"Why I Borrow for the Terms I Do
How I handle the Balloon Payment"
I almost always borrow money from private lenders to buy my houses. I borrow at the following terms;
$0 Down payment
8% Interest
Interest Only
5 yr Term
Non-Recourse
Early on it’s important to borrow “Non-Recourse”, meaning “collateral only” (no personal guarantee).
It’s also important to borrow with permission from your private lender to “Wrap” their underlying mortgage when I sell the collateral to my buyer using owner financing. This is called a "wrap around mortgage.” I create a 1st lien when I borrow the money from my private lender to buy the property. I create a 2nd Lien when I sell the property to my buyer and owner finance the balance they owe to me. I owe a payment on a first lien to my lender and my buyer owes me a bigger payment to buy the property from me. My buyer pays me and I pay my lender; my buyer’s mortgage "wraps around" my lenders mortgage.
Here is my typical deal:
- I find a home I can by for $23K
- I borrow $25K @ 8% interest only for 5 years; my payment is $167/mo.(I pick up $2,000 when I buy the property)
- I sell the property As-Is for $57K - $5K down and finance the balance using a wrap-around mortgage; I carry the $52k balance at 10.5% for 20 years; my incoming payment is $524/mo
- (I pocket the $5K as well)
In this scenario I pick up $7K in cash for creating $357/mo positive cash flow for 240 months…of which I am not a landlord…I am the bank!
($357 x 240 months = $85,680 + $7,000 = $92,680)
You absolutely do not have to use my exact borrowing formula. You can borrow at whatever you can negotiate and for whatever terms that work for you. Some investors I know do borrow amortized money instead of interest only. Of course, I’d prefer to borrow at 20 to 25 years fixed at 6% (or 1% for that matter). I have to borrow at terms lenders want to participate in. I borrow the money with the terms 8%, 5years, interest only, non-recourse for several reasons.
1). Early on I needed all the cash flow I could get. Interest only is the best one can do.
2). My private lenders are very focused on NOT eroding their principal. They only want to spend the interest their money makes and protect their principle investment. My private lenders, in general, are up in years. I need to keep things simple for them. If I send them "interest only" payments, my lenders automatically know they can spend all the payments I send them. If I sent them a "Principle + Interest" payment, my private lender has to go to an amortization schedule each month and figure out how much of the payment was principle and how much was interest; they only want to spend the interest amount. Simple enough right? ...It's too complicated for them.
As I stated earlier, I’d prefer a fully amortized loan that’s good for me and easy enough to sell to my lenders; let’s say 8% for 20 yrs. However, my private lenders tend to be up in age and unwilling obligate their money for long periods of time. This is part of the reason I arrived at a 5 year term. The other reason is that we simply have to have an ending date.
3). When you have a principle + Interest payment, you’re going to pay tax on your principle reduction; you'll pay tax on money going out of you cash flow that is to your credit. In the early days I wanted to pay tax on just the money I collected in my bank account. I did not want to owe tax on income not in my bank account because it was listed as a gain; it reduced my debt (principle pay down).
4). I borrow Non-Recourse because I can. When given a choice between borrowing money by signing a "Personal Guarantee" or by borrowing "Non-Recourse" ...always pick "Non-Recourse" ...meaning, the only recourse against you (the borrower), if you don't pay, is the lender can take the propertyfrom you. The lender can't sue you and/or attach all your other assets in a judgment against you and your holdings.
Eventually, as your reputation and financials grow, you be forced to make an important decision; do I borrow at 8% and non-recourse from a private lender ...or do I borrow from a bank at 4.5% and sign a personal guarantee? When the time comes, you'll need to make you own decision, but, if you go with a bank loan I'd strongly suggest you include an interest rate cap (if the loan is adjustable), no covenants, and that the loan be fully amortized.
So that's why I borrow money at 8%, Interest Only, Non-Recourse.
What Happens at Balloon Time?
So, a lot of people have asked, "Mitch, how do you handle the balloon payment in 5 years?”
