Mortgage Counter-Magic


Kurt Schultz

Are you paying a mortgage? If you have been paying down your mortgage for some time, you may be sitting on a valuable (although inactive) asset.

There are a variety of programs available to help you pay off your mortgage early, so that you can save long-term interest costs by paying the principal down early. While of admirable intent, this is probably not the most efficient use of your assets.

Do you know that it is possible to reduce your monthly mortgage payment by borrowing more against your house? I know, that seems impossible, but it isn't. And it's not just a matter of negotiating a better deal when you re-finance, either. The key to making it work is in knowing what to do with the extra money that you borrow.

There is a huge difference between "Bad Debt" and "Good Debt". "Bad Debt" is a burden on your financial situation, and could very well help keep you poor. "Good Debt" eases the burden on your financial situation and might very well help make you rich. The distinction between "Bad Debt" and "Good Debt" is simple: "Bad Debt" is debt that you have to pay off; "Good Debt" is debt that you arrange to have other people pay off for you.   One example of "Good Debt" is where you take out a mortgage to buy a rental property - the rental income should pay off the mortgage debt for you; that means you buy the house (i.e. pay off the mortgage debt) with money that other people (your Tenants) give you.

How does this apply to borrowing more against your home? If you just spend the extra money that you borrow you still have to pay back the mortgage. If you spend the money on something that gives you back less money than it costs (like most cars, boats and motor homes), your net burden INCREASES - which is not good. You still have to pay back the mortgage with your money, so you've increased your "Bad Debt".

But if you spend the money on something that gives you back MORE money than it costs you, and you use that extra income to repay your mortgage, then the net change is that your monthly mortgage burden DECREASES. Because your new, larger mortgage is being paid off partly by your money and partly with other people's money, your new mortgage will be partly "Bad Debt" and partly "Good Debt". If you make a successful investment, you increase your "Good Debt", and that helps you pay off some of your "Bad Debt" too.

That's the key: you invest the money and use the returned income to help pay off your mortgage.

When you invest money, other people pay you for the use of your money (at least they do if the investment is successful). This is the way it is when you buy stock in a company, or if you lend money to a company, or if you buy promissory notes at a discount. So if you borrow more money by refinancing your mortgage, invest the extra money and use the income that it produces to repay your new, larger mortgage, you are reducing your burden by paying your mortgage off (in part) with other peoples' money. While it is true that your larger mortgage may also have a larger monthly payment, some of the payment will be made with your money, and some of the payment will be made with someone else's money. This means less money out of your pocket each time you pay the monthly mortgage payment. The net result is that it costs you less each month.

Now it's fine by me if you want to pay your mortgage off early. Personally, I think it's better if you can get someone else to pay your mortgage off for you.   If you can't get someone to pay it off for you, the next-best thing is to get someone to pay part of it off for you. If I can get someone else to pay off my mortgage for me, I don't really care if it's paid off early or paid off on time. If I pay my mortgage off early, perhaps I can save 33% or maybe even 50% or more of the interest costs. On the other hand, if I can get someone else to pay off all of my mortgage, I can save 100% of my interest costs.

There are lots of investments that are not appropriate for this sort of strategy. First of all, you want to make darned sure that you are going to get that extra money back. This means that whatever investment vehicle you use must be secure - there can be no other way. Secondly, it has to pay back more than it costs you. Thirdly, it should pay you back with the same frequency that you have to pay your mortgage (or more often). These three criteria pretty-much eliminate the stock market, the commodities market, the bond market, retail sales and the service sector.

The obvious candidate for an investment of this nature is another mortgage.

It has taken me some time to learn that there is another way to get wealthy besides the orthodox advice of "Buy Low, Sell High". There is also "Borrow Low, Lend High". In order to make this work in the most efficient manner, you want to be able to borrow cheaply, and that means you want to achieve (and then keep) a good credit rating. Fixing bad credit is beyond the scope of this article, but I want to point out that if you have good credit, this strategy will work better for you than if you do not have good credit. In fact, if your credit is really bad, you might not be able to do it at all. If your credit isn't great, it's still worth looking into this approach before you decide it can't be done.

The basic theory here is to borrow the money as cheaply as you can, and lend it out more expensively. If you can borrow at 5%, lend out at 10%. If you can borrow at 7%, try to lend out at 14%. If you can't borrow at a rate less than 7% and you can't lend out at a rate above 9%, do the deal anyway - it might not be much, but that 2% difference will help.

There are other things to consider as well. One thing to be avoided is to borrow on an adjustable rate mortgage and then lend into a fixed rate mortgage. If the adjustable rate increases and becomes more than the fixed rate, you will have to pay out more than you get back. Then there's the mirror situation of borrowing at a fixed rate and lending into an adjustable rate.

In order to see this problem more clearly, let's take a look at the four possible combinations. Two of them work well and the other two don't work well.

Case I - Borrow Fixed, Lend Fixed. This will give you a constant spread between the rate you borrow at and the rate you lend at. To make a deal like this work, you have to borrow for less than you lend.

Case II - Borrow Adjustable, Lend Adjustable. This approach will also work, but it has a little more complexity. You need to mirror the terms that adjust your borrowing rate when you set up the terms you lend at. For example, do not borrow at "Prime plus a half" and lend out at "Eleventh District Cost of Funds plus two". When your costs are pegged to some index, make your income pegged to that same index - and don't forget to add in your spread.

