House Rich! Cash Poor!

What the mortgage investor knows that you don’t.

What if I were to tell you that using your existing assets in a better way you can dramatically increase your passive income, reduce your net tax bill on your existing income from employment, and substantially increase your freedom from having to work in a job at all?

Unbelievable! You might well say.

Well, not really. Actually, it’s true. If you have significant equity in your home, a reasonably good credit rating, and a desire to increase your take-home real income then listen up!

And be prepared to be surprised at how simple and logical it is to use the equity in your home to maximum efficiency, and without a significant risk of losing your home as a consequence of taking action.

First Principles

Most Canadians were raised to believe that debt is a bad thing, in and of itself. If this notion has you firmly in its grip, and you don’t think you can get past it, then you might as well stop reading this article right now, as the whole point of the strategy is to use leverage against your largest single asset, your home, to acquire other assets that produce a significantly higher return than the cost of borrowing the money.

So if the very idea of borrowing money bothers you, then remind yourself of one simple fact – if you had never borrowed money you probably would have never owned a home.

Most financial advisors acknowledge that there is two different kinds of debt. There is “bad” debt borrowed to pay current expenses or luxury items, which advisors would generally recommend against. Then there is “good” debt – money borrowed to earn income or acquire assets that will eventually increase in value, but which have an investment return at some point in the future.

So there are circumstances where borrowing money for a sound purpose, and with a sound plan to invest those monies in income earning investments, can be a good idea. Once you get to really understand how and why it works as well as it does, it is far more than simply a good idea, it is a compelling one.

What makes it compelling is the simplicity of applying a few simple ideas to your own situation and putting it to work.

If you bought a home a few years ago, especially in British Columbia or Alberta, but almost anywhere else in Canada these days, and have been paying off your mortgage and watching the value of your property increase, then you are a good candidate to enjoy the fruits of the increase in wealth represented by your home equity.

Let say you bought your home in 1985 for a pretty average price, then, of perhaps $150,000 to $200,000. It wasn’t easy to buy your home, but you scraped together the down payment, of perhaps 25% down, perhaps less. And between then and now, more than twenty years later, your home is now worth upwards of $700,000 to a million dollars.

Nothing else you own will likely have increased as much as the value of your home, unless, of course, you own other residential real estate in similar markets.

So it would seem that leaving your money in your house isn’t such a bad idea, if it could increase in value by so much, doubling and redoubling in twenty years. The problem is that while it very well may continue to rise in value over time, it will continue to increase in value whether you owe nothing against it, or borrow 75% or 85% of its value to invest elsewhere. And the rate of return on your invested capital is dramatically increased if you reduce the amount of your capital tied up in the property.

So if you come to me I will arrange a Home Line of Credit, otherwise known as an HLOC, which can drawn down and paid up as you invest in private mortgages or a Mortgage Investment Corporation.

The HLOC will cost you anywhere from Prime less .5% up to Prime plus .25%, depending on your Credit Score and other elements on your loan application. In other words in today’s interest environment you will pay between 5.00% and 6.25 for your line of credit. Since this money is for investment purposes it is fully tax deductible against earned income from any source.

If you invest this money in second mortgages, secured against residential real estate you could currently expect to earn an average interest rate of 12 to 14%, an annual rate of return of slightly more than 15%, when all penalties and other lenders fees are included. If the funds are invested in a MIC, the rate of return will be slightly less, more in the range of 12% to 14% depending on the specific mix of mortgages held in the portfolio of the company.

Either way, you have a nice net return of between 5.5% and 9.5% for every dollar invested in mortgages. That is an amount up to $5,500.00 to $9,500 per year net income before taxes in passive income on money current sitting passively in your home doing nothing.

Given the example above where the property is currently worth $750,000.00 and the line of credit is 75% of the value of the property, that would equal an investment of $562,500.00 earning a net income after the cost of HLOC interest of between 30,000 and $90,000 a year, without having to go to work for one day.

Wow! Something to consider.

A word about risk

Isn’t leveraged investment dangerous? Will I lose my home? Or find myself in a cash crunch if some of the mortgage investments don’t pay? What if I have to foreclose?

All investments have risks. The nature and degree of risk is critical, and you should always have a clear understanding of precisely what it is that you are risking, the likelihood of catastrophic loss, and probably most importantly, the effect of a catastrophic loss on your personal financial success or failure.

Let me be clear. If you invest in residential second mortgages on properties in BC or Alberta in strong markets through a reputable mortgage broker you could lose all your money.

It's not likely, unless of course you completely abandon your sense of self preservation, or simply don’t pay attention to the disclosure documents you are provided by your broker.

So when you invest in mortgages there are a few simple rules to protect yourself from making poor investment decisions.

Read everything sent to you by your broker and make reasoned decisions based on a fully educated understanding of the situation your borrower is in, the security of your mortgage and lands and buildings on which it is based, and the disclosure statement made by the broker.
Accept no substitute for being fully accountable. As your broker I am your agent. I act for you, in your best interests, and to your best outcomes. At the end of the day, however, the decision to invest or not to invest in a particular mortgage or mortgage based security must be based on your own best judgment.

Be honest with yourself about your goals for investment, and your tolerance for risks of different types. Just because I’ve said that I don’t think it is likely for you to lose all of your money on any deal, doesn’t mean that a deal won’t drive you crazy if it ends up requiring your attention, or distracting you from your day-to-day life.

If collecting NSF checks will drive you nuts, invest in a Mortgage Investment Corporation, where an administrator and her staff will handle all that jazz. The management will charge something for the service, but the investment will feel more like a traditional investment, without the day to day hand holding and personal involvement required in direct investment in mortgages.

There is more than one way to offset, ameliorate, mitigate, or reduce the risk of investments in mortgages (or in other investments for that matter). Understanding and managing risk is a critical component in successful investing. If you feel more comfortable leaving individual investment decisions up to the experts, then invest in pooled mortgage products or investment funds. On the other hand, don’t underestimate your ability to assess the risks involved in home mortgages. It might not be simple, but it something you can learn, and learn relatively quickly.
Don’t put all of your eggs in one basket. Diversify even within your mortgage portfolio. Don’t put the majority of your money into one mortgage or even a single investment marketplace. I don’t recommend that an individual place more than 20% of his available mortgage investment capital into a single investment. If there are difficulties in collecting or managing a single mortgage, it shouldn’t be sufficient to upset your cash flow to the point where you are having to pay for the LOC from your other sources of income.

The whole point of investing in mortgages with LOC funds is to produce more income and make a better retirement by leveraging your assets. It is not to create a stressful cash flow drain, so work with your broker to reduce stress and risk, while at the same time pursuing a highly profitable strategy.