousands of dollars in equity, it is often a struggle for them to meet their monthly bills and cash flow needs. I have changed their names to protect the innocent, but because their situation is so common, you may think I am talking directly to you. Keep in mind the numbers I am going to use are for illustration only; using only my financial calculator. Real numbers will be slightly different but this will be accurate enough for our purpose.

Let’s get started by laying out the facts. The Smiths own a home that would appraise today for about $150,000. They currently owe $70,000 on the home. They also own an RV which is encumbered by a $45,000 loan. The retail value of the RV is probably about $50,000, but if they were forced to sell to dealership or quickly, the sales price would more likely be about $35,000. Their credit is excellent and their income would support a new loan. How can they turn their equity into cash? Safety is a primary concern. IRA funds are about $2,000. Current house payment is $851; the RV payment is $431.

The first recommendation is to do a cash out refinance. Scenario one is to utilize an Option Arm. Many people are using this loan because most lenders send you a monthly statement and the option to make your payment as if you had a 30 year fixed loan, a 15 year fixed loan, an interest only loan or a set minimum payment which does not cover the interest owed that month. Instead, you make a minimum payment and any interest owed but not paid is added to the principal balance. This is referred to as negative amortization.

Since the home appraised for $150,000 a loan for 80% of the value (LTV or Loan to Value) equals $120,000. This loan amount will pay off the $70,000 mortgage, the $45,000 RV and leave $5,000 for closing costs. The new monthly payment will be $200 per month. This represents a minimum payment of 2% annual interest. The actual interest rate being charged by the lender in our example is 6.5% and adjustable. Therefore, 4.5% per year will be added to the principal amount since our borrower is not paying the full interest owed. If we add $200 per month for taxes and insurance, our borrower is trading $1282 per month in payments for $400. This frees up $882 per month.

If that were the end of it and Mr. and Mrs. Smith spent the money on current living expenses, it might result in a horror story. The negative amortization of $5400 per year would quickly add up to about $27,000 plus interest after five years. They would then owe about $155,000 on their home, which in five years, at 3% appreciation, would be worth about $173,000. If they sold this home with a Realtor, their costs of 10% would leave them with about $155,000. After paying off the balance of $155,000, they would break even.

We are in the business of happy endings, though. Here is what I recommend instead. Sell the RV and keep the $35,000 from the sale. This will be ammunition for our retirement catapult. We now have $35,000 and $882 per month to play with. The Smiths already have an IRA funded with $2,000. Mechanics of the following transactions can be cumbersome and are outside of the scope of this article. Therefore, we will leave out specifics and focus on results.

The Smiths are in their fifties. Current IRA regulations allow them to make individual contributions of $5,000 each to their IRA. This includes a catch up provision for those over fifty. If you are not yet fifty, the annual contribution is capped at $4,000. Every month each Smith will deposit $416.67 into their IRA. We will assume that each Smith IRA will start with zero. After five years (60 months) at 12% annual growth, the. Smiths will have $34,029 in each IRA. This means that the Smiths have $68,058 between them for retirement. Not bad in five years, starting from nothing!

We use a 60 month time frame because with the mortgage I am doing for the Smiths, the minimum payment option is only for the first 60 months. At month 61, it converts to a 25 year payoff. This way, the loan is still paid off in 30 years.

But wait! We still haven’t addressed the use of the $35,000 from the sale of the RV, nor have we factored in the negative amortization. If the Smiths are not paying their mortgage balance down, won’t they be in a world of hurt? Maybe, maybe not. Let’s see.

With the $35,000, I advised the Smiths to invest in a discounted mortgage. We’ll explain the mechanics in a different essay, but for now, let’s go over just the numbers. I find the Smiths a discounted mortgage for $35,000. Originally, this mortgage was for a $50,000 home purchased with $5,000 down. Therefore, the note was written for $45,000. It has “seasoned” for one year; twelve payments have been made on time by the borrower. The term is 30 years at 11% interest. This means each month the borrower pays $428.55.

Because the seller would rather have cash now, I negotiate for the Smiths to purchase the note at a discount. The purchase price is $35,000. The principal balance owing on the note is $44,797.38. Immediately, the Smiths have turned $35,000 into $44,797.38. On an annual basis, this represents a yield on their investment of about 14.5% The best is yet to come, so keep reading!

If the borrower doesn’t pay off early, the Smiths will have 348 payments of $428.55 coming in. That’s 29 years of payments to supplement their income. This exceeds what many people receive in Social Security. 348 X $428.55 is $149,135.40. Remember, when we started, the Smiths had only $2000 saved for retirement in a small IRA earning about 4%. Wow.

