7

WHAT MAKES SOME DEBT DANGEROUS AND HOW TO BORROW SAFELY

I don’t believe that all debt is dangerous. However, I do believe that the leading cause of going broke is borrowing money you can’t pay back. Those who have gone broke, filed for bankruptcy relief, or had a foreclosure are rightfully fearful of debt.

There is good debt, and there is bad debt. Debt used to buy an investment that can repay that debt is valuable to a real estate investor. Debt used to support a lifestyle you cannot afford is the road to bankruptcy.

Consumer debt is typically bad debt. If you can’t afford to pay cash for a new car or a vacation, drive your old one until you save up to buy one you like better, or have a staycation. If you have a car loan or consumer debt, make a plan to pay it off as a first step to becoming an investor.

FIVE REASONS CONSUMER DEBT WILL KEEP YOU POOR

1.   The interest rates are high.

2.   The term is short.

3.   The payments are high in relation to how much you owe.

4.   The interest is not deductible.

5.   Whatever you bought is going down in value.

You can now get a seven-year car loan that may outlast the car you buy.

Contrast that with a house mortgage. The lender has a house as security for her loan and you probably made a down payment. Therefore, your interest rate will be lower and the term long enough to allow you to rent the house and have immediate cash flow. The interest is deductible, and the loan is secured by an asset that might grow in value.

A 70 percent loan ($160,000) on a $200,000 rental house is safer than a $10,000 credit card “loan.” The house, if managed well, should produce enough rental income to repay the loan. Things you buy with your credit card rarely produce any income.

A CREDIT CARD CAN BE A VALUABLE TOOL

Credit cards used for a business purpose are valuable. A landlord can pay his contractors, buy needed materials, and maybe even pay insurance and tax bills. As long as he pays his credit card bill when due, he can get an interest-free loan from the time he charges until he pays his bill.

It’s a business tool, and your business plan should include paying it on time every month. Otherwise you will start paying interest and, even worse, deferring payments of your current expenses. This is a sign of serious danger in your business or investments.

Personal credit cards can be a valuable tool, as long as you have the discipline and money to pay your bill on time each month. Not paying on time is a sign of financial danger.

UNINTENTIONAL DEBT

Life is full of unexpected surprises, not all of them good. Personal debt due to an accident or health and family issues is nothing you can plan for. However, you have a few options. One might be to renegotiate for lower payments. Another might be to negotiate a discount, if you can pay it off in a shorter time.

If you owe a hospital, it will certainly work out a payment plan that you can afford. The hospital may also be open to discounted payments. Ask anyone you owe if they can give you a discount if you could pay them early, and then make a plan to pay them.

Although this may seem out of reach today, in the future you may be able to sell an investment house and make a large enough payment to wipe out this debt. In the meantime, you could use the rental income that the house produces to begin to pay down the debt.

UNDERSTANDING WHY SOME REAL ESTATE LOANS ARE DANGEROUS

Not all real estate loans are created equal. In fact, some have little risk while others are extraordinary dangerous.

These are the factors that make a loan dangerous:

1. Short Term

A five-year loan may sound safe, but five years is not long enough for most markets to go through a full cycle. If interest rates are higher five years from now, you may have a hard time refinancing or selling at a good price.

Time is your friend as an investor. Plan to hold your investment properties until they double, and get a loan long enough to ensure that you can hold the property that long. Ten years is the shortest loan that I recommend for a real estate investment, and longer than ten is safer still.

2. A Variable Interest Rate or Payment

Although you may be able to get an initial lower interest rate with a variable-interest-rate loan, you are betting that rates will drop or stay low. A thirty-year, fixed-rate loan has an interest rate that has been adjusted to compensate for the risk of the longer term. If the cash flow from the house that you are buying will not make the payments on the thirty-year, fixed-rate loan, then you are speculating.

If you get a fixed-payment, thirty-year loan, as you raise your rents, you get a raise. With a variable-rate loan, your payments may increase in a market where rents are dropping.

Don’t gamble, invest. Finance houses that you buy with long-term, fixed-rate loans. If everything goes according to your plan, you can pay them off early. If rates jump up, then you won’t risk losing your houses.

