Private Money Lending , How to Beat the Madness Part 2

I encourage you to take a look at part 1 here.

The Economic Outlook

The closer you look, the worse things get. You just saw that the long-term investor looking for growth in the market is living in a shark tank. Unfortunately, the retiree looking for income is looking at a dead end of a different kind, because interest rates will be cripplingly low for a very long time.

The reason is simple: Debt.

Back when life was normal – before Bernie Madoff Syndrome and political expedience took over our financial institutions right down to the core – economic realities still made sense. Not so long ago, around the time Jimmy Carter was turning things over to Ronald Reagan, our national debt (still less than one trillion dollars) was about 14% of our GDP. Today, our debt is 110% of our GDP. That changes everything.

The interest rate on our 10-year Treasury note hit a high of about 15% in 1980. We had a $900 billion dollar debt and a $6.5 trillion dollar Economy (GDP).

So, even at that high rate that we had to pay to China and others who bought our debt, our GDP was more than seven times greater than our debt. So the service on our debt in dollars represented only 2% of our GDP.

Stay with me…

From 1980 through 2014…

…our GDP increased just 2.5 times, from $6.5 trillion to $16.5 trillion.

…but our debt exploded, increasing by a factor of 20 from $900 billion to $18 trillion.

…and our budget jumped almost 7 times, from $600 billion to $4 trillion.

That means that the federal government now spends $12,500 a year for every man, woman, and child in the country – $50,000 for a household of four, which is virtually the same amount as the nation’s average family income.

Now, with a debt that outstrips our GDP and is still growing by billions every day, even our relatively low 2.7% interest rate takes a whopping half-trillion dollars out of our budget just to pay the interest on our debt. That’s comparable to our military budget.

This is why interest rates cannot be allowed to rise in any significant way. We would not be able to service our debt. If interest rates went back to the1980 rate, we would need more than two-thirds of our budget just to pay the interest on our current debt. [And if our budget still represented the same percentage of our GDP it did in 1980, our debt interest would be nearly twice as much as our entire budget.]

The rest of the bad news is that other nations are losing interest in buying our debt because, like the CD rates, it’s not worth tying up their money for such a low return. That means that the Fed might have to keep printing money indefinitely. Can you say, Downward spiral?

The Fed is talking about raising interest rates a quarter of a percent in the fourth quarter of 2015. So, while you can expect this to cause stock prices to soften a bit, it is not going to do much for the CD rates at your bank. And if they stop printing money…run for cover.

The Sensible Solution

The answer to it all is actually quite logical: If you can’t beat the bank, be the bank.

And be the bank in your own backyard.

Some tangible investments, like gold, have already been incorporated into the big investment house game, and, while “Gold has never been worth zero,” its trading price has been falling steadily for the past two to three years, losing about 40% from it’s peak a few years ago.

But real estate is about the only thing that is living according to real economic principles these days…appreciating slowly with the price often lagging behind its intrinsic market value. It was battered and torn as the super storm of the financial crisis enveloped it and left it to crash in 2007 and 08. But, we need houses; we can get by without gold. And they will always have to be affordable for the working family.

You could never compete with banks in the highly regulated owner-occupant segment of real estate mortgages, but those players would not be interested in you anyway. They can get a mortgage at 3 or 4 or 5 percent from a bank.

But there are a lot of skilled and ambitious real estate investors who are interested. The problem for them is that they need to move fast when they find a good house so they can accumulate properties, fix them up, and put qualified tenants into them. The rental market is hot, and these entrepreneurs can get ahead if they can buy houses with cash. The banks want big down payments, months to process things, and ask them to jump through endless hoops to get their low interest rates – and they aren’t that keen on investors anyway.

But there are dozens of great investors with proven track records within ten miles of your front door who will gladly pay a premium interest rate for a year, using hours of their own sweat as their equity and down payment, to get one more home rehabilitated and ready for one of the thousands of families clamoring for a good rental home.

And, once the home has been improved and is reliably producing rental income, then they can go to the bank and refinance the property at today’s interest rate. And you can move on to your next deal.

You can be the shoehorn. You can be the seed money behind a qualified entrepreneur that you interview and hand pick personally. You can help stimulate the economy in a real way and contribute to the long-term improvement of your community and the welfare of your neighbors. You can take a piece of the banking system away from the wolves and bring it back to your neighborhood.

So, what’s the big deal about first-lien mortgages? That’s easy. I challenge you to go to any investment banker, broker, or commercial banker in the country and ask him to guarantee you a 7% ROI with your earned income paid to you every month. It’s not going to happen.

But when you are the banker, your rate of return is locked-in in writing. You can readily get a 7% interest rate from property investors. Why? They can turn a $125,000 fixer upper into a $160,000 home in a month or two and start collecting $1,500 in rent each month, while their property appreciates at the same time.

Your risk is low because, as the first-lien-holder, you will be collateralized by the property and the rents. Typically, investors are looking for properties that they can rehab to gain sweat equity. These may be selling for 30% or more below the value of comparable properties, which your investment will be worth when it’s completed. And, in this hot rental market, commercial values based on rents are often even more than appraised values based on square footage and such. And, since it is not owner-occupied, all of the time-intensive hoops that banks have to jump through to foreclose are, in most states, reduced to a fast and simple process. A foreclosure might put you much further ahead than a normal turnaround. But if you find property investors with a good track record, this is unlikely to happen anyway.

Compare this to a CD. You invest $100,000 for one year at 1%. After the year is up, you get you $100,000 back plus…$1,000.

Let’s say instead, you invest $100,000 in a first-lien mortgage on an investment property. You collect about $580 a month later…and again the next month…and the next month…for 12 months. Then you get your principal back when the investor refinances with a bank.

It doesn’t really make much difference if you agree on a 15-year, 20-year, or 30-year amortization – or even if it is interest only. You will earn the same 7% on your $100,000 investment. You will recoup over $300 a month of your principal each month with a 15-year note and $80 or $90 with a 30-year, so your interest on the declining balance will drop a few dollars a month more with the shorter term.

It would take 5.6 years for a CD to give you the same return on your investment.

It may take a slightly larger effort to control your own destiny and to add profit and security to your financial future, but it is probably better than betting your entire retirement on the investment houses’ craps tables or stuffing your life’s savings under your bank’s mattress. At least a portion of your assets should be allocated to some form of self-managed real estate investment. Ask your tax accountant about how you may be able to put that investment into a self-directed IRA or use your other retirement savings to fund your mortgages while sheltering your income at the same time.