Can you believe that it gets even better? The above represents about a 14.5% yield. What if the borrower paid off early? What would that do to the Smiths’ investment?

Let’s do a few round calculations. We are going to assume that as soon as the Smiths buy the mortgage, they approach the homeowner/borrower with a win/win proposition. If the homeowner agrees to do a mortgage with Lucy the Mortgage Broker, working with Lucy to fix their credit, the Smiths will pay $2000 in closing costs when they refinance within 12 months. Why would the homeowner agree? Simple. They get a better credit rating, lower payment and cash out. For the homeowner, we will assume that we are in month 24. The home will now appraise for $56,000. Their credit has gone from a 500 to a 600 in one year. Pretty easy to do with some cooperation. They can now refinance to a rate of 8.25 fixed. Realistically, we are assuming that they will not be able to get a better rate because they are unable to pay some collections on their report. No matter, they will get a loan with Lucy in spite of their debts. Their new loan amount is $50,400. Their new P.I. payment is $378.64. They get to save $50 per month. We point out to them that $50 X 336 payments is $16,800 and congratulate them on saving that interest on their home that they would have paid. $50,400 - $3,000 in closing costs - $44,571.32 equals $2828.68 in their pocket when they walk away from the closing table. Do you think there is any chance they won’t show up for closing? Not a chance in the world!

How do the Smiths make out on this deal? Well, they bought the Note for $35,000. They received 12 payments of $428.55, or $5,142.55. Then, they were paid off to the tune of $42,571.32 (don’t forget the $2000 incentive!) for a grand total of $47,713.87. So in one year, they turned $35,000 into $47,713.87, a difference of $12,713.87. Divide the profit by the investment to reach a return of 36% in one year. Did you see that? 36% ROI, Return on Investment. How much do the Smiths love Lucy? A lot! They can’t wait for me to do this over and over again.

Think of it this way. If you retire and then supplement your income as a greeter at Wal-Mart, you are bound to make $6 per hour. If you work 30 hours per week, you’ll make $180 per week X 50 weeks and you’ll gross $9000. The average retiree does this or a similar plan. They don’t want to make too much money or it reduces the amount they can collect from Social Security (a discussion for another day, don’t get me started…). Or, you can take the equity in your home which is doing NOTHING for you, but keeping the bank very secure and turn it into wealth.

Now, to be fair, we have to look at what all that negative amortization did for their home. The loan started at $120,000. With negative amortization of 4.5% per year, using simple, not compounded figures, at the end of five years the Smiths will owe $155,000. Of course, they will also have $68,058 in their IRAs. If they can do five note deals just as described, they will parlay that $35,000 into roughly $98,569 for a grand total of $166,627. Kind of makes the mortgage balance insignificant, doesn’t it?

Of course, they could have followed the advice of the average mortgage broker. Mr. Suit and Tie would have told them to refinance the $120,000 at a 6.5% fixed rate for 30 years. He would have told them to pay off their current mortgage and RV, dropping their payments to $958.48. This would save them $323.52 per month. They could have added that amount to their existing IRA each month and made the 5% they are currently earning in that institutional IRA. After five years, they would still have the RV, BUT their IRA would have a balance of $24,568.05. After that same 60 months, the balance on their mortgage would be $112,323.38. Remember, we assumed earlier that five years from now with a low 3% appreciation rate, they could net $155,000 on the sale of their home, so after paying off the mortgage, they would have $42,667.72.

It boils down to this: You can have $68,058 in your IRAs, $98,569 and break even on the sale of your home in five years for a grand total of $166,627. You also have the peace of mind you get from having over $98,000 in liquid funds and $68,000 in retirement when a short 5 years before you had nothing but bad debt and an anemic IRA.

Option two: Your IRA has a balance of IRA would have a balance of $24,568, you have a RV that’s five years older, now worth $20,000(which you didn’t use because you couldn’t afford to) and you realized $42,667 when your home sold for a grand total of $87,235. Seems rather obvious doesn’t it?

Wal-Mart greeter or Wealthy Retiree….the choice is yours!

Lucy Brenton is available to strategize with you for mortgages on your properties. You may also hire Lucy to help you with credit repair for your buyers or sellers. Lucy has been a Mortgage Broker since 1996. Because she and her husband, Dorn, are Real Estate Investors, they understand how to structure the financing from the very beginning with the end in mind…getting you paid! Just give her a call at 317-332-5829 or send an email for a rapid response.

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