How to Build Continuous Cash through Noteworthy Investments | Think Realty | A Real Estate of Mind
Investing Strategies

How to Build Continuous Cash through Noteworthy Investments

IdealRetirementPlan Notes

How would you like to have a retirement plan that builds up cash continuously with as little as one initial contribution from you? Imagine a plan that you do not have to set up with a brokerage firm, a plan that has no fees of any kind, a plan in which you are totally in control with no government restrictions and very little paperwork, a plan that allows you to withdraw funds no matter your age. Does this even exist?

You bet it does. Imagine this scenario:

Mr. Smith sold his house and “seller-financed” a $10,000 note secured by the house, amortized for 10 years. The buyer of the house, Mr. Jones, will pay Mr. Smith $132.15 per month for the next 120 months (10 years).

As an investor, you approach Mr. Smith about buying that note. You offer him $8,000 cash for it. Mr. Smith says, “Why should I take $2,000 less?” You say, “Because, Mr. Smith, I am buying your risk. Anything can happen to Mr. Jones in the next 10 years. There are no guarantees that he will make his payments on time, and I may have to work to get them. If he defaults, I will have to go through the considerable expense, time, and headaches of foreclosure, which could take months (or years, depending upon the state). 

Once foreclosure is complete, who knows how much damage Mr. Jones might have done to the house. It’s not uncommon for those who lose their homes in foreclosure to be angry and deliberately damage the house. I have known of foreclosed homeowners who poured concrete down the toilets before they were evicted, and you can imagine how much it costs to repair something like that. I calculate for the worst-case scenario to make repairs on the house once foreclosure is done.

If you were Mr. Smith, would you rather have $8,000 now, or hope Mr. Jones sends you $132.15 every month for the next 10 years and have to deal with it if he doesn’t?

Here’s another way to illustrate the point to Mr. Smith:

You put a twenty-dollar bill and a hundred-dollar bill on the table and say, “Suppose I offered you the choice of this twenty or this hundred. Of course, you would take the hundred. But what if I told you that I will give you the twenty right now or give you the hundred six months from now – which would you choose?”

If Mr. Smith is like most people, he will choose to wait six months to take the $100.

You then make the same offer, except you increase the time when you will give him the $100 from six months to a year and ask him which he will choose. If he still says he will wait, increase the time to two years, three years and so on. At some point, he will choose to take the $20.

That’s when you say:

“Mr. Smith, you have just told me that 20 dollars now is more valuable to you than the promise of 100 dollars two years from now” (or whatever period of time he chose).

Both the twenty-dollar bill and the hundred-dollar bill are pieces of paper with different numbers written on them: just like your note. The numbers are not as important as WHEN and IF the money is paid. If you wait for the hundred dollars, something could happen to me and I would not be able to pay, or I might refuse to pay. You chose the sure thing rather than take those risks, and that is exactly the situation with your note. I am offering you the sure thing, $8,000 cash, and if you accept my offer, you will not have to worry about something happening to Mr. Jones and him not being able or willing to make the payments.”

Mr. Smith decides that he could use $8,000 cash now instead of wondering if he will get a payment every month. You pay him $8,000, he signs the note over to you, and writes a letter to Mr. Jones telling him to send his monthly payments to you from now on. (I’ve skipped some due diligence steps to keep this example simple.)

The transaction does not affect Mr. Jones in the least, other than where he sends his payments. His interest rate stays the same as does his monthly payment.

You paid $8,000 to receive $132.15 a month for the next 120 months. What is the interest you are receiving on your $8,000 investment? You plug the numbers into your financial calculator and discover that you are getting an annualized interest of 15.63 percent!

But we’re just beginning.

You contact a note investment firm and ask, “How many monthly payments of $132.15 would you expect to buy for $8,000?” If the firm currently invests to get an interest rate (or yield) of 9.6%, the answer is that to get a 9.6% return on $8,000 they need to receive 83 monthly payments of $132.15.

You assign them the next 83 payments. The firm pays you $8,000. Mr. Jones mails his payment to them each month. Your out-of-pocket costs for this transaction? Zero.

At the end of the 83rd month, the firm has received all the payments they bought from you. They are out of the picture. But remember, you bought 120 payments. Mr. Jones has agreed to make 120 payments. Who gets the remaining 37 payments? YOU DO. And you have nothing invested in this deal. What’s the interest rate, or yield, on your investment?

Don’t try to put that in your calculator. You’ll terrify the poor thing.

In the note business, we call the above transaction “keeping the back end or the tail end.” Imagine doing this over and over. In a few years, the back ends will start reverting to you, and your retirement income will just keep growing. Except, you’ll have to pay income tax on the back-end payments. Avoid that by having your self-directed Roth IRA do these transactions. Your Roth will keep growing with back-end payments that cost nothing, and the distributions will be tax-free.*

That’s why I call this the Ideal Retirement Plan.

*Always check with your tax advisor first. Be sure your self-directed Roth IRA is not borrowing money to purchase the note and is not dealing with a related person or entity.