Personal Finance

Increase Debt To Retire Better And Become Debt Free Sooner — What? Huh?

Expertise: Personal Development, Personal Finance, Mortgages & Creative Financing, Real Estate News & Commentary, Business Management, Real Estate Investing Basics, Flipping Houses
248 Articles Written
Retirement

What kinda double talk is this? Like so many things in life, first impressions are often best kept in reserve ’til the whole story is known. The principle we’re gonna use to make this happen in real life is simple, and old as dirt. Borrow money at a low interest rate, and pay it off with income generated by a much higher yield investment. None of the following is rocket science. However, it’s always mystified me as to why it’s not a more universally employed strategy. Let’s do this backwards and summarize the process first, then illustrate it.

Want more articles like this?

Create an account today to get BiggerPocket's best blog articles delivered to your inbox

Sign up for free

The Scenario

  • Her goal is to be able to retire with more income than her status quo will provide — and before she’s 65.
  • She’s diverting her monthly 401k contribution to pay taxes on any unsheltered income.
  • The 50 year old investor has a free ‘n clear property (fourplex) valued at a total of $500,000 or so.
  • She refinances it for 70% of value at 4.75% interest, fixed for 30 years — about $350,000.
  • She then acquires two more properties totaling around $500,000 at 25% down — about $140,000.
  • The remaining $210,000 will be used to acquire discounted notes secured by real estate.
  • The payments from the notes will be used to pay off the property loans sooner rather than later.
  • The investor ends up with at least triple the income at retirement.

The refi terms are as follows:

A total of $350,000 at 4.75%, amortized for 30 years, with monthly payments of $1826.

The property is cash flowing at a conservative $725 monthly, but we’ll be even more conservative by assuming just $600 a month. That cash flow will be added to any other cash flow generated towards paying off loans as soon as possible.

NOTE: Refis for cash out are only possible (sans portfolio lenders) when the investor ends up with four loans or less. Those with more than four loans are barred from gettin’ any cash out on refis.

Allocation of Refi Funds

Since this investor now has two loans — her home and the small income property — she can still buy a couple more properties without having her down payment increased. She does just that, buyin' a couple duplexes for a combined total of about $500,000. At 25% down this takes around $140,000 of her $350,000 — leaving her $210,000 from her cash out refi. The cash flow from these new purchases is somewhat less than her newly refinanced fourplex, approximately $600 monthly. We'll call it $400 though, remaining more conservative. She now has about $1,000 a month from cash flow on her income properties to allot towards loan pay down.

She then takes the remaining $210,000 and buys notes at a discount — about $320,000 worth, as it turns out. The notes are paid at 10% interest, amortized for 30 years, with no balloon payments. The monthly payments on these notes adds up to, give or take, just under $2,810. We’ll round down to an even $2,800. The total cash out of $350,000 has now been reinvested.

The Next Step — Eliminating All Loans

Her cash flow and note income now total about $3,800 monthly. She will immediately apply that amount each month to the new fourplex loan payment. This will result in it's elimination in a little over 7.5 years, about 91 months. If we invoke the ‘50% expense rule‘ this results in an immediate and big time increase in the fourplex's cash flow to roughly $2,550 a month. This means the two duplexes are the next ‘dominoes' to knock down. The balance on the first duplex's loan is now a tad more than $161,700.

She'll begin applying the $400 monthly cash flow from the duplexes, plus the $2,550 from the fouplex, which will be added to the note payments of $2,800. That's roughly $5,750 a month allotted to pay off one of the remaining duplex loans. It takes our investor just 26 of those enlarged payments to pay off this loan. So far, less than 10 years have passed, and she's gotten rid of $537,500 in loans — all from investment generated income. Let's continue.

Takin’ Out the Last Loan

The cash flow from her properties is now $2,550 from the debt free fourplex — $1,275 from the debt free duplex — and $200 from the remaining encumbered duplex. Her note income remains $2,800 monthly. That’s highly unlikely, but we’ll address that later. She’ll now be happily adding a total of $6,825 to her last monthly payment. This results in that duplex becoming debt free in around 21 months. All three of her small income properties are now debt free. It took her less than 12 years, and the only money it cost her personally was the annual income taxes on the interest she received from her note investments. This was easily covered by having diverted her monthly 401k contribution of $1,500. No loss there, as she merely stopped throwing good money after bad.

The Bottom Line

She’s gonna celebrate her 62nd birthday soon, and retire. That’ll be a big cake. 🙂 Let’s take a look at what she created via one cash out refinance at 50 years old.

