19
GETTING YOUR HOUSES FREE AND CLEAR
SETTING YOUR GOAL FOR FREE-AND-CLEAR HOUSES
The first step is to set a goal for the number of free-and-clear houses that you want to own. Work backward into this goal by first setting an income goal and then asking how many free-and-clear houses you will need to produce that target income.
For example, suppose that the house you would like to buy in your town produces rent in the $1,200 to $1,400 per month range and has operating expenses equal to about 40 percent of the gross rent. How many houses would you need?
Use real numbers in your town, and then make a projection using today’s values and income to determine how many houses you will need to earn your desired income. As rents increase with inflation, this income will provide you with the same lifestyle, even as consumer prices increase over time.
THREE PLANS FOR GETTING YOUR HOUSES FREE AND CLEAR
Plan 1: Use the Increased Cash Flow from Increasing Rents to Pay Off the Debt
How many years will it take you to pay off a thirty-year loan? Thirty years if you make the same payment each month for thirty years. If you increase the amount of the payment you make as you raise your rents; you can pay off your loans much sooner.
As you acquire property with fixed payments—amortizing loans—your cash flow will increase each year as you increase your rents. You can use the increasing cash flow from one house to pay off the debt on that house.
If your rents increase at an average of 5 percent a year and you use that increase to make additional principal payments on your loan, you can pay off a thirty-year loan in just over fourteen years. Table 19.1 shows what your payment schedule would look like if you applied your increasing rent to your loan each year. The original loan is a thirty-year $150,000 loan with 7 percent interest and payments of $997.75.
Table 19.1 Paying Off Your Thirty-Year Loans in Less Than Fifteen Years
Although this is a simple plan and it works, it is not the quickest way to pay off the debt on your houses. A better plan is to use the cash flow that the house produces to continue to buy other houses until you have the number of houses that, if paid for, will produce the cash flow that you need.
When you pay off a loan with an interest rate of 7 percent, you are investing your money at that 7 percent rate. If you buy another house with a small down payment, the return you will make on your investment during the first few years could be 20 to 40 percent, or higher. You can then use those profits to pay off your loans, and you can pay them off faster.
If you make prepayments of principal on any loan, keep careful records of your extra payments. It would be wiser and easier to keep track of if you just made one larger prepayment of principal each year rather than making increased monthly payments. For example, in year two, rather than making twelve payments of $1,050, you could make one prepayment of $600 at the end of the year. You would pay a few dollars more interest during the year, but the fourteen-year payoff plan would still work.
Bank bookkeepers do make mistakes, and when you make many unusual payments, they may not record them accurately and give you the proper credit. Keep your own records, keep proof of your payments, and make your own amortization schedule by using programs that are widely available.
Plan 2: Buy More Houses Than You Really Want and Sell Off Some to Pay Off the Rest
Knowing that you can make more than a 7 percent return when you buy a house as an investment, a better plan is to use the profits that your houses will generate to buy additional houses. This will take more work—buying and managing more houses requires more of your time and effort—but the results can be spectacular.
If, using the same cash flow as in the preceding example, you took the excess cash and bought more houses, here is an example of how the plan would work: Year 1, buy the first house. Years 2 through 10, buy another house each year using the cash flow from the earlier houses to provide down payments and to fund any cash-flow shortages in the new houses that you buy.
Remember the 10/10/10 rule? Here is an example of how the equity would grow in the first house that you bought if you did a little better than 10/10/10. You will do better as you practice making offers and learn your market.
Using a conservative rate of growth of 5 percent, let’s look at the value and the debt after just ten years:
It’s hard to project what income tax rates will be in ten years, but even after taxes, you should be able to sell one house, gross $194,000, pay taxes, and pay off another house that will have a loan balance of about the same, $125,920.
Rather than waiting fourteen years to pay off a loan using the increased rents, this plan allows you to get a house free and clear in ten years at a conservative 5 percent rate of growth.
Plan 3: Refinance Some Property to Pay Off Others
If you follow plan 2 and continue to buy houses at below-market prices and with good financing, you will one day own a number of houses. Each will have a different loan balance and a different payment schedule. Some of these loans will have better interest rates and terms than others.
Take the time to carefully study the payments and amounts on all your loans and compare them. Which loans have the largest payments compared with the amount that you owe?
Suppose that you owned three houses with the following loans:
Without knowing the interest rate on the loans, which would you want to pay off first? Obviously, the one with the highest payments. You can invest the same $100,000 and increase your monthly cash flow by paying off the loan with the largest payment. The interest rate is not as important as the ratio between the amount that you owe and the amount of the monthly payment.