3. Negative Amortizing Loans

These loans have payments that are less than interest only. At first look, they may seem like a great deal, since with lower than normal payments you would have more cash flow. But that’s not the complete picture.

As you are paying less than interest only, your loan has a growing principal balance. In addition, you may be paying a higher interest rate in return for the low payments. You could end up owing more than the house is worth.

4. Loans Requiring Personal Guarantees

When you personally guarantee to pay a debt, the lender has all of your personal assets (not protected by law) at its disposal to satisfy your debt. Should the house you borrow against drop in value and go into foreclosure, and should the lender not recover its loan balance, the lender can take your bank account or other property that you own.

Most borrowers do not realize this. In states where trust deeds and trustee sales are common, banks typically do not pursue other assets of the debtor, but they can and have. In mortgage states, lenders routinely get deficiency judgments and pursue other assets the borrower has to recover their loan plus the costs of foreclosure.

If you just have one house and not many other assets, the lender will probably just write off the deficiency and not pursue you. However, if you own several houses with equity, then the lender may well go after your other houses to recover its money and costs.

The next time you borrow from a bank, read the paperwork that it makes you sign to get the money. You will notice that it heavily favors the bank. If you plan to acquire a large amount of real estate equity, every loan you get from a bank will put that equity at risk if you can’t make your payment on the loan.

Investors with bank loans lost their property due to this cross liability when they failed to make payments on one loan. They would lose one house, then the bank would come after another and on and on until the investor’s houses were all gone. You will not be able to borrow once a bank starts foreclosing on your property.

Learn to finance with nonrecourse loans and reduce your risk of loss during a recession.

5. Borrowing Against the Wrong Collateral

The best collateral for a loan would be a property that is easy to sell and that can rent for more than enough to make the payments on the loan.

Properties that are hard to sell are often older, need work, or are in declining neighborhoods. In addition, some houses are just strange and don’t appeal to many buyers. A one-bedroom house or a five-bedroom house both have limited appeal. In our town we have a house that looks like Noah’s Ark. It is fun to look at but hard to sell.

Buy conventional-looking houses in well-maintained neighborhoods, and if you have to sell in a hurry you will be able to command a higher price.

Be sensitive to the ratio between the price of the house and the rent it will generate. Buy houses that will produce enough income to pay the expenses and repay your loan. In more expensive markets, buying on creative terms or with a larger down payment may be necessary to avoid having negative cash flow.

Early in my career I bought a number of older, less-expensive houses in the path of progress. Thirty years later, these houses are still in the path of progress. Because they are older and destined for demolition someday, they are a challenge to manage.

When I tried to sell these properties, I found that my tenants could not afford to buy and that my only market was other investors. They could not get bank loans, so I had to sell with owner financing to get rid of the properties.

Rules for Borrowing Safely

1.   Buy properties that produce enough rent to pay the expenses and repay the loan.

2.   Buy properties that are relatively easy to manage and easy to sell.

3.   Avoid personal liability on any high-risk loan.

4.   Borrow with the longest term possible—you can always pay it off early.

USING LEVERAGE WISELY

Leverage lets you do things that are impossible without it. You can lift a very heavy object, for instance a car, with a simple jack. A six-year-old who weighs fifty pounds can balance her two-hundred-pound father on a properly positioned seesaw.

In real estate, you can manage fifty or more houses without employees using systems that allow you to delegate, as I teach in my management course. These systems allow you to leverage your time. Or you can start with $10,000 and acquire a million dollars or more in property without ever borrowing from a bank.

Leverage also has its ugly side. Anyone who has been upside down with a loan balance greater than the property value knows the pain of leverage gone bad. Anyone who has purchased a property with negative cash flow has paid for a lesson far more expensive than a seminar.

Leverage can lead to a fortune or bankruptcy. Here is the most important thing to know about leverage: some loans are far more dangerous than others, even if they are the same amount and have the same terms.

Millions of borrowers lost their property because they borrowed from the wrong lenders, lenders who immediately sold their loans. Other investors survived and even prospered with the same amount of debt.

The losers were encouraged to borrow by lenders who had no concept of the risk of borrowing. Bankers used to understand risk, and they would refuse to lend to those who probably could not repay. Today, the people making the loans are commissioned salespeople, not bankers.