She now has cash flow of about $5,100 monthly from her three properties. This assumes that over the nearly 12 years that passed the NOI on these properties didn’t increase a dime. Her net worth from these units is $1 Million. Again, this assumes they didn’t appreciate a penny in well over a decade. If one or both went up, all the better, but NEVER project it when buying for the long haul.

Her note income remains steady at just over $2,800 monthly. That’s a total retirement income of approximately $7,900 a month, almost $95,000 annually. Now, even though she was adamant about retiring before she turned 65, she retains the option of taking all or part of this income to pay off her home loan, which is not much anyway, about $125,000 or so. If she waited just another 15-16 months, she'd have her home paid off too. I'm betting retiring at 63 might prove only mildly irritating at that point, don't you? 🙂

What if She’d Kept the Status Quo, and Never Refinanced?

No doubt she would’ve paid her home off. She’d have the $2,550 a month from her free ‘n clear fourplex. And that woulda been it. By combining a couple strategies utilizing some pretty basic economic principles, she more than tripled her probable retirement income. So, let’s revisit the note income, shall we? Her 401k? At retirement she’ll roll it over into a self-administered 401k, Roth version. She’ll invest in more discounted notes, all of which will yield tax free income. She wins again.

Those notes are written with terms encouraging early payoff. In fact, in the last few years they’ve been paid off in an average of 2-5 years from the date originated. I didn’t project them being paid off, even in over a decade, to avoid comments about my crystal ball gazing. 🙂 If her notes had indeed followed the empirically demonstrated recent trend, they’d of all been paid off, at a handsome profit, sometime along the way. This would’ve allowed her to then use the after capital gains tax profits to buy more notes, with higher aggregate monthly payments. She would’ve been able to retire 1-4 years sooner than this example. But since nobody can predict when notes will be paid off, I simply ignored the likelihood, and let it slide.

Let’s say they paid off the day she retired, just for fun.

Her after tax proceeds would’ve amounted to around $260,000 or so. This would’ve allowed her to buy more notes, maybe $400,000, give or take. This would take her note income from $2,800 monthly to roughly $3,500 a month — a $700 a month raise. In retirement. This will happen every time one of her notes pays off. Not bad.

And that’s one way to increase your debt in order to end up debt free with far more retirement income — sooner.

