The average homeowner in America already holds the secret to perpetual income and endless cash flows in their hands and they don’t even realize it. There are some real estate investors who grasp the concept of cash flow and will spend large amounts of money to purchase these income producing properties. The fact is that anyone one who owns a piece of real estate is already in possession of the most important ingredient in the cash flow formula. Now they just need a little education.
According to the 2005 census nearly 33% of homes in the United States were owned free and clear, meaning that they no longer have a mortgage that encumbers the property. These homeowners certainly have achieved a certainly level of financial maturity. But how are these great investments benefiting these owners?
Consider this hypothetical example. John Homeowner bought his home for $100,000 at 7% interest which gave him a monthly payment of approximately $700/month (PITI). By the time John paid off his home mortgage the value of the home has gone up to $200,000. Now John has an asset (his home) worth $200,000 but that investment isn’t a great performing asset because he is making $0 return annually on this investment.
Now consider this cost/benefit analysis for John’s situation. By doing nothing but living in his home John is saving $8,400 each year (12 months x $700/mo mortgage payment) because he has no mortgage payment. But if John were to make the same $200,000 (the current value of his home) and invest it into an investment that had a return of just 4.5% he would make $9,000/year (better than his savings by over $600). And if he were to make a smart and safe investment of that same $200,000 at 6% ($12,000/year), 8% ($16,000/year) or 10% ($20,000/year) his return would be far better than the $8,400 savings that he has by owning his property free and clear.
Here is how this scenario relates to seller financing. Let’s say that John has to move to another city and he is forced to sell his home. John understands the power of seller financing and he decides to sells his home to a buyer using “free and clear seller financing”. Because John offers seller financing he is able to sell his home quickly and for slightly more than average market value. Imagine that John sells his home with the following terms: 1.) 5% down payment ($10,000), 2.) $200,000 principle balance, and 3.) 8% interest only payments ($1,450/mo, $16,000/year).
John can now move to a new city and find himself a home for about $200,000. He is able to purchase the property with 5% down payment and can borrow the balance of the purchase price at a 6% interest rate. So John now has a principle balance of $190,000 at 6% which gives him a payment of about $1,140/mo. John now has a positive cash flow of over $300/month (the difference between his investment payment and his current mortgage payment). Not only does he have a positive cash flow but the principle value of his asset stays at $200,000 but the principle value of his new home will amortize and eventually go away giving John additional value (a second asset of significant value). Now his original house is actually paying for his new house with additional cash flows.
What happens if John doesn’t want to move? Because John is savvy he knows that he can do this same process without leaving his home. Imagine that John pulls the equity out of his home through a traditional refinance at 6%. He now has roughly $200,000 to invest in another house. John pays cash for the next house and then he sell that house to a buyer using “free and clear seller financing.” The buyer pays 5% down with a $200,000 principle balance and 8% interest only payments. Without leaving his home John and just created his $300/month cash flow and the monthly income is now paying off the refinanced mortgage.
What happens when the buyer eventually refinances or sells the property and John’s seller financed mortgage is paid off? John will find another home to buy with the cash and sell it using seller financing. This is how John can create perpetual income through seller financing. In fact, any home owner can create perpetual income through seller financing following this cited example.
Let’s consider the risks to “free and clear seller financing”:
Risk 1 – What happens if the buyer stops making payments? When the buyer purchased the property they gave a $10,000 down payment. In addition, the seller was saving $8,400/year because the property was owned free and clear. If any of this money was saved then there should be more than enough money to hire an attorney to foreclose on the property. The owner takes the property back and sells it again. The new buyer will give a new $10,000 down payment and if property values have gone up then the owner will be able to increase the principle balance and possibly the interest rate which will increase the cash flow. In most typical situations the original owner is actually in a better situation after the foreclosure and 2nd sale.
Risk 2 – What if the buyer destroys the property? The purpose of home insurance is to protect the lender (the owner) in case of property destruction. So if the buyer destroys the home the owner will make an insurance claim and have the home professional restored (paid for by the buyer’s insurance premiums).
Risk 3 – What if the property values go down? It doesn’t matter. The buyer is still obligated to make the mortgage payments regardless of market conditions.
Risk 4 – What if the buyer defaults in a down market? Then the owner can foreclose using the buyer’s down payment money (or personal savings) and then resell the property. The owner may end up sell it for less because of the market conditions. Or, the owner can invest the positive cash flow into private mortgage to protect the investment (principle balance). Or, the owner could take the property back and then rent it until the market recovers and at which point the property will sell at the market higher values. Or, the owner could invest their money in a partnership with a trusted real estate investor who will buy the property and assume most or all of the risk for a slightly lower return on the invested money but with a guarantee on the investment (principle).
Risk 5 – How will I know if the buyer’s payments are being made? A good practice is to use a third party escrow company to receive the mortgage payments from the buyer. The third party escrow company will then send the owner a receipt of payments along with the payment money. This way all the money is being tracked for financial and legal reasons.