As we like to say, there is ''good'' debt and ''bad'' debt.
Of course some would say all debt is bad. In some respects we might agree with that, but we're aware that ''good'' debt enables you to create wealth.
The one advantage you have in a real estate transaction is that real estate can appreciate in value.
It's leverage that makes money for you. If you do not use leverage in a real estate transaction, you might as well go buy a bond because it's the leverage that increases your return on investment and increases your yield.
Here's an example that will show why it makes sense to use leverage and why it's better to have cash in your pocket—rather than have your hard-earned income tied up in equity in a long-term mortgage.
If you have a $200,000 property, which you can rent for $16,000 a year (without taxes and insurance), it is generating an 8% return on your investment. Not a bad return, right?
But if you take the same $200,000 property and get a 75% mortgage ($150,000) by using the New Smart LoanTM program that we employ a great deal in our business, you would have a minimum pay rate of 1.75% based on a 30-year amortization. This means that you will have to pay $535 in monthly payments, or $6,420 annually.
The property in our example generates $16,000 in rentals, and is now costing you $6,420 in mortgage payments. That means it's generating a net of $9,580 a year (without taxes and insurance).
But, since you would have only $50,000 invested in the property (the amount you would pay to obtain the $200,000 mortgage) and were getting this nearly $10,000 return, the return on your investment would be almost 20%. By leveraging your property, you have increased the yield from 8% to 20%.
So which is better?
It is clearly better to have the $200,000 cash in your pocket. With that $200,000 in cash, you could, in addition to spending $50,000 on the first $200,000 property, invest $150,000 for three more properties ($50,000 each), and you would have a grand total of $800,000 in real estate equity from the four properties ($200,000 per property)—generating nearly $40,000 in income.
That is a far better outcome than simply paying $200,000 directly for the $200,000 piece of property and having no mortgage to pay.
Hopefully it is now easier to understand why it is better to have cash in your pocket, and why it's of no value whatsoever to pour money into long-term fixed mortgages.
Investors can only benefit by shifting their investing strategy away from building equity toward creating cash flow. Paying off the mortgage deprives the investor of large quantities of cash flow. None of the $800,000 in value that is mentioned above would be available to investors who simply pay off their mortgages. The investor loses all that potential income by not capitalizing on cash flow.
Having said all this, it becomes self-evident why we propose the next strategy.
KEEP YOUR MONEY OUT OF THE BANK'S HANDS. NEVER PAY OFF YOUR MORTGAGE—NEVER!
This sounds like radical advice; and it's certainly not what most people hear from their advisers at the banks and other financial institutions. But it is perhaps the most important advice that can be given to real estate investors.
People look at such strategies and argue that they are imposing heavy risk on people. But there is risk in everything that one does—especially when it comes to investing and trying to create wealth. The only real way to avoid risk is not to invest.
What we offer is a way to generate usable cash. As part of that process we identify the risks and then help new real estate investors adopt strategies to manage the risk. We help them protect their principal while maximizing profit on as much of a tax-deferred basis as possible. The more money that can be freed up, the more managed the risk will be.
Once you accept this point of view, you are ready to move on to bigger and better things. You need to think long term, to plan not just the first transaction but future transactions.
Real estate is a great investment because it has one trait that no other investment possesses: it is not perishable. With real estate, it's possible to extract the equity built into it—and yet hold on to the asset and retain the value of the asset. Extracting equity means to take out the equity, reaffirming the fact that once the equity is sold, it's gone. Stocks and bonds don't allow for that.
To extract the equity of a stock or bond, you must sell it, and once it's sold, that's it; it's gone, and you don't own it any more. That's what makes real estate the best way to invest.
FIND A MORTGAGE FIRST, THEN FIND THE PROPERTY.
Here's a strategy that may seem unorthodox, but makes great sense: find the mortgage before the property. Many real estate specialists insist on locating a piece of property for a client first and only then searching around for a mortgage. But, one does not need to own a property to secure the loan. The property is really the last thing you need; what you need to know is what kind of mortgage you qualify for and you can find that out even before locating a property.
You could find a property first—but then it could take a long time to go through the approval process, whereas you can be approved for a specific amount of money based on becoming qualified in a relatively short amount of time. The financing is based on one's credit and one's ability to make the monthly payments. It is not based entirely on the value of the property.
One disadvantage of finding the property prior to securing the mortgage: You could become qualified to purchase a property for $1 million but could decide ultimately only to purchase a property worth $200,000.
If your credit is not good, greater attention is paid to what you own by way of real estate; and you are going to wind up with a much lower loan to value and a much higher interest rate.
You must find a mortgage first, the best possible mortgage that works best for you; it will be the mortgage that goes hand in hand with your qualifications. Finding the right mortgage is crucial. It must be a mortgage that allows the investor to free up lots of usable cash. That means finding a mortgage in which the monthly payments are as low as possible.
Make Sure Your Credit Is in Order
Being financially creditworthy is important. It does not do you much good to have a great income and good assets if you have a poor credit score.
Credit scoring is tough. Sometimes simply checking one's credit can pull the credit score down. That can really add up if multiple sources are requesting credit checks on you. If you signed on to a mortgage company, and you gave them your Social Security number, that would provide them the opportunity at their discretion to look at your credit. Those inquiries count against you. They can pull your credit score down.
The people who do credit scoring have some pretty strict rules. With a 681 credit score you could qualify for certain mortgage programs but you could easily dip below that figure, losing 20 points if you made one credit card payment late.
We recommend that you try to get these inquiries wiped off the books by writing to the credit-reporting agency and challenging the inquiry. Sometimes these companies don't really have specific authorization to request a credit report. It is important that your mortgage broker work with a credit repair company to fight with the credit companies on your behalf.
We once had the owner of a carpet store as well as a fleet of trucks come into the office. He had gotten his credit scores up and had found just the mortgage that he wanted. But his credit was challenged because each time he bought a new truck the car dealer gave his Social Security number to 20 lenders as part of the effort to secure financing for him.
The effect of all these inquiries was to lower his credit score again.
We advised the carpet store owner to work with a bank with which he does business rather than with the car dealer. The bank will be the only one pulling the carpet store owner's credit, while the car dealer is going to shop the loan to many banks. It is quite possible that the loans are being shopped to the bank the carpet store owner does business with in the first place.
People usually don't know what their credit score is. They will still insist that their credit is excellent. They brush off their problems by saying, ''Oh, I have just a few lates.'' But each of those ''lates'' probably cost them 30 points of their credit score. The public unfortunately doesn't have a true idea of how important credit scores are to obtaining a mortgage.
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Discover the Jealously Guarded Insights of Real Estate Tycoons and Hot Dealers! Back in the days of the wild, Wild West, when easterners traveled across this vast country looking for opportunity in the newly opened territories, they were often referred to as a ‘tenderfoot’.