Case III - Borrow Fixed, Lend Adjustable. This is an approach I would avoid, but mainly because it's difficult to set up successfully. When you borrow at a fixed rate, you can probably borrow at a lower adjustable rate. If you borrow at a fixed rate, that could be the rate that you'd have to lend at for in an adjustable rate loan (which means break-even cash flow). You would have to wait until the rates adjusted upwards before seeing positive cash flow - and the rates might go further down while you are waiting. I might try this if I knew we were at the bottom of the trough in the interest rates chart, and I could build in enough of a spread to make for positive cash flow. You might make a killing several years down the line with this, if you still have a low fixed rate cost and the adjustable rate has significantly increased your interest income. I don't want the gamble and will trade off that potential extra income for the comfort of knowing that Case I or Case II will always produce an interest rate spread that's in my favor.

Case IV - Borrow Adjustable, Lend Fixed. The problem with this approach is that the adjustable interest rate can rise, and that costs you more. I don't like setting myself up for this sort of a "rate pinch", or worse a "rate inversion" where you pay out more than you take in. I might try this approach if I thought that interest rates couldn't possibly get any higher.

The first two cases should always work, whether rates are low, middlin' or high. The last two cases should be avoided, unless you are willing to gamble in a couple of very limited extreme cases. Note that you can hedge your bet with these last two cases, if you really need to work out this kind of a deal. If you need to hedge your bet, you would do so by buying an appropriate futures option in an exchange where interest rate options are traded. I want to mention this possibility for the sake of completeness, but this kind of investing is way beyond the scope of this article. If I ever do this, I may write another article that shares some of my experience in the matter, but until that happens, you're on your own to find out how.

There are some other things to be avoided as well. Anything that would lead to you losing your house should be avoided. The obvious risk is when you've refinanced your mortgage, taken out capital amounts of cash and invested it... then suddenly, the borrower that you loaned the money to stops paying you back. You still have to pay back the mortgage on your home, even when the other income stops. If you don't make the monthly payments, you go into default, the lender forecloses and you lose your property. Of course, you might foreclose on your borrower's property too, and then sell it off to regain your capital, but can you keep your house long enough to go through all of that? Maybe. Can you do all of that if they file for Bankruptcy? In that case, you might find that you have to file for Bankruptcy as well. That's really bad.

So what's the answer? It's simple, really: you refinance to a level where you get some capital to work with, but still allows you to maintain the monthly mortgage burden even if you don't get any extra income back from investing that capital. You take what you can afford to repay. Take all of the mortgage debt that you can afford to repay as if it were "Bad Debt", because the more you invest (and the better you invest), the better the returned income will be. Don't take more than you can repay, though, because you might lose your house if you can't pay the monthly mortgage payments without help when the investment stops producing income for a while. As long as the investment is repaying on schedule, it is supporting your "Good Debt", but if your borrowers go into default, your extra mortgage will be "Bad Debt" until you can foreclose on their property and sell it (which might take years). If you loaned money into a mortgage, it should be secured by real estate and you should get your capital back eventually, but that won't be much comfort if you lose your house in the mean time.

The above paragraph is intended to guide you to an answer for the question "How much should I borrow?". Another question that you ought to consider is "How much can I borrow?". I can't give you a hard answer, and the soft answer doesn't really satisfy me very much. The soft answer is "Well, it depends.". I do know that if you've been paying the mortgage for a year or more since you took out the mortgage (or refinanced it), you're probably able to do something. If the current interest rates have dropped (compared to when you financed or refinanced), you could probably do something. If it has been five years or more since you have taken out your mortgage (or refinanced it), it's quite likely that you can get enough capital out of your appreciated equity to use this strategy. The way to tell for sure is to get a current appraisal. This is one of the things that your mortgage lender will want to do before lending you more money, so it's 'part of the process' when you refinance. Once you compare the appraisal to your last mortgage statement, you should have some idea of how much money you can borrow.

There is also the question of "Where can I find such an investment?", and this can be difficult. If you are able to run an information search on the internet, you might try to look for "mortgage management" or "mortgage syndication" and the name of your state. You might look for "second deeds of trust" or for "sub-prime lending" and the name of your state. Start with companies in your own state so that your costs are reduced. Don't be surprised if state laws prevent these companies from soliciting you. If you find any company that looks like it might be a candidate, contact them and ask for an Investor's Package. Don't be surprised if you hear that there is a minimum amount of capital needed to start (US$25,000 seems to be a common 'buy-in' amount). Two of the firms that I have used are Spartan Mortgage Services, Inc., in Sacramento, California (their web site is at ) and Royce Capital in Reno, Nevada (their web site is ).

If I think of anything else to add to this, I'll make some changes. If you have comments or suggestions, please e-mail them to me. Happy investing!

April 25, 2004

Kurt Schultz

Addendum, September 27, 2004: The State of California Department of Real Estate has a 13-page primer on Trust Deed Investments available at: . This is information that you should know before you attempt to invest in the way I've described in this article.

Copyright © 2004 by Kurt A. Schultz