The Art of owner Financing and Private Money Terms
"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
- -There were no covenants
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)
- -9% interest rate cap
(maximum interest rate possible)
-15 year term – fully amortized
(Fully Amortized – meaning no “Renew & Adjust”…just adjust)
- -No Covenants
(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--
That is fantastic! I'm currently looking at some creative financing solutions and this explained it perfectly.
Thanks!
Thanks for this informative post. I've been looking into creative financing and your borrow formula may just work for me.
Wow! Thanks for the informative post @Mitch Stephen.
Good info. Thanks for sharing, @Mitch Stephen.
That is exactly what I do. It works great for the folks loaning me the money, they get a good interest check each month and I get to keep buying. No closing costs, no loan origination fees, no appraisals.
@Mitch Stephen. Do you always sell these homes in as-is condition? Or are there others that you are forced to do some rehabilitation to get in livable condition?
Dustin,
I try to do as little work as possible. Believe me, the best plan on the planet is
BUY IT - DON'T FIX IT - OWNER FINANCE IT for Double ...and watch your buyer go over budget fixing up your collateral. This makes for a great note sale with NO Discount. Now, there's a time and a place to do a little rehab; It makes sense to do some work especially when it's cosmetic.
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#3 Guru, Book, & Course Reviews Contributor
- Investor, Entrepreneur, Educator
- Springfield, MO
Mitch, I know you are an author, nice story telling.
Problem is, your stories go out to the newbies, like those posting above, giving them total BS crap and dangerous ideas to play with that are illegal and unethical, I won't even touch the unethical as I'm not writing that much.
Let's not even begin with Dodd-Frank, let's start out in San Antonio, Tx. predatory dealing and lending. Prove that the 23k house you bought is worth 54K or something, you mean to say you run around inside the I10 loop finding 54K properties and you buy them at so something? If you are, fine, if not, you not only fit the City Ordinance concerning predatory practices but you blow it out of the water at selling 50% over value.
Still staying local, you're a lender as well. Predatory lending practices get tagged on there as well. Check with your TX state banking authority as well as TREC.
Knowing just a bit about San Antonio, I'd suppose that in that group of buyers, you're probably dealing with many under educated, less aware, non-financing persons who have difficulty with English or English as a second language, an ethnic group of Hispanics. Problem is in place like that, you bump into fair housing issues and fair lending issues concentrating your business in minorities, yes, this is federal.
I'm sure that the State of Texas also has consumer protection laws concerning dealing with seniors, most states do.
Non-recourse lending or borrowing is not for the amateur lender or borrower, since investors present the terms to their "money investors" they are liable for what they get these people into. There are cases where non-recourse financing must be used, such as with tax qualified retirement accounts, bond financing which is beyond the scope of this site, but otherwise, there are tests as to non-recourse financing with prudent lending practices and you elderly lenders don't fit as non-recourse lenders. Saying, the marketing aspect of obtaining non-recourse is again misleading elderly lenders from generally accepted practices providing them with security and recourse. Dealing with retirees is a delicate area, I've seen brokers nailed for such practices with seniors and there was no loan default, it was simply based on the unfair loan covenants being lop sided in personal financing transactions, a broker lost his license!
At least you didn't say what the bank valued the loans at, hopefully they did their due diligence taking your notes as collateral. I suppose again your deals were pre-Dodd-Frank as those over valued notes would be illegally originated now.
You're speaking of hypothecation of notes, using notes you hold as collateral for other loans advanced. Selling over market homes and financing them is a really good way to get yourself involved in bank fraud! Presenting 50K notes on 25K properties showing your assets at 50K as secured. .......No!
Even suggesting that walking away to an obligation owed to some retiree private lender is beyond repulsive, just walk away because you did it on a non-recourse basis. That is exactly why non-recourse transactions are predatory when used improperly. It sure sounds great that an investor can't be held personally liable, but that is for sophisticated lenders to determine, not elderly individuals who were "sold" on their investment ideas. Had you said you had done that, I'd really be coming off the ceiling, but at least you claim you haven't.
And, as a note shuffler, borrowing, creating new loans, collateralizing notes, you're now in the world of mortgage brokerage activities. Now you're hitting the big time, federal laws, go get a mortgage broker's license.
Having other investors lying in waiting to fund your next deal, are they used repeatedly, now investors can also address SEC requirements. Not jut 3 guys funding for, heck no, we have 25 old guys with money, we move there money in to pay off exiting debt with other investors........HELLO..... does Bernard Madoff ring any bells?
A mortgage broker here in Springfield got 10 years in federal prison for using other investor's funds to payoff obligations to prior investors without having sufficient capital involved to meet obligations, it's covered under PONZI SCHEMES!
Yes, guy by the name of Mr. Charles Ponzi discovered this trick, he's famous now, keep it up, you may be too.
I have no idea why con artists pick on real estate deals as much as they do, I guess it's the easy pickings among the public playing on people's greed while fleecing them.
I'd change the title to this thread, the "Art of The Scam".
Oh, PS. gurus usually come back saying their methods are fully compliant, they have a room full of attorneys, everyone is fully informed, etc. ..... Right, it's clear there isn't enough knowledge to begin to fully disclose the issues. So, whatever. Horsefeathers! :)
@Mitch Stephen. Thank you for a wonderfully thought provoking post. Inspires me to consider new possibilities.
@BillGulley. Bill thank you for your down to earth comments. Inspires me toward balanced reasoning.
Bless you both
@Mitch Stephen -- thank you for your generosity with this post and your other resources.
How are you finding homes for $23k that people are willing to buy for $57k without any extra work done and for 10.5% interest rates?
Am I missing something?
Originally posted by @Bill Gulley:
Mitch, I know you are an author, nice story telling.
Problem is, your stories go out to the newbies, like those posting above, giving them total BS crap and dangerous ideas to play with that are illegal and unethical, I won't even touch the unethical as I'm not writing that much.
@Mitch Stephen, @Bill Gulley
From my understanding of Mitch, he is not only an author, but an investor of over 1,000 deals under his belt. He is not a born writer and unlike some authors of REI books, what he wrote stem from decades of experience doing owner financing deals. Allow me to try clarify some of the concerns raised here, if I may.
1. As for Dodd-Frank, I believe Mitch uses RMLO (Residential Mortgage Loan Originator) when qualifying buyers, which seems to work well for all investors doing owner financing in Texas.
2. In the matter of 'Prove the 23k house you bought is worth 54K or something...', I think Mitch does a ton of marketing to purchase properties well under its ARV, e.g. 50% ARV- these houses may have deferred maintainance that bring the value down, e.g. 23K at the time, but could worth e.g. 54K when fully renovated. Therefore, if an appraisal has to be done, the number may not be too far off $54K. Oftentimes buyer would do repairs after move-in, and in 5 years appreciation plus buyer renovation may bring the FMV to 54K, if not more. Under these circumstances, there is probably no 'predatory practices' in any of the transactions.
3. A huge difference between Mitch and Bernard Madoff/Ponzi is Mitch's notes are backed by real properties and buyers making timely payment over the years, while that's obviously not the case with Madoff or Ponzi.