CW 918 FBF - Know Your Financing Options: Wrap Around Mortgages & ARM

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Welcome to the Creating wealth show. This is episode number 581. 581. This is your host, Jason Hartman. Thank you so much for joining me today as I've got Naresh across the country. You know, in the old days we used to say in studio, but in our virtual studio, Naresh here. And we're going to talk about a few things that I think will be very valuable to you today, not the least of which is the ABCs of real estate investing. We're going to talk about, you know, several things like that. So let's go ahead and dive in. Naresh, welcome. How you doing in Tampa, Florida?

Thanks so much, Jason. It's great to be here. It's been, it's been more than a month and I'm glad to be back. Tampa. Tampa's great. I think while the rest of the country is getting cold, we're so warm over here, I have no complaints.

Yep, that's how it is here in San Diego, too. So first of all, I want to start, by gosh, where should we start today? We've got several things to cover. Let's talk about the ABCs of real estate investing for a moment. What I've talked to you about, Naresh is just grabbing a real estate glossary and picking a couple of terms and we could talk about them on the show for the benefit of the listeners because these, these kind of tie in with the frequently asked questions that we get all the time, whether it be our Investment counselors or I get them directly, let's just go ahead and dive in. What do you have today under A. And, and this might sound simple in the beginning, but we're going to complicate it for you. So.

Yeah, yeah.

And then we'll bring it back to simplicity after that.

Yeah, well, I'm a pretty, pretty new to the real estate space and so like you said, we'll start simple. And I know you're going to start getting really, you're going to start diving deep and making it a little complicated. But let's start with the adjustable rate mortgages.

Yes, yes, adjustable rate mortgages. Now that on its face would seem pretty simple. And you know, my philosophy, listeners is that I really like long term fixed rate debt for three decades. So at the time of this recording, it's 2015. And just imagine that if you buy a property now and you close this year, you're not going to pay off that three decade long, wonderful, beautiful investment grade debt until it's 2045. Do you think we're going to have some inflation before then? Do you think you're going to take advantage of my trademark term inflation induced debt destruction? Of course you are. And it is going to create a lot of wealth for you. And if inflation doesn't happen for a while, you're going to be getting yield when other investors aren't getting yield, because the income property asset works best in any of the three basic economic scenarios. So I like fixed rate mortgages. However, let's talk about adjustables for a moment just so listeners have a better understanding of how they really work. So the adjustable rate mortgage, the ARM, as it's called, the ARM loan, that could cost you an ARM and a leg. It's the more aggressive, less conservative approach to managing your mortgage. It basically has five important elements that you need to understand. The first element of the adjustable rate mortgage is the start rate or the teaser rate. And usually this interest rate is artificially low and it goes up. And of course in the mortgage meltdown and the Great Recession, we saw a lot of people get into trouble with these types of loans. And I don't think they're necessarily problematic, but they become that way in practice. Okay, so the adjustable rate mortgage or the ARM has this start rate, this teaser rate that is artificially low. And because of that the rate has to go up so the lender can get their yield ultimately out of the, out of the loan. And so they tie it to something called an index. And so that adjustable rate mortgage will be indexed to this index. Now there are many indexes out there. A couple of years ago we all heard about the LIBOR scandal. What does LIBOR stand for? Well, it's the London Interbank Exchange Rate or something like, you know, I can't even frankly remember. I feel a little embarrassed. But I don't use the libor and I don't really care about it that much because I don't really believe in adjustable rate mortgages. But there's the LIBOR index, there's the cost of funds index. If you're getting a loan here in the Socialist Republic of California, you, you might be tied to the 11th district cost of funds index and there are many other indexes. You know, these could be anything, right? If you were making a loan, a hard money loan, you could do an adjustable rate loan as a lender, and I've done this before as a hard money or a private lender, where you could tie it to anything. You could tie it to the prime rate, you could tie it to the rate of inflation, which be careful because of course that's understated. And the most common index for inflation is the cpi, the consumer Price index. You could tie it to any one of a number of things. You could tie it to, you know, your mother in law's mood index, right? It could be tied to anything. Anything could be the index. But the common indexes you'll see out there are the prime rate, the cost of funds, the libor, things like that. And you have this economic index which is readily available. You can find out what the index is at the Wall street journal@bankrate.com at any of these various places, because these are published agreed upon indexes. So there can't be any fooling around there. Unless of course, you're a crook like some of these big financial institutions are, and you actually manipulate rates like the LIBOR rate, which of course that was the big scandal a couple of years ago.

