Just after the end of the Carter real estate boom, Jimmy Napier wrote a best-selling book he called “Investing in Debt.” His timing was perfect. In most areas of the country, the interest earned on borrowed money far exceeded the gain earned from capital appreciation. It’s easy enough to figure out why: Suppose he bought a house financed at 8%. Every $100,000 loan would earn $8,000 per year. A $300,000 loan would pay the lender $2,000 in income per month in interest with little or no effort on his part; and virtually none of the liability associated with real estate ownership.
Suppose you took out an 8% “interest only” loan with the balance due at the end of ten years. During this time, let’s assume the lender had been able to collect all payments on time and had immediately reversed the payments to continue earning 8%. The 120 payments of $2,000 each would have been capitalized to $366,000 plus your principal repayment.
The price paid for this income would be the depreciation loss, which would be recovered at the 25% tax rate if the house were sold; and loss of appreciation. On the other hand, there would be no property taxes, maintenance, or insurance to buy. The borrower’s home would have to appreciate at 8% per year, plus $2,000 per month, plus property maintenance costs above income, to produce the same net return for the homeowner as for the lender; and would not have to have other expenses.
To keep things the same when comparing earnings, we’ll assume the lender was a Pension Plan, IRA, or Tax-Exempt Trust that didn’t pay taxes on your investment earnings. Let’s look inside the numbers: If the house were the personal residence of the borrower, it could not depreciate. Aside from providing housing, the only benefit of the property would be tax-free appreciation. The cost would be the loan payments. The interest cost of $2,000 per month plus property taxes, insurance, HOA fees, and maintenance would increase the investment. These would have to be repaid before any benefits are realized. Using the same numbers as before, this is as much as $375 per month for some people without maintenance. This could easily add another $200 per month. Over a decade, all things being equal, around $309,000 would have been spent on this house. If it were sold tax-free, the net gain on the mortgage would have to be about $366,000 on top of the $308,000 in expenses just to keep up with the gain the lender would have made.
If both the lender and the borrower paid federal taxes only on their earnings, assuming they each paid 25% of their income in taxes, the lender would only have been able to reinvest $1,500 per month at 8%. This would have added up to just over $274,000. Ignoring the Alternative Minimum Tax and costs of sale, the borrower would have had to be able to come up with about $777,000 net before taxes to match this.
The essential difference between home and mortgage investment returns is the speculative gamble on appreciation and liability versus the regular monthly income from a secured loan. When the leveraged appreciation offsets the risk and potential negative cash flow, homes are worth buying; But when it’s not, it makes sense to consider being a lender. When a house is your residence, there is little tax shelter per se. For rentals, at best, only expenses of $25,000 per year in excess of income can be deducted against non-passive income. Any excess spending must be carried over until the home is sold. This could amount to many years.
There are many ways to become a lender, even when you have very little cash to work with. The essential requirement is that you find houses that you can buy by combining your existing financing with the seller’s financing; then sell them in whole contracts or whole loans at higher prices and interest rates