Before you ever borrow again, take the responsibility for making the decision to borrow. Don’t let a salesperson talk you into a loan you don’t need or may not be able to repay. Make the decision to borrow based on your research and knowledge of the property and the income that it will produce.

SCHAUB’S LAWS OF LEVERAGE

Leverage Can Increase or Decrease Your Cash Flow

How can borrowing possibly increase your cash flow? Let’s say that you have $100,000 to use to buy property. You can buy one house with the $100,000 that will produce $8,000 net annual income ($666 a month), or an 8 percent return.

What if, instead of buying just one house, you decided to buy four houses, each with $25,000 down and you were able to get four $75,000, 6 percent thirty-year loans? The payment on each loan would be $449.66 (call it $450) a month. Now, each of your four houses would have cash flow of $666 per month less the $450 payment, or $216 per month. Your net spendable income would be $864 (4 × 216). That is substantially more than the $666 one house would produce. In addition, the four loans would pay down approximately $304 per month the first year, with principal payments increasing every year. Together the income and principal paydown total $1,168 a month compared to $666 a month if you owned one house free and clear.

Negative Leverage Reduces Your Cash Flow

“Negative leverage” occurs when a loan reduces your profit on a property. Using the same four houses mentioned above, change the interest rate to 9 percent and the payments to $603.47. Now your spendable income on the four houses is only ($666 − $603) = $63 a month, or a total of $252. This is far less than the $666 a month you could realize from one free-and-clear house. Of course, in an appreciating market owning four houses will make you more money than if you were to only own one house.

The amount of your payment is the key here. A higher interest rate will normally increase your payment but a shorter term can too.

These are all before-tax examples. Beginning investors often pay little, if any, tax. If you happen to be in a high tax bracket, you may want to use leverage to lower your tax burden. Don’t confuse negative leverage with tax shelter. You will still have more after-tax income with positive leverage. Paying more interest to pay less in taxes is faulty thinking. Would you want to pay more to your plumber next year and have bigger deductions? Of course not, and you don’t want to pay more interest to your lender, either.

Leverage Can Increase or Decrease Your Risk

Does more leverage increase your risk? Is a 90 percent loan more dangerous than a 70 percent loan? It’s easy to say yes, because normally the larger loan would have larger payments, thus more risk. But, from a different perspective, with which loan do you have more to lose if disaster strikes and you lose the property? Obviously, the answer is the smaller loan.

Lower payments give you the ability to reduce your rents in tough times and still survive, thus making your debt safer. A loan with lower payments would reduce your risk. However, if you could not make your payments, a lender would rather foreclose a 70 percent loan, because the lender has a better chance of recovering its money instead of the house.

Therefore, an investor with a loan of 90 percent is in a better negotiating position should he have trouble making the payments because of a downturn in the economy. Combine this idea with avoiding personal liability on a loan and the borrower is in a much stronger negotiating position with a very small equity.

HOW THE TYPE OF COLLATERAL IMPACTS YOUR RISK

Some properties are much easier to sell at a near-retail price than others. This is liquidity, or the ability to get most or all of your money back from an investment quickly. Note that there are two important points—speed and recovering your money. Securities salespeople brag that stocks and bonds have liquidity, meaning you can sell them quickly. Of course, you can sell some real estate quickly (hold an auction), but the amount that you recover will depend on what type of property you own.

When banks curtail their lending, they stop lending on the hardest to sell properties first. Raw land, commercial and office buildings, and small investment properties are the first to be eliminated by the bankers. Owner-occupied single-family houses are the bankers’ best collateral, so buyers can often get house loans when all other loans disappear.

If you are going to be stuck with a property during a recession, you don’t want to be stuck with property that cannot be financed. If you have to sell to a cash buyer during a downturn, the price you get may be a small fraction of the property’s actual value. A great time to buy is a lousy time to sell.

WHOM YOU OWE MATTERS

Banks and other institutions are harder to deal with than individuals. When you deal with an individual, a seller, or an investor, you are talking about their money. If someone’s personal funds are at risk or if they can receive money that is owed to them sooner, they are generally very interested in talking.

