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

Jeff Brown
5 min read
Increase Debt To Retire Better And Become Debt Free Sooner — What? Huh?

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.

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

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.