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So now we have the index, right? The next element, the third element of the adjustable rate mortgage we need to understand is what's called the margin. Because when you have what's called a fully indexed rate, what happens here is you have to take that index and then you have to add the margin. Now, you know, it could be said that the margin represents the lender's profit, although that's not really true because they're not necessarily borrowing that money themselves to loan it to you at the index rate, but it's just a way to kind of keep score and have the loan adjust. So, index plus margin. So let's take an example here. Let's say the index is 2% and the margin is 2.25. That means, well, let's say the margin is 2 and a half and the index is 2 and a half. That's probably a better example. So that means that the fully indexed rate for that adjustable rate mortgage would be 5%, a 2.5% index and a 2.5% margin. Add those together and you have what's known as the fully indexed rate. In other words, the real interest rate. Now, your start rate on that loan might have been 3.5%, but when it adjusts to the fully indexed rate, it could be 5% in the example I just gave you. But wait a sec. We've got to consider another element. Now the fourth element is what we're going to call the annual cap or the six month cap. And the cap could be anything. It could be a five year cap, but usually it's an annual cap. And what this does is this limits the amount of adjustment the loan could have so that we don't put borrowers into what is known as payment shock. Okay? And naresh, look, if you borrow at an artificially low start rate or teaser rate and then the first adjustment comes around a year later on your mortgage, you could have a fully indexed rate that would just wipe you out. Right? You could have bought this property, whether it be a property in which you live or, or an investment property. And that fully indexed rate changes the whole complexion of the deal. Right? And that can get you into trouble. What do you think?

I was actually just about to ask you a question, applying this to the current situation with the Federal Reserve where they've kept rates at zero. So if I were to get an adjustable rate today, would you say that's a horrible, horrible decision because rates are probably going to go up next year?

I think ultimately rates will go up just again, I've been right about almost every prediction I've made, except one glaring failure on my part, and that is interest rates. Okay? Because look, 10 years ago at seminars I was telling people rates will be higher. And rates are not higher, they're lower. And as we've talked about many times on past episodes, this is because there's nothing rational in the system. This is because the government and the Federal Reserve and the unholy alliance between the two can kick the can down the road, export inflation to other countries, essentially screw them over. Because the US has the bully pulpit and you know, it has the reserve currency. So nothing is logical about the interest rates. But yes, I still am clinging to my idea that ultimately we will have substantially higher interest rates. So that's why I would not recommend an adjustable rate mortgage. Now, if you're young and reckless and not as conservative as I am, well, you might take an adjustable rate mortgage. And that really this decision is hard to make because you're gambling, you're speculating, you're predicting the future essentially as to what's going to happen there. In so doing, you could certainly be wrong and you might get caught in a, in a pinch because you can't unload the property necessarily, it may not be a good time to sell it. You know, if people are like, this was a common practice and it still is a common practice in places like Orange county, where I spent my adult life, Orange County, California. And you know, I would buy a property in Newport beach, you know, a big glorious home in Newport Coast, California, which is Newport Beach. Same basic idea. You know, I would get an adjustable rate mortgage and I would think, well, you know, my hold time on this property is going to be three years or less and I'm going to move in, I'm going to live there, I'm going to make the ridiculous payments and if I got a fixed rate loan, I would have to pay a lot more. So if you have this short term thinking, well, you know, it could work out, then that could be okay. But our strategy is the long term buy and hold strategy. So for our type of real estate investing, I would pretty much always recommend a nice low rate, fixed rate mortgage. Okay. Because that mortgage really is part of the asset. It's part of the asset. Okay, makes sense, makes sense.

