HI 117 - Thank You For Your Service, Wrap Around Mortgages & ARMs

Welcome to the Heroic Investing Show. As first responders, we risk our lives every day. Our financial security is under attack, our pensions are in a state of emergency. A single on duty incident can alter or erase our earning potential instantly and forever. We are the heroes of society. We are self reliant and we need to take care of our own financial future. The Heroic Investing show is our toolkit of business and investing tactics on our mission to financial freedom.

Hello and welcome to episode 117 of the Heroic Investing show where we focus on challenges unique to those members of the first responders armed services and those of us no longer wearing uniform, including myself, the veterans and the retirees from the police forces, firefighters and EMTs that have lived a life of service have put themselves in harm's way numerous times. I'm sure to protect the liberties and the freedom that the rest of us enjoy. I'm in New York City and I have to apologize for a little bit of a tinny sound here on the introduction, but I'm starting the Venture Alliance Mastermind weekend event here on Memorial Day in New York City and there could not be a better place to spend this historic holiday than than walking by one World Trade center, seeing the Trade Center Museum and all of the American flags, the service providers that are out there again working on a long holiday weekend to keep us safe. I think that in this city you get a very strong sense of what went on in 9 11. Of course I've mentioned in the past about the Tunnel to Towers race that my wife sue and I have ran in and our family has ran in a couple of years, you know, giving tribute to catastrophically wounded warriors, but also remembering the huge sacrifices of many firefighters, many police officers and other service providers during 911 now almost 17 years ago. So I don't think this city will forget anytime soon. I hope that America does not forget anytime soon. And as I was leading up to this one, I wanted to think about and give a few moments pause for just that, for liberty and for, you know, everything that that stands for. I want to call attention to one of my mentors, Patrick Donahoe, and his podcast called the Wealth Standard. And you can go to that@wealthstander.com and his Wealth Standard Radio podcast in 2018 talks specifically about these topics. He's broken it up into three four month long segments called Life, Liberty and Property. And if you've studied any of John Locke's work from a few centuries ago, he created what was the fundamental work to the Declaration of Independence really, our founding forefathers as we're all familiar, used the phrase life, liberty, and the pursuit of happiness. And really the pursuit of happiness was converted from property because they felt, and probably rightfully so, that property would be misunderstood. But Patrick is on, I think, episode four now, as I'm writing this or I'm producing this one of liberty. He's been through. The section of Life and Liberty is just an amazing one where he goes through some really fundamental things that are needed to protect liberties around the world. He dives into what has made America the greatest successful free country and likely will retain that for, you know, a very long time. And Jason Hartman talks about that, recently, talked about it on one of his podcasts as well. So I won't continue there too long. And our episode today is not necessarily focused on that, but I just wanted to pause and think a few minutes here about, you know, Memorial Day and what it means, what a great country we have. And to give my personal thanks to those who continue to serve as a first responder and as a member of the military, my hat's off to you. I hope you had some time with your family, and if we're not able to on this Memorial Day, that you will be able to shortly after that. Thank you very much. So on our show today, Jason talks with a member of his company and a friend of mine, Naresh, and they go over a couple of really good topics that I think are very pertinent today as interest rates start to rise and as property prices start to rise. And these topics are adjustable rate mortgages and wraparound mortgages. So Jason first recorded this in 2015, and I would say that it was much less relevant then than it is today. I was perfectly recently just looking at an apartment building that I was considering partnering on with a friend. And we were looking at it in a market that was extremely hot. And so I knew that it was near the top of the market. And as I was struggling to figure out, how can we make this work? Because there were a lot of really positive things, unique things about the property, about the location of my partner, about a desire for him to get into real estate investing. And it caused me to kind of have maybe an unreasonable desire to make this one work. But thankfully and proudly, both of us stuck to some of the lessons we had learned from Jason Hartman and from Robert Kiyosaki, that the thing has to cash flow and the numbers have to make sense. But I also took a lesson from Robert where I think this was rich dad, poor dad, where he talked about, you know, his rich dad commenting that I will pay nearly any reasonable price as long as I can set the terms. Because if you can set the terms, you can define cash flow. You can ensure cash flow even with a little bit higher price. And so we looked at very strongly this apartment complex. Now, in the end, somebody offered, you know, $500,000 more than the property was worth or that you at least could make it cash flow for. So we ended up backing away from this. And I think the story's not ending yet, but I believe that's what will happen. But the terms in this loan were so good that we were considering it very strongly and had intended to make an offer. And the terms were that we were able to do what's called a wraparound mortgage. We were going to able to assume somebody else's mortgage and they were considering an owner, excuse me, a seller, carry back mortgage. And so with a combination of those two, we were going to be able to go in very low money down. And then it also had very strong rents, but we had to lower the purchase price a little bit to make it actually cash flow. So again, I was trying to fit into the box of rich dad's father, of Robert's rich dad, I should say. But in the end they were able to find somebody, a less reasonable buyer, someone who was willing to overpay and I hope the best for the seller, I know the seller and great person, I hope they do get that price because they're getting more than they should get in a given market. They're getting someone who is willing to look for some additional appreciation at the very top of the market. And I'm very proud to say that my partner and I, even though we wanted this properly, badly walked away from that. And I still believe it was the right answer. So they go over again, adjustable rate mortgages, wraparound mortgages, it's not a super long clip, but here on Memorial Day, I'm sure you are all busy and I think that you will find that this is, this is relevant today because we have to start thinking about creative financing if we're going to make properties that have a little bit higher price. Makes sense. Listen, back when I, in 2011 when I bought my first property and it was, you know, $38 a square foot, it was not hard to make that cash flow, especially when mortgages were also very, very inexpensive. So I hope that this adds value and I look forward to a couple of really, really good episodes that I've recorded and have in the hopper here ready to go with recent guests. I'M excited to, to have you here from, from these individuals. One that I'm very excited about that I recorded just a couple of days ago was Julie Ziglar, Norman so Zig Ziglar's daughter. It was such a treat to have that, that wonderful lady on my show. I'm looking forward to, you know, much, you know, a strong personal connection and doing many things together to help turn around the lives of many other people that hopefully are finding value in what we do here at the Heroic Investing show. So thank you. I'll go over now to Jason and Naresh talking about adjustable rate mortgages, wraparound mortgages and some other related concepts.

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 is 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 is 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 kind of tie in with the frequently asked questions that we get all the time here, 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, I'm a pretty, pretty new to, 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, listener, 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 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. 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 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, 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, you know, find out what the index is at the Wall street, at 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. 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 indexed 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 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, 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. And 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, 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 the 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'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. 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's gonna 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 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 it's, it increases your ability to think about finance and investments, right? So in that example I gave, we had a 2.5% margin and a 2.5% 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 capture, 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. And 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 operation 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 and 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? 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%, and the day it started, the fully indexed rate, the day you took that loan at 3% was 5%, 2.5% index plus 2.5 margin. So you know that you're getting an artificially low rate. Now, unsophisticated people don't know this, and this is why they accused many lenders of predatory lending and so forth. But the lifetime cap 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 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 go deep in these subjects. So AITD stands for All Inclusive Trustee. The other name for this is wraparound or wraparound mortgage. And you gotta 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, 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 is $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 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 we've, 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 a. And the appropriate professional. But that's basically the idea of it. Okay, thank you so much for listening. Please be sure to subscribe so that you don't miss any episodes. 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