Why I Borrow at the Terms I Do
I almost always borrow money from private lenders to buy my houses. I borrow at the following terms;
$0 Down payment
5 yr Term
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 payable to my private lender when I borrow the acquisition money.
Then, a 2nd Lien goes on the property in MY FAVOR when I sell the property to my buyer and owner finance the balance they owe me. I owe a payment on a first lien to my private lender and my buyer owes me a larger payment for the second lien. My buyer pays me and I pay my lender; my buyer’s mortgage “wraps around” my lenders mortgage.
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, preserve and even grow their principle. 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 is principle and how much is interest. They have to break out the principle portion and deposit that amount in a separate account. Then they have to go and deposit the interest portion in to yet another account.
It’s too complicated for them.
Most of my private lenders only want to spend the interest. Simple enough right? Again, I’d prefer a fully amortized loans say 8% for 20 years, however, my private lenders tend to be up in age and unwilling to obligate their money for long periods of time…and a 20 year term is simply too long for them. A 15 year term and even a 10 year term seems to be too long for them as well. This is part of the reason I arrived at a 5 year term.
3). As the borrower, 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 your 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.
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.” The only recourse against you (as the borrower), if you don’t pay, is the lender can take the property from you. The lender CANNOT 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’ll 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 your 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: Yes, you could renew but at some point something has to happen. Rarely have I ever had to ask for a renewal. 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, strangely enough, when I do pay them off they want their money back out immediately. The answer to the question, “What happens at the 5 year Balloon time?” is I rarely make it to that time. Something always happens before then; orchestrated or not.
Remember, my typical private lenders 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 I send them each month. By now, they’ve grown to trust in that monthly payment’s arrival. They are relaxed knowing that there are always checks coming in 30 days, and those checks 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 just paid off and wants their money back out. Refer to #1.
#3. Replace Them with a “Low Interest” Institutional Loan
Did you know that smaller community banks will take your owner financed note as collateral? It’s not that difficult to get four or five little community banks competing for your business! It’s called “Hypothecating the Note”: you pledge the note as collateral and refinance the underlying debt.
EXAMPLE: Let’s say an investor has $1,000,000 worth of private lender debt up for re-finance and they took their spreadsheet to 4 community banks looking for certain terms (+/-)
The loan has to be fully amortized
(Meaning the loan has to be for a full 15 or 20 year term…the bank has no option to discontinue the loan if the payments are turned in and your reporting is timely)
– 4.5% initial rate (Prime + 1)
– The rate will probably have to adjust every 5 years at Prime + 1 (+/-)
– There definitely has to be an interest rate cap (I’ve seen 6.5% to 7.5%)
– There can be no covenants
When you move from 8% interest only, private money loans, to a 4.5% institutional amortizing loan, your payment goes up by $1,017 per month, but your principle reduction goes from $0 per year (Interest only loan) to $67,000 per year in the first year of the amortization and gets to be more and more with every passing year.
#4. Sell the Note:
After five years of collecting payments, the note balance should be down and the property value should be up. By the time 5 years pass this is what we call a “well seasoned note” (Meaning it has a good performance record over a decent period of time). If your 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. Pay the Property Down or Pay the Property off!
If you do this business right for 5 years you should have the money to pay the property off! If you fall a little short, certainly you could pay the property down enough to get an extension or to make finding a replacement lender an easy task.
#6 Deed the Property Back to the Lender and Call it a Day!
Bare with me here…
If all else fails, give the deed to the property to the lender! Since you borrowed non-recourse, this is the worst case scenario. Look at it like this; if you got into an investment property with none of your own money, and collected a down payment (you put in your pocket), and then collected a positive cash-flow of $350 to $450 per month for 5 years (you put in your pocket), and then you had to give the property back in 60 months…would that be such a bad deal? NO, IT WOULDN’T! Some would call this a strategy! This is the worst case scenario.
EXAMPLE: Let’s say you got $10,000 down and collected $450 for 60 months.
($450 x 60 = $27,000) + $10,000 is $37,000. That a great investment considering you have $0 out of pocket; an infinite ROI! However, you do have a reputation to protect.
There should never be a need to give a private lender the deed to your property. You should never have to do it!
There should always, always be another lender or a note buyer in waiting. Giving back deeds is not the goal. If you give deeds back you are going to lose your private lenders…and this is counter-productive.
This is the last option and should never be taken lightly.