It just, it. To me it seems like common sense. With rates this low, why wouldn't you want to get a fixed rate? It's zero. Well, at least the Fed rate is close to zero percent, so.

Well, I agree with you. But you know, I've had a couple of guests on my show even fairly recently saying, oh yeah, get adjustable rate mortgages. We recommend adjustables. We're in a low interest rate world. You know, it's going to be that way forever. They're going to have to keep it that way because the economy will never have a chance to really recover if they don't. So, you know, look, there is that type of thinking out there. But I like my cost to, I like to know what the costs are and I like them to be fixed. Okay, so let Me go on and just finish the five elements here.

Okay, yeah, you can finish. I had another question about what you said. Now what's this I've been hearing about negative rates? How, how can that be? How can that happen?

Well, there, there are two places around the world where we recently, it may still be, I haven't checked lately, experiencing negative interest rates. And one was Germany. Okay. Basically, I mean that is absolute insanity. Like it's an insane idea that you would have to pay the bank to store your money. But that really is what is going on in some places where you have an environment of truly negative interest rates. It's absolutely weird, insane and almost never happens throughout history. But we are touching on that experience and really that's what, you know, that's what's been going on with the last two decades in Japan. I mean they cannot even with Abenomics, okay? Which is, you know, they cannot get that economy to really recover. And one of the big reasons is that Toyota is selling trucks to isis. Ha. I'm joking. But you know, by the way, that was recently in the news a couple days ago and I've been asking that same question for five years, not about isis, but Al Qaeda and all of these little warlord tin pot warlords. You know, where do they get all these Toyota trucks to fight their wars? You know, I think Toyota is going to have a little PR problem on their hands as if they didn't already have one from a couple of years ago with the accelerating Prius problem. But anyway, so the negative interest rate environment, Japan's problem is not really a problem that can be solved with monetary or fiscal policy. It is a problem of demographics. The Japanese just have to have kids, they have to grow their population or they have to start allowing immigration if they want their economy to recover. So that's another subject. At the risk of getting off on a tangent, that's the negative interest rate thing, okay? So you know, look it, if you take an adjustable rate mortgage, you're gambling. So I think these little sensible, inexpensive rental properties, you just tie them up with three decade long fixed rate loans and you're going to be in great shape to finish up. So the annual cap. Now here's a question for you. What happens if the fully in. What if it happens if there's an annual cap of 1% where it means that the loan payment. Now the, the other question to ask about an annual, and I'm going to talk in a moment about a lifetime cap is are those interest rate caps or are they payment cap caps? This is an important distinction. And you know, I think even though I'm not recommending anybody listening, get an adjustable rate loan. I think it's important to understand this stuff just because increases your ability to think about finance and investments. Right? So in that example I gave, we had a 2.5% margin and a 2 1/2% index where the fully indexed rate was 5%. Well, the start rate on that loan. I can't remember what I said about the start rate, but say it's 3% as the start rate. Now, if there is an annual payment cap, not an interest rate cap, a payment cap, which you will not see this anymore, I don't think anywhere. But it's possible that it will come around again or it might be out there today and I may not be aware of it. Of 1%, then that means that the payment on that loan starts at 3% and the payment cannot go up to more than 4% in payment amount. But wait, the fully indexed rate is 5%. This is where we get into the subject of what's called negative amortization. And these loans are pretty much frowned upon. I think they may have been outlawed, actually by Dodd Frank. I think they may be completely gone. You could probably do them, though, regardless of Dodd Frank, if you're loaning to an investor and it's a private loan and it's not a loan to a homeowner, I would bet there may be an exemption, if that even is in Dodd Frank. I honestly am not sure because Dodd Frank is like 2200 pages. And Nancy Pelosi says we have to pass the law to pass the bill to see what's in it. Right. As she said about Obamacare.

So what happens there is that extra 1% that you're not paying each month negatively amortizes, which means it is tacked onto the loan balance and the loan balance actually increases. Okay, now.