At a bank, you are talking with an employee who is much more interested in keeping his job than helping you, even if it is in the bank’s best interest to work with you.

As many builders and developers learned the hard way, if your bank goes broke, it may cause you to go broke. A builder or developer with a bank commitment to fund a project loses his ability to borrow if the bank goes broke. This generally happens during an economic downturn, so another bank loan is not available. That leaves the developer stuck with a partially finished project that has very little value.

Investors who have loans with “their” bank would face a similar problem, should their bank fail. Their loans will be acquired by another lender that will be difficult to negotiate with if the borrowers have a problem.

Consider the difference if you have loans with sellers or with investors instead of a bank. The seller or investor generally wants her money back, not the property. She will renegotiate the terms of a loan to allow you to survive a downturn if you have a plan to repay her eventually.

What you need in a downturn is an extension of time to pay. Markets recover eventually, so if you can negotiate an extension with your lender, you can survive and eventually repay the loan.

A MAJOR ADVANTAGE OF OWNER FINANCING

When you buy with owner financing, you can avoid personal liability for the debt. Therefore, if you cannot make the payments, you can give the property back to the seller without the fear of having the liability for the debt. This is not the case with institutional loans. If you have borrowed cash from a bank to buy a property and do not pay it back, the bank can take other assets that you have in order to satisfy your obligation.

As a private lender, I have reduced interest rates and lowered payments for borrowers who owed me but could not afford to make payments. My borrowers have been able to hold on to property and survive to eventually make a profit. I made less of a profit, but by helping them survive we both came out better.

LONGER REPAYMENT TERMS (WITHOUT PREPAYMENT PENALTIES) ARE ALWAYS BETTER

If you like to pay off debt, as I do, then a short-term loan with large principal payments has some appeal. I have one loan that pays down just over $400 a month. If I break even on that property, I still make $400 a month—but when?

When do I benefit from that $400-a-month principal reduction? The answer: when I sell. Because I have the obligation to make the same loan payment next month, I get no advantage from the $400 paydown. I won’t get it back until I sell.

My lender, on the other hand, gets the extra $400 each month. It makes their loan safer. It gives them a higher return on their money. That brings up the question: If it’s good for the lender, is it bad for the borrower?

If I plan to keep this house for a long time or forever, does it make sense to pay down $400 a month, or would I be better off with the $400 a month in my pocket today? Your choice: $400 a month more cash flow or $400 a month saved up for you until you sell the house.

Hopefully, you voted for more cash in your pocket today. How can you have less principal paydown? Borrow with long-term loans from institutions and interest-only loans from investors and sellers whenever possible.

Every deal is a little different. If a seller insists on some amortization and the rest of the deal is good, take it. Most investors are good at math and if they lend you $100,000, they would rather keep their entire $100,000 invested with you and receive interest on the entire amount each month. Getting a little principal back each month that will go into a low-interest account is not wise investing.

Risk tolerance decreases with age. By learning to use safe leverage, you can continue to borrow wisely at every age. Although your personal holding period has limits, it’s okay to get a new forty-year loan when you are eighty, as long as it’s a safe loan with no personal guarantees, and the payments are ones that the tenants can easily repay.

Your heirs will probably inherit some real estate. If it is encumbered with safe debt, they can inherit more (two houses with 50 percent loans rather than one free-and-clear house). As I discussed earlier, this portfolio could have more cash flow.

NEVER SIGN A SHORT-TERM LOAN WITHOUT A WAY OUT

If you have bought property with owner financing, you have probably been asked to pay the loan off in a shorter time than you planned. It’s not uncommon for sellers to ask for a “balloon clause” requiring that the note be paid in full at a certain date. This is dangerous for you as a buyer, since you cannot predict what the credit market will be like in, for example, five years.

It is reasonable and wise for you as a buyer to counter with this offer: “If you are unable to refinance the property in five years at a rate equal to or lower than the rate you have agreed to pay, you have the right to begin amortizing the loan for the next five years with payments based on the same interest rate and a thirty-year amortization schedule.”

Ten years is generally long enough for the credit market to cycle. If you can’t get a loan in five years, you may not be able to sell at a fair price, either. Building in an extension of time makes the financing safer.

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