Marching Toward Retirement Using Neg-Am Loans? But Only By Prescription — Here’s How

Posted @ 2:55 pm - Filed under Cool Info, Real Estate Investing, Purposeful Planning, Financing, Real Estate Markets

What with the negative (pun intended) press constantly surrounding neg-am loans, it’s almost impossible for the real estate investor to know which way is north on the loan map. Let’s take a look at exactly what a neg-am is — and more importantly — what it’s not.

The difference between the negative amortization loan and the traditional amortized, fixed rate loan, is principal pay down — or the lack thereof. If you have a neg-am and opt for the minimum payment, you will add some to your loan balance each month. The loan Grandpa had paid a little principal each month along with the interest owed. As time went on, the principal portion of the monthly payment increased. At the end of the loan period, usually 30 years, the loan was paid off completely.

Wow.

Given the above descriptions, why would anyone with an IQ above room temperature choose a neg-am loan? The answer is not so simple, as it depends on all kinds of market factors.

The #1 requirement for even allowing a neg-am loan to be on your menu? You must reasonably believe the region in which you’re investing is highly likely to increase in value.

Reasonably?

Now for those who’re screaming in their living rooms and offices that nobody knows that for sure — you’re right. At this point I’ll invoke one of the Top 10 most used BawldGuyisms: My crystal ball is as cracked as yours.

Let’s take a market and take a look at what I mean.

The population is currently about half a million. Every demographic study done in the last few years says the region will double that figure in 15 years. The job market is great, and among the nation’s leaders in new job creation. Homes haven’t yet hit a median price of $250,000 yet. The weather offers four seasons, none of which are extreme. National size retailers are moving in steadily. Local and state governments are pro business.

That area is ripe for neg-am loans.

How might you analyze the property with an eye towards using a neg-am loan? Here’s the way I look at it. It’s proven itself over the last 20 years. In that time dozens of clients have made use of hundreds of neg-am loans — very profitably — especially in the bad times. (We’ll come back to that nugget later.)

Let’s make some assumptions here.

Your loan is 80% of the purchase price. The difference between the payment rate and the indexed rate is 5%. Let’s say your payment rate is 3.5% and your starting indexed rate is 8.5%. That’s how we arrive at the 5% difference — which is the unpaid interest added onto your loan balance.

The price will be $100,000.

Let’s not make this more complicated than it is. Your loan is $80,000. It’s growing by 5% a year. Bookmark that in your head.

You’re a married couple making about $80,000 yearly between the two of you. The tax shelter (read: depreciation) for this property is $5,000 a year. This results in an income tax savings, fed and state, of around $1,500 or so.

Let’s put some of these numbers together.

The loan balance grew by $4,000, but you’ve saved $1,500 in taxes. You’re behind so far, by about $2,500 for the year.

This means if your $100,000 property increases in value that first year by just 2½%, you’re even. If it appreciates more, you’re ahead. It ain’t complicated.

If your property is cash flowing, and you already have a Sominex (Ambien) Account, it might make sense to apply that cash flow to your payment each month, thereby lowering the neg-am affect. Since your investment goal is to grow your capital, this move is an option. It’s not necessarily the best option for all investors — but it’s an option.

How ’bout the bad times?

During the S & L crisis over a decade ago, we had clients everywhere with neg-ams. Here’s what happened.

One client in San Diego owned a couple fourplexes, while their friend down the block owned just one. They both used the exact amount of capital to buy their units. Our clients used 10% down payments, 80% neg-am loans, and 10% owner financing for the balance. They banked about $200 monthly. Their buddies used 20% down, an 80% fixed rate loan, and lost about $100 a month (not the end of the world).

Then the smelly stuff hit the fan.

Vacancy rates shot — rents dropped — simultaneously.

The guy with the safe 20% down payment and the prudent fixed rate loan? He was now losing $250-400 a month, and hating life.

Meanwhile, our clients went from a modest positive to either a break even, or a miniscule negative. ($100 a month or less — again, not the end of the world.)

Who was more at risk? Whose bank account took a bigger hit?

Fast forward to normal times. Appreciation emerged from years of hibernation, and my client’s $400,000 worth of property benefited twice as much in the same time span as his buddy’s.

And before you start bellowing about the enlarged loan balances of my client’s units, let’s look at that.

At 5% appreciation, the traditional investor made $10,000 as the market normalized. My clients made $20,000 — which back then, amounted to a complete deletion of all added loan balance during the bad times. His buddy lost over $10,000 in negative cash flow.

Ask his buddy how he’s ahead and listen to his answer. If his reply was a movie it would’ve been rated at least ‘R’. He lost $10,000 directly out of his Levi’s, then gained it back with the appreciation. My guy held his own on a month to month basis, and the first year’s appreciation wiped out his increased loan amount. This doesn’t even take into consideration the tax savings my guy was enjoying — twice as much as his friend. Don’t gloss over that last statement. Twice the shelter means twice the tax savings, means twice the dollars remaining in my guy’s Levi’s each and every April 15th. Don’t think for a second he doesn’t bring that up every spring.

The next several years post S & L bad times? My client left his friend in the dust. By 2000 he exchanged his then significantly increased value units for more than twice the number of units — again using just 10% down and negotiating owner financing. By 2004 his buddy wasn’t talking much because of the chasm between the size of their net equities.

Bottom line: There are times when neg-am loans are simply stupid to use — and for many reasons, both client, property, and market related. Until just recently I’ve been telling clients not to use them, because the hybrids were a better deal.

Lately though, the indexes are falling. Even Libor fell a little bit yesterday, and they’ve been horrible lately. If Bernanke reads the script I sent him, and lowers the Fed Funds rate next week, they’ll continue to fall. This makes neg-am loans, relatively speaking, a better bet.

But remember I said: THEY’RE NOT FOR EVERY INVESTMENT IN EVERY MARKET FOR EVERY INVESTOR.

Why?

Because it’s called Purposeful Planning, which means you’re doing everything on purpose — including how you’re structuring your acquisitions.

This is 2007, not 1957. One size doesn’t fit all. It’s those who understand that principle, and understand rational real world analysis who will prosper in the long run.

Neg-am loans are simply one of many investor tools. Kinda like wrenches. They’re magnificent for dealing with bolts and pipes, but they’re horrible as hammers. Used in the right circumstances neg-am loans are workhorses allowing investors to not only benefit month to month, but create much higher capital growth rates.

Contrary to what’s in much of the media on the subject, neg-am loans are not an invention of Satan — but they’re not sent from the Lord either.

The next time you use a wrench to pound a nail, remember for what purpose the wrench was created, and go get a hammer.

This entry was posted on Friday, September 14th, 2007 at 2:55 pm and is filed under Cool Info, Real Estate Investing, Purposeful Planning, Financing, Real Estate Markets. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.