As loans get older, their balances pay down, but the monthly payments remain the same. House 3 may have started with a $150,000 loan that has been paid down to $100,000.
If you are going to refinance one or more properties to pay off another, either refinance or pay off the loans with the highest payments to increase your cash flow.
Looking again at the house in the preceding example:
Banks generally will lend investors 80 percent of the market value when you refinance a property. If you refinanced this house with a new 80 percent loan, you would be able to borrow $256,000.
If you owned another house with about the same loan balance of $126,000, you could pay off the loans on those two houses by refinancing just one house.
Now you would own one house free and clear and one with an 80 percent loan. If you can refinance when rates are low, you should be able to cover your payment with the rent that one house produces.
Owning a house free and clear and one with an 80 percent loan is a much safer position than having a $125,000 loan against both houses. When you have a large loan balance, the lender will not want to foreclose and will work with you in the event you have financial difficulties. When you have a small loan balance, the lender will gladly foreclose, confident that they will be repaid.
Another advantage is that replacing two old loans with a new thirty-year loan will reduce your payment. If you can borrow at a lower interest rate, your payment will drop even more.
A third advantage is, because you have not sold a house, you will pay no taxes. Because you have not sold, you still have both houses earning money for you.
You can use all three strategies, depending on the market, your desire to own a certain number of properties, and your need for cash flow. One thing is certain: You will change your plan if you start today and invest for the next ten years. You will continue to learn more and will find ways to make even higher returns with your cash.
INCREASING YOUR PROFIT DRAMATICALLY WITH A PHONE CALL
Always ask for a discount when paying off any loan. This may seem strange to you, but lenders, especially private lenders and some smaller banks, want their money back sooner. To get it sooner, they will take less than the full face value—but only if you ask them to do so.
You must make this offer before they know that they will be paid off. You can ask them this way, “I was planning to pay off some of my loans, and yours was one I was considering. Would you be interested in being paid off today rather than over the next ten (use the real remaining loan balance) years? If so, my closing costs to refinance and pay you off would be $4,320. Would you be willing to pay that amount if I paid your loan off now?”
You receive discounts by asking for them. I owed one seller $10,000 due in less than one year. She offered to take a $4,000 discount to get her money nine months early. It would have been smarter for her to wait the nine months. Where else could she earn $4,000 on a $6,000 investment in nine months? I knew that I was going to pay her, but lenders never know that they are going to get paid until the check is cashed. The certainty of money today, rather than waiting for it, is worth a lot.
Check with your tax advisor on how to report any discount you are able to negotiate. The amount of the discount probably will be taxable, but if you save $4,000 and owe a tax of $1,000, you are still $3,000 ahead.
BEING EFFICIENT WHEN REFINANCING
Interest rates and the credit market have cycles. When the rates are low and credit is loose, borrowing money to restructure your existing debt or to finance new purchases can be profitable. When interest rates are high, you don’t want to replace a low-interest loan with a high-interest loan.
If you are a long-term investor, you can play the cycles. When rates are low, borrow when you can refinance your debt and reduce your payments. It costs less to refinance one house than three houses. If you can, refinance just one with the most equity to get the cash you need to pay off other debt or for other investment.
INCREASING YOUR INCOME TODAY BY SPENDING SOME OF YOUR PRINCIPAL
You can increase your income even more by systematically selling some houses.
By talking to my estate attorney friends I learned that most people who accumulate significant assets during their lifetimes become more conservative as they age and end up with most of these assets in their estates.
Unless you have a reason to leave a large estate, you can sell some of your assets and spend or give away the money while you are alive. One of my favorite preachers likes to say, “Do your giving while you’re living, so you’re know’n where it’s going.” People who discover the joy of giving really get a kick out of making gifts that help others change their lives. Give while you are alive to see how your gift makes a difference.
If you supplement your rental income with income from sales of properties, you can meet your financial goals quicker and do it with fewer properties than if you depend only on the rental income.
Suppose that at age sixty you own twenty houses; ten that are free and clear and ten with amortizing loans. The loans on the ten financed houses all will be paid off within the next twenty years.
Your plan is to produce the greatest possible income during the next twenty years so that you can enjoy those years to their fullest, and then at age eighty, you want to own ten free-and-clear properties to support you comfortably for the rest of your life.
During the next twenty years, you plan to sell ten houses to increase your income, keeping the remaining ten houses for your more passive retirement years. Today, each house is worth about $150,000. Your plan is to sell one every two years on average to increase your income by about $75,000 (in today’s money) per year. You can adjust this strategy to get the best prices by selling only in strong real estate markets.
Selling will reduce your workload, since you will have fewer tenants and houses to watch over. It will also reduce your rental income over time. This may be offset by increasing rents.