Photo: Neil Kremer

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

    Mark Ferguson
    Replied over 6 years ago
    Finding a good portfolio lender is a key to my strategy. They let me finance as many properties as I want, I can do cash out refis with more than four mortgages. I can get 20%+ cash on cash returns on single family homes and I am taking as much debt as I can I buy as many properties as I can.
    Mark Ferguson
    Replied over 6 years ago
    Finding a good portfolio lender is a key to my strategy. They let me finance as many properties as I want, I can do cash out refis with more than four mortgages. I can get 20%+ cash on cash returns on single family homes and I am taking as much debt as I can I buy as many properties as I can.
    Roy
    Replied over 6 years ago
    Mark, Just started looking into the portfolio(blanket) lending and having a hard time finding one locally in alaska. Would you be willing to share the information on who your dealing with for these loans? We are looking at picking up groups of SFR’s, say 4 to 5, and bundling them like a traditional multi-family under a portfolio loan for the ones that cash flow consistently but are not appreciating quickly. Roy
    Mark Ferguson
    Replied over 6 years ago
    I deal with First Bank in Colorado. Finding a portfolio lender usually requires finding a local lender that will work with local buyers. I’m not sure my lender would bundle multiple properties together like that, that sounds more like a commercial loan. I would call all the local banks in your area to see if they lend their own money and would be willing to work out a deal like that. I get individual loans on each property.
    Roy
    Replied over 6 years ago
    Jeff, Once again the ability to be creative is limited by the imagination. I knew how notes worked, but when combined with “debt stacking” it creates a pretty impressive strategy. Thank you for the great article and yet another jump start for even more ways to retire comfortably. Roy
    Jeff Brown
    Replied over 6 years ago
    You bet, Roy. Thank you. Reply Report comment
    Jeff Brown
    Replied over 6 years ago
    You bet, Roy. Thank you.
    Brandon Turner
    Replied over 6 years ago
    Jeff – this is some epic [email protected]*%. 🙂 Great writing, great post, great ideas! Thanks for posting this! I need to re-read a couple times, cause there is a lot of great stuff in there! Then I need to follow!
    Jeff Brown
    Replied over 6 years ago
    Thanks so much, Brandon. Actually, you’re the perfect investor for an approach like this.
    Charles McNelly
    Replied over 6 years ago
    I was told by my lender that she can do a cash-out refi up to 65% LTV after 6 months from purchase date. I had 4 loans at that time…now working on #6. This was in December of 2012. I’ll be hoping she can still do this as my 6 months seasoning will be due in about 2 months!
    Jeff Brown
    Replied over 6 years ago
    If they’re Fannie/Freddie type loans it’s unlikely, Charles. If your lender is a ‘portfolio’ lender, i.e., not selling the loan, then I’d count on what she said. With Fannie/Freddie if the borrower has over four loans, they simply won’t get cash back on a refi.
    Lee Keadle
    Replied over 6 years ago
    I think it’s safe to say that you’ll be retiring in comfort! This is the most in-depth and inspiring article I’ve seen in a few weeks. I use investment properties to plan for my retirement as well, so it’s always helpful to see how other people manage their portfolios.
    Jeff Brown
    Replied over 6 years ago
    Thanks so much, Lee. Good luck out there.
    Greg
    Replied over 6 years ago
    That’s the reason I know Jeff is da’ man. He can talk in the simplest terms, but this article shows the complexity of investment property gears that crank in that man’s head! If something confuses me, I call him up and he can cut through the cruft and get to the solution fast.
    Jeff Brown
    Replied over 6 years ago
    Thanks Greg — I’m forwarding this comment to The Boss. 🙂
    Shaine Cobb
    Replied over 6 years ago
    Outstanding! Thank you for taking the time to share your wisdom, experience and ideas. Great motivation booster. Makes me even more excited for the future!
    Jeff Brown
    Replied over 6 years ago
    You bet, Shaine.
    Jon W
    Replied over 6 years ago
    This is a great article. Well written and easy to understand, nice job. Now I need to learn the ins and outs of notes!
    Rick
    Replied over 6 years ago
    Outstanding article. It opens ones eyes to what is possible when you have the resources and the willingness to control your own destiny. Thank you for your time and sharing.
    John G
    Replied over 6 years ago
    What about this: Sell the $500,000 property and buy notes. Using similar figures that should generate ~$6690 per month with no property to manage…
    Chris Clothier
    Replied over 6 years ago
    The surprising Jeff Brown…at it again! Great article and really cool, I think, that you were able to pull this article off. You are one of the smartest, experienced guys I know in this industry and I really appreciate your articles. This is one that I am going to print out and spend a lot of time researching and discussing with my staff and some of our investors. I want to put into practice on a small scale everything you are talking about and test it out. There are some moving parts, but the simplicity is really good and the ultimate goal – again – is to own your property outright. Thanks again – Chris
    Jeff Brown
    Replied over 6 years ago
    Hey Chris — I’ll grant you the experienced part. 🙂 A guy like you will be able to make this strategy happen pretty easily. It sure speeds things up, doesn’t it?
    Robert Steele
    Replied over 6 years ago
    “She then takes the remaining $210,000 and buys notes at a discount — about $320,000 worth, as it turns out.” Is there a reason these notes are selling at a discount? Is this key to the strategy? What happens if these people stop paying on these notes? At least when sticking to just rental income you can always swap out one non-paying tenant with a paying tenant. Can you do that with a non performing note? Perhaps by selling it for an even bigger discount? I’m sure this is a fantastic strategy but it seems too risky for my tastes. Thanks for sharing!