As much as this is frowned upon in concept, I would love to have all of my loans be negative amortization loans because I am the complete opposite of Dave Ramsey, who just does not get it when it comes to investing. He totally gets it when it comes to people that are over their head in stupid consumer debt and car payments and stuff like that. Dave, I love you for that. I mean, you're really helping people. But if you're, if you're a sophisticated investor, you're just missing the mark, my friend. Okay, so Dave Ramsey has his place, and I love him in his place. I just don't think we should extend his concepts to the world of sophisticated investing techniques. Because if I could just let my loan balance go up and keep all that monthly cash flow, I would love to negatively amortize if someone would let me, but nobody will, so it's. Forget it. Okay, so now what if it is an actual interest rate cap, not a payment cap? That's the difference in this annual cap. That means you start out at 3%, and the fully indexed rate could say, well, you're supposed to be at 5%, but there is an interest rate cap, and it can only go up 1% a year. You started out at 3, now you're at 4. You're fully amortizing, which amort is the Latin term to kill. Amortization means you kill the mortgage. You kill it off by paying principal and interest every month. You will ultimately kill that mortgage in 30 years. I mean, I just want you to understand that if it's an interest rate cap, you never negatively amortize. Okay.

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Now, there's one more kind of cap, and that's the lifetime cap. And the lifetime cap might be 5 or 6% above that start rate or teaser rate. So in this example, the loan started out at 3.3percent, and the day it started, the fully indexed rate, the day you took that loan at 3%, was 5%, two and a half index plus two and a half margin. So you know that you're getting an artificially low rate. Now, unsophisticated people don't know this, and this is why they accuse many lenders of predatory lending and so forth. But the lifetime capture in that example might be 8% or 9%, right? If it's 5 or 6% above the start rate, and that means that no matter what the fully indexed rate is, for example, if the index is at 8% and the margin is 2.5, by adding those two together, it would tell us our fully indexed rate should be 10.5%. But if the lifetime cap on the loan is either 8 or 9%, that's the highest it can go, period. Okay, so that is the essence of an adjustable rate loan and how it works. And I really don't think very many people understand that. So I'm glad you asked the question, Naresh, and I wanted listeners to understand that. At the risk of going too long, let's jump into another subject. And what is your next A. It's the good old aitd, right? Is that what you want to talk about?

It's the aitd. I was gonna. I was just about to ask you next. Yeah. But before you get into that, you brought up libor. And I just wanted to say that LIBOR stands for London Interbank Offered Rate.

Ah, thank you. Yeah, I thought it was like exchange rate. I just, I couldn't remember the acronym. But, yes, that's a. That's a very popular index, the libor. And there was a big scandal about it, and there's. Now, I think there's a trial going on of the two people who. It really came down to, just a couple of people with one of these. These big financial firms that were basically manipulating the libor. I mean, it's insane. And. And we've talked about that in prior episodes, so we won't. We won't get into that.

Yeah, I think it was Barclays. Barclays, which was price fixing those rates.

