Recently, I wrote an article about successfully managing equity from the eyes of a pretty famous financial planner and wealth building expert, Doug Andrew.
I referenced how I had originally started out on a path of trying to acquire real estate with the intentions of paying the properties off as quickly as possible. Later, I became more educated with both wealth building and financial planning techniques, and after having discussed my thoughts and concerns with my accountant and tax advisors, I changed my strategies. Today, after successfully investing in many asset classes (not just real estate), I'm truly grateful and blessed that I didn't continue down the path of paying down principle. It did take some time and experience gained over the last 26 years, utilizing Doug Andrew's strategy, to get where I am today.
Doug starts off by describing the first myth, that the best way to pay off a home early is to pay extra per principle on your mortgage. Now, the next statement he makes is pretty bold. He says that in reality, no method of applying extra principal payments to your mortgage is the wisest and most cost-effective way of paying off your house, thus defying the myth. Now, I don't know if I'm that bold to make that statement. But, I can tell you from some of my life experiences why I believe that what he says is true.
The reason I chose the story of my mom's plan is because it's a common strategy, and serving as an example, it also demonstrates some the flaws of buying into that first myth. My parents were both from an upbringing where you were supposed to go to school, study real hard, get a job, work real hard, pay your home off as quickly as possible, and live happily ever after. There's only one problem with that plan: people are living too long (by the way, today mom is 81 and my dad is deceased).
She and my pop bought their home in 1964 for $19,500 with a 25 year mortgage at 4% interest. I remember seeing one of their payments, and it was around $250 a month. So, in 1989, the house was paid off and my mom had since divorced my dad. She was 56 at the time, and it would be another nine years before she retired and encountered the reality of her situation.
To put it simply, she was equity rich and cash poor. Sure, she had a small pension, Social Security, and her house by 2004 was worth about $250K, but it really wasn't enough income to do much of anything. Taxes, maintenance, and utilities were starting to add up. Even if she sold her house and moved into a rental, she would quickly deplete her money if she continued on long into retirement (and the good news is: mom is in really good health). She really couldn't afford to buy again even if she downsized.
So, what went wrong?
Looking back, it's easy to see that mom never worked her equity. For example, if mom did rehab loans for real estate investors at 15% and borrowed out approximately $200K of the equity at 4% for the last 25 years, she would have an extra $550,000. Many folks say that lending on first mortgages at 65% loan-to-value is risky, but I think not leveraging your equity is the real risk. What a huge opportunity cost that was lost in mom's case.
Luckily, about nine years ago, I was able to intervene with some strategies to help fix the situation. I purchased mom's house, and we put the proceeds into an LLC, where mom only owns a small percentage but she's the manager and draws a salary. We invested the proceeds into reperforming mortgages that pay a nice yield close to 18%, and this provides enough cash flow to pay our interest only mortgage, pay mom a salary, and there's cash flow left over.
In fact, today, our notes are starting to buy more notes. We're well on our way to really accelerating a quarter million dollars estate into some significant net worth, depending on how long my mom lives. We managed to get all of the assets out of mom's name, which is great in regards to taxes and nursing home situations in retirement (i.e. nursing homes now have a five year look back period). Now, these are all positioned favorably for mom's future.
My First Property
In 1989, I purchased my first property, and it was a $65K duplex that I bought with an FHA, 30 year fixed mortgage. When interest rates fell a year later, I was able to refinance to a 15 year mortgage with no money out of pocket, and my monthly payment only went up by $10. I was sticking to my plan of paying this property off, just as my parents had taught me.
Then, when I got more involved in financial planning, I spoke to my accountant about the relevance of paying the property down. Around the same time, I built some commercial garages on the property for approximately $25K to $30K using credit cards. The property suddenly appraised for $175K.
Guess what I did next? I refinanced to an interest only 10 year (ARM) mortgage for $131,250, which is 75% LTV. I used that money to pay off the credit cards, and I moved into a real nice house, in a real nice area.
It would've taken me much longer to save up for the down payment on my primary residence, if I hadn't accelerated the process by utilizing the equity of my first property.
Also, I rent out both apartments in the duplex, as well as the commercial garages. After factoring in the mortgage payment (PITI), I still cash-flow approx. $849/month on the property.
My Primary Residence
Because I pulled out equity from my duplex, I literally moved with $300 paid out of pocket for my loan application. I bought the house for $190K with a seller's assist for closing costs. One year later, it appraised for $250K, and I borrowed $35K to do some real estate deals. A few years later, I refinanced it again at $356K. I took that money to do more real estate deals and even lent out some money to do rehab loans. Then, in 2005, it appraised for $560K, and I took out another HELOC for $118K and used the money to buy reperforming notes that I put in a separate LLC, with my heirs as the majority owners, and my wife and I are the managers who control the cash flow.
Then the market crashed, and the house dropped in value to about $400K, but we didn't care because we own so many notes and mortgages that we bought with the equity. To me the biggest risk would have been not separating the equity with my 3% HELOC to go by notes, that average in excess of 18% returns plus kickers. Again, my notes are starting to buy more notes. If I need capital, I can just sell or borrow against my note portfolio, which by the way, is in a separate, safe bucket.
Over the years, I've had over $2 million in equity—with 11 lines of credit borrowed at an average of 4%—that I utilized for real estate deals and notes paying 15% and better. If I had not done this, I would've lost approximately $300,000 a year. To me, that's a huge, huge opportunity cost.
So, as you can see the best way for me to pay off my real estate is on the balance sheet with my money off the table in a separated, safe bucket, of which I have many (various vehicles) and full control over. I can pay off most of my real estate anytime I feel like it. To be quite honest, I still have too much equity out there (exposed and underutilized) because banks have been too conservative lately and because appraisals have been low. But as Bob Dylan use to sing, "the times are a changin'..." and as soon as lending loosens and values return and increase, I'll be the first one in line at the bank getting another loan or HELOC. Will you?
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This article is Copyright 2014 BiggerPockets, Inc
Dave Van Horn is President at PPR The Note Co. - an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.
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