    Jeff Brown
    Replied over 6 years ago
    Hey Robert — Your point is very well taken. However, real estate can be incredibly risky if invested in haphazardly. Notes are similar. In the example used in the post, the investor bought notes putting her in first position as the lender of record. Also, she enjoyed a loan to value, based on her purchase price, of about 52%. Note holders sell for all sorts of reasons, but when they do, the market at the time will dictate it’s value, which is virtually never the note’s face value. I acquired my first discounted not back when Ford was president, and not much has changed. What if the payments stop and you must foreclose? I’ll begin by repeating what I tell first time note buyers almost daily: “If you’re not moved to do the HappyFeet Dance at just the thought of foreclosing on a particular note you might buy, DON’T BUY THE NOTE.” That said, if you buy enough notes, you will find yourself foreclosing at some point. But with a 52% LTV, here’s what might happen. You paid $65,000 for a $100,000 note. The property appraised for $125,000, which means the note seller received a 20% down payment when they carried the note at sale. Remember, that value is post bubble burst. But let’s be Draconian about it, and say it falls another 20% in value, to $100,000. You foreclose. You sell it for $90,000 to get it done quickly, and after costs of sale you net around $82,000. However, you lost $5,000 in payments, spent another $5,000 in prettying up the house for sale, and another $4,000 on various foreclosure expenses. That brings your net down to roughly $68,000. You only paid $65,000 — you’re good. Also, if this happened after say, three years of payments, that means you’ve already collected approximately $31,500. So, even though we’ve allowed Murphy to camp out on your front porch on this one, in three years your note purchase turned your $65,000 into a total of almost $100,000. Make sense? When investing in discounted notes, Robert, the risk is established at purchase. Pay close attention to all factors, but the loan to value will be pivotal.
    Greg
    Replied over 6 years ago
    Jeff, Are you saying that the final math on this one would be: ($68,000 + $31,500) / $65,000 ^ 1/3 = 15.2% average annual ROI ^———— total years spent on this investment ^——-initial investment ^———— total rent collected ^———- final walk away cash ?? I just want to understand the math on this one.
    Greg
    Replied over 6 years ago
    ($68,000 + $31,500) / $65,000 ^ 1/3 = 15.2% average annual ROI ………………………………………………..^———— total years spent on this investment …………………………………..^——-initial investment ……………………^———— total rent collected ….^———- final walk away cash I hate when blog sites mess up my pretty formatting.
    Jeff Brown
    Replied over 6 years ago
    Hey Greg — I’m in a hotel lobby ready to head to the airport, so no handy dandy 12c. 🙂 Your numbers sound about right. Imagine when, like the vast majority of notes do, it performs to full payoff.
    Glenn Schworm
    Replied over 6 years ago
    Jeff, great article. I will be saving and implementing this strategy in our business. I always enjoy your posts.
    Jeff Brown
    Replied over 6 years ago
    Thanks so much, Glenn.
    Mike McKinzie
    Replied over 6 years ago
    Here is my question, “At what point do you “stop” the refinancing, buying, selling, managing, and REALLY retire?” My uncle is 86, has over $10 Million in loans that he gets monthly payments on and he is still looking to lend money, mainly because everyone keeps paying off his 6-10% loans. I guess the best scenario would be to hire someone to assist with the managing of a larger portfolio. But for me, I am considering refinancing my personal residence, paying off a couple of higher interest mortgages, maybe buy a rental. But doing all that increases my monthly income by only about 4-5%. What do you think Jeff? Keep ‘playing the game’ or truly retire?
    Jeff Brown
    Replied over 6 years ago
    Hey Mike — It’s really about personal preference. I’m an addict so will ‘retire’ in very small stages, but remain in the game. Others prefer to retire early and do other things. My dad retired three times, from three careers in separate industries. The key is having the options available allowing you to do what you want.
    Neil
    Replied over 6 years ago
    Great article Jeff. Just one question. Are you saying she’ll have a day job until she “retires” and that’s how she’ll be able to dump all the cashflow back to paying off the loans (i.e. not spending it on daily living expenses)? If so, I can’t help but wonder if I’d prefer to stay at my day job to allow myself quick loan payoffs, or leave early so I can be more efficient at picking up deals all day. Maybe its more of a rhetorical question. 🙂
    Jeff Brown
    Replied over 6 years ago
    Hey Neil — See my reply to Mike. When the options are available, we all exercise the ones making us the happiest. When we talk about retirement, I’ve learned it means far different things to different folks.
    Gautam
    Replied over 6 years ago
    If she reinvests all her cashflow to pay off the mortgages what about funds for repairs, vacancies, etc?
    Jeff Brown
    Replied over 6 years ago
    Hey Gautam — Greg’s right, but only in the sense of having cash reserves. Vacancies and repairs have already been accounted for in the income & expense side of the cash flow equation.
    Greg
    Replied over 6 years ago
    That’s why you need a certain amount of cash in the bank to handle those situations where you need more than the rent coming in.
    Jeff Brown
    Replied over 6 years ago
    Hey Gautam — Greg’s right, but only in the sense of having cash reserves. Vacancies and repairs have already been accounted for in the income & expense side of the cash flow equation. Reply Report comment
    Greg
    Replied over 6 years ago
    That’s why you need a certain amount of cash in the bank to handle those situations where you need more than the rent coming in. Reply Report comment
    Richard Forrester
    Replied over 6 years ago
    Jeff, great information sir. that’s something I’m really looking at, especially the notes at discount portion. I’ll call you soon sir. v/r RF