You know, these big companies, they just get totally abusive. They really do. Okay, aitd. And this is probably all we're gonna have time to cover today. Okay. Because we. We go deep in these subject. So AITD stands for All Inclusive Trustee. The other name for this is wraparound or wraparound Mortgage. And you got to be careful with this one because people get themselves into trouble with it, and you run the risk of having the lender call the loan due and having them invoke what's called the due on sale clause, which is legal, and it's been upheld by the Supreme Court a long, long time ago. So here's what this basically is. There's a property out there and say, naresh, that you want to buy this property. And you think, well, your choices are you can pay cash for the property. You could go to a lender and get a new loan and pay for the property that way. But then you look and you say to the seller, you. Or you, you know, just look up in the county records or whatever, and you look and you say, well, what kind of financing does that property already have on it? Maybe I can assume that financing or I can take over that loan. And then, you know, if it's a residential property, the due on sale clause has been upheld by the Supreme Court, and the lender will probably not allow you to do that. So what many investors do, and, you know, I don't think this is really a great strategy, but I'm just saying people do it. Okay. I think you can get yourself into trouble with this is they do what's called an AITD or a wraparound mortgage. And basically what that says, and let's look at an example. Let's say the property's $100,000, and let's say that the existing loan on that property is $80,000. And that's the one you're going to essentially assume, but you're going to do it without telling the lender. You're going to play games here, which, again, you could get yourself into trouble with this. So be careful. Okay, so there's an $80,000 loan on it. And Naresh, you have only four, $5,000 to put down on the property. So you go to the seller and you say, hey, Mr. Seller, look, I want to buy your property with an AITD or a wraparound mortgage. So what we'll do is we will create a new mortgage and it will be for $95,000, and I'm going to give you 5,000 down on the $100,000 property, and you're going to carry paper, basically carry a second trustee. Now, the names change. In states, it might be called a second mortgage, but in concept, it's the same thing. Okay, so you'll say to them, keep your $80,000 loan, don't pay it off, and loan me another $15,000, and I'll give you 5,000 down. And we will have the title company or the escrow company do a wraparound. And so we want to keep the escrow account open to make sure everybody plays fair and pays the payments. So every month, I'm going to send you a payment that's uniresh. You're saying this to the seller. I'm going to send you a payment based on a $95,000 loan, but you're going to keep paying the existing $80,000 loan, and you're going to keep a little extra every month from the $15,000amount that you didn't collect from me that you agreed to carry the paper on. So what happens here and why people, whenever they do an AITD or a wraparound mortgage, they want to keep an escrow account open. Open is because the seller of the property may not make the payments on the underlying loan that was wrapped or included. So the seller could collect the payments from uniresh based on a $95,000 loan, but not pay the underlying $80,000 loan. Now, of course, that would mess up their credit report, but they might not care because the cash might be more valuable than their credit, which is a decision that literally tens of millions of people made during the last eight or so years where they just strategically, intentionally decided to default on their mortgage. And you know, by the way, that strategy frankly worked out pretty well for millions and millions of people. Okay. And, and we've done episodes about that in the past. So that is basically the essence of an AITD or an all inclusive trustee. Now I want to say on all this stuff, of course, like I've said on many episodes before, I am not a tax advisor, I'm not an attorney. So if you require advice on those subjects, go to the appropriate professional. But that's basically the idea of it. Okay. Any questions on the aitd? Naresh and I want to play a, a quick recording from our website and wrap it up.

We're good there. There, there are a couple of terms, I guess we can talk about it on the next episode. But like convertibles. So like the arm.

Yeah, we'll do that on future shows.

We can talk about that later.

Right. So we'll talk about, you know, we're going to talk about a lot of stuff, these sort of frequently asked questions, the ABCs of real estate. So we're going to talk about bridge loans, convertible ARMs, we're going to talk about homeowners associations and common area issues and things like that. So there's a bunch of good stuff coming up on future episodes. Anyway, I hope that helped really provide a deep understanding of adjustable rate mortgages and all inclusive trustees or wraparound mortgages. So I hope everybody can join us for our Orlando property tour coming up in mid November. It's going to be fantastic. We're going to have an emcee there kind of co hosting the event with us us and we're going to do some good stuff, look at some great properties and you know, take your kids to Disneyland. Go to or not Disneyland Disney World or go to Disney World yourself when you're there. Lots of great Orlando attractions and you can register for that property tour. End Creating Wealth Seminar. Again, I don't think we've ever done our Creating wealth seminar on the east coast before. So for those of you in Europe or as they say, the British say across the board pond, it's a good opportunity for you to come out, see some great properties and come and tour and hear the Creating wealth bootcamp as well. So you'll get that, the property tour, several meals together with us. You'll get to spend some time with our other clients, our property managers, our rehabbers, our team in that market. We've got a really good team there. So we're looking forward to seeing you in Orlando in mid November. Go to jasonhartman.com Click on the events section and get your tickets at the early bird price before it goes up. Naresh, thank you so much for joining us and we will look forward to talking to you on a future episode and doing some more ABCs of real estate.

Thanks so much Jason. I learned a lot. Thanks for all your help.

I've never really thought of Jason as subversive, but I just found out that's what Wall street considers a to be.

Really? Now, how is that possible at all?

Simple. Wall street believes that real estate investors are dangerous to their schemes because the dirty truth about income property is that it actually works in real life.

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