Isn’t it great that there is so many ways to get funding for Real Estate Investing projects today? That’s important since Sellers kind of want to get paid for their houses when they sell them… Right?? Now, just because there are what seems like an endless number of sources for funds, doesn’t mean those funds are easy to get… or when you can get them… they’re easy to afford. The borrower is required to, in many cases, “Jump through hoops” in order to end up with the funds they need. Credit approval, Appraisals, LTV/ARV… and, even then they usually don’t get it. All they need, is “skin in the game”.
Good debt vs. Bad Debt
Most Real Estate Investors are familiar with the expression “Good debt vs. Bad Debt”. The problem is most don’t fully understand the difference. My daughter knew the difference when she was 8 years old. I remember when we went to lunch and she went from asking me to do “plusses and minuses” to doing story problems. So, in the interest of “training her early in life”, I gave her story problems involving business. She would accidentally learn about everything from expenses, to profits… including the differences between good and bad debt. Her understanding was so thorough she could recite the definition, and more importantly explain it when asked to.
Unfortunately, we are not taught any of this in school today. We are taught how to be spenders/savers instead of how to be investors/entrepreneurs. In other words, we are never taught how “money works”, but we are most certainly taught how to “work for money”. Knowing the difference between Good and Bad debt isn’t brain surgery, but the negative effects of ignorance can be huge. The difference is very simple. Bad Debt costs you money, Good Debt makes you money. Yes, it’s just that simple.
What the Banks Know that We Don’t
The Banks are well aware of the difference. Just look at the difference between what they “pay you” (and I use the word “pay” very loosely) for your deposits, and what they “charge” you when the “sell” you credit. Understand the business of banks are to sell credit. They also know and understand the dictum, “Own nothing, but control everything”. They live by it. What’s fun, is with the use of Non-lien-able debt, the Real Estate Investor can do the same thing. They can almost become their own bank.
Bad Debt costs you money since the net result of it is you end up with less than what you started with. Good debt makes you money since the net result is you end up with more than what you started with. In business, you are comparing Profit vs Expense. In our personal life, we are comparing income to, well “Income substitute’… sometimes referred to as Credit Cards.
The obvious examples of Good Debt would be things like SF rentals, Multi-family rentals, commercial properties, and other appreciable cash flowing assets. Bad debt examples would be the previously mentioned Credit Cards, boats, RV’s, etc… The equity in our own home is not an investment. It makes us no money, it costs us money to build it. Now, if we tap into it in the form of a loan, it becomes debt… what type of debt depends on what it is used for. Note that I’m not saying we should all go out and refinance our homes, cash out the equity, and invest. If you decide to do that, you don’t have my blessing. You are putting your home at risk. Not smart. Particularly since there are so many other safer ways to get funds to invest with.
The Power of Compounding… Duplication on Steroids
Banks understand all of this. They leverage your assets/deposits into credit/debt. That’s, credit from them, and debt to you. They own nothing, and in fact can leverage credit, actually sell “virtual money” to you at many times the “face value” of your asset on deposit with them. That topic is for another time. For this discussion, understand that the bank is exploiting the power of Duplication. Actually, they are taking advantage of what Albert Einstein referred to as the “Greatest Invention of the 20th Century”… compound interest. He went even further to state that those that understood it (banks) live off of those that don’t (the rest of us).
You want a very powerful example? Start with a penny… just 1 cent. Then, for the next 30 days, double it. So, day 1 would be 2 cents, day 3 would be 4 cents, day 4 would be 8 cents, and so on. Do it on paper. It will have a much greater impact on you. What’s the answer? Try it. You’ll be amazed. What you will be watching is an example of compounding at its finest.
So, how do we, as Real Estate Investors, do the same thing? Can we do the same thing? The answer to the second question is a resounding yes! The answer to the first question is, you guessed it, with the use of Non-lien-able debt.