#1. Simply Renew:
Understand this, if your private lenders are up in age, they don’t want to be paid off! Yes it’s true, they won’t obligate their money for 20 years but at the same time, I seldom have to pay them off at the five year balloon.
Remember, these folks are generally living on fixed incomes at this point in their lives. They are 65 – 70 – 75 – 80 – 85 years old. They are living off the interest payments you’re sending them each month. By now, they’ve grown to trust you. They are relaxed knowing that you always send a check and your check always gets there on or before the first of each month.
#2. Replace Them with Another Private Lender:
In my experience, there is always another private lender that wants to get more money out or that you just paid off and they want their money back out. Refer to #1.
#3. Replace Them with a “Low Interest” Institutional Loan
Did you know that smaller community banks will talk your owner financed note as collateral? Get four or five little community bank to start competing for your business! I’ve done this and it worked like a charm.
I put $1,000,000 worth of private lender debt up for re-finance and took my spreadsheet to 4 community banks. I told the lending officer at each bank I was looking to refinance my underlying debt and pledge my owner financed notes as collateral. They asked me what kind of terms would work and I told them I wanted a 15 – 20 fully amortized loan at Prime Rate+ 0.50%. I knew this was overly optimistic but that is truly what I wanted. Almost all of the officers came back and said they couldn’t fix the rate for 15 years. So I went back and said I’d consider an adjustable rate mortgage under the following conditions:
-The loan had to be fully amortized
- (Meaning the loan had to be for a full 15 or 20 year term…no chance to discontinue the loan)
- -The rate adjusted every 5 years at Prime + 0.50
- -There was some sort of interest rate cap
Within days I had letters of intent (LOI) rolling in. They weren’t offering exactly what I wanted but I went to the worst offer and informed them that I had other offers that were better than there offer, and that they ‘d have to get closer to XYZ terms or they would have no chance of winning the loan. I did this in round robin fashion until I ended up with the loan I accepted;
- -4.5% initial rate
- (Prime + 1)
- -5 year adjustment
(interest rate to adjust to Prime + 1)
(maximum interest rate possible)
-15 year term – fully amortized
(Fully Amortized – meaning no “Renew & Adjust”…just adjust)
(They can only call my note due if I did NOT make the payment…they could not call the
note due based on any ratios;debt vs. income or appraised value vs. loan balance, etc.)
#4. Sell the Note:
After five years of collecting payments, the note balance should be down and the property value should be up. This is what we call a “well seasoned note” (Meaning it has a good performance record). If you payer has paid on time as agreed, this should be an easy note to sell because of the spread between the note balance (The balance owed to you by your buyer) and the property value (the collateral’s value).
#5. Deed the Property Back to the Lender and Call it a Day!
Give the deed back to the lender! Since you borrowed non-recourse, this is the worst case scenario. But look at it like this; if you got into an investment property with none of your own money (even borrowed a little extra to put in your pocket), collected a down payment (you put in your pocket), and then collected a positive cash-flow of $350 t0 $450 per month for 5 years (you put in your pocket), and then you had to give the property back…would that be such a bad deal? NO, IT WOULDN’T! Some would call this a strategy!This is the worst case scenario
Now I’ve never given back a deed before in my entire career. I’ve never had to. There was always another lender or a note buyer in waiting. But, I bet you if I offered an 80 man the deed to the house…he’d reconsider extending the loan…no doubt! But giving back deeds is not what we got into the owner finance strategy for. We got into the owner finance strategy because it creates income today while building cash flow for tomorrow.
The coup de gras in almost all creative real estate investing strategies is one’s ability to find and access private money. If you master the art of finding private lenders, you are a multi-millionaire in waiting. All that’s left is to learn how to find great deals and how to paper them up in such a way there’s little to no chance you can get hurt in the ebb and flow of economies. Accept the challenges, move forward, and make sure you can live with the worst case scenario. Plan for the best prepare for the worst. Becoming financially independent is a way of thinking, a strategy with a path, a tact into the wind; knowledge!
--Mitch Stephen--