The Power of Non-Lien-Able Debt… Compounding on Steroids
How you ask? Simple. First, remember that typical financing used in Real Estate Investing is lien-able debt. There is a lien of some type on the asset… the property we are buying. When we use non-lien-able debt, there is no lien on the property. In fact, there is no tie at all to the property. This is critical. This is what makes this work. This is what makes us our own bank. How?
What’s the first thing that happens at closing, after the mountain of paperwork is signed? The answer is, the original lender of the seller, is paid off. In other words, the lien is paid off. The seller doesn’t even see the money. Wouldn’t you like to at least touch it when selling… even for a minute? How about doing more? How about being able to re-use it, over and over again? Yes you can. That answer was for all those reading this and saying “know you can’t”. Here’s why… and how.
Let’s look at a typical property funding. First, a loan is acquired and we buy and rehab the property. We flip the house, and upon sale we do two things: 1) We pay back the original funding (lien); 2) We make a profit (hopefully). Now, to move forward, we need to get new financing and deal again with the “App triplets”. You know, new Application, Appraisal and Approval. All costly, time consuming and with no guarantees.
Now, if this was a form of Non-lien-able debt, we wouldn’t need to pay back the money we borrowed… at least not right away. This also means, that instead of only walking away only with our profit to use, we walk away with all of the proceeds from the sale. Sell a house for $75,000 with a lien-able debt of $50,000 and we walk away with only $25,000… the profit. Sell that same house with non-lien-able debt, and we walk away with the entire $75,000… minus closing costs. Which would you rather do?
Turning “Bad Debt” into “Good Debt”
OK, before I go further, I need to answer all the readers who are saying “I still have to pay back the debt”. In fact, I have monthly payments coming up that is usually very high due to the nature of the terms on most NLD. So, what I do, is I fund a cash reserve as part of the NLD. The cash reserve is your silent partner whose only role is to make the monthly payments until you can develop your system to become self-sufficient, and self-sustaining. Combine the profits from the first couple of flips and buy/rehab a 2nd “Flip House”, that you will also be re-using those funds over and over again, since there would be no debt at all on that 2nd house… you bought if for all cash. The idea is to NEVER use the principle for anything but the cost of the next Flip House. You are working with two “flip houses” now after that 2nd flip
Flip these two Houses, combine the two profits and buy/rehab a third Flip House. Again, you will be re-using the costs for all three houses to buy/rehab the next 3 Flip Houses in line. You now have three lines of Flip Houses. No matter how many times you try to spend the principle… they keep giving it back to you. Now, this is where the real fun begins.
While you’ve been developing your system, your Cash Reserve is dwindling down to nothing. So, it’s about time you refunded it, don’t you think, and “buy yourself” more time. Keep in mind that these payments you are making from the cash reserve is actually paying off the debt… or it doesn’t work, so when you calculate how much to put into the cash reserve, keep that in mind. Now for the real fun.
Like I said, the cash reserve is “no more”, so refund it… with one of the profits from one of the three flip houses. What do you do with the other two profits? Buy/rehab a “Hold house” for the cash flow… with all cash. Then, just continue to flip the three Flip Houses, over and over again, using the “profits only” to buy more “Cash flow” houses, with all cash, and occasionally refunding the cash reserve until the debt is paid off… and you are completely debt free.
The Tale of the Tape… Einstein was a Pretty Smart Guy
Question #1: How many times did we pay for these funds?
Answer: Once… we just didn’t pay it back all at once, as we would have if it was lien-able debt.
Question #2: How many houses are we able to use these funds for (remember, we are only going to pay for them once)?
Answer: I don’t know. I’ll let you know when I stop re-using them.
We just became our own bank. We are now leveraging our own money to ourselves, at no extra cost. Every time we re-use these funds, at no extra charge, we make the cost of the debt per house go down. This means, we also just made the initial cost of this type of funding insignificant.
Einstein was right. Compounding is a beautiful thing. When combined with Non-lien-able debt, it can be a “gold mine” to Real Estate Investors.
Original article by Joe Villeneuve