Nothing down?

Copyright 1997, 1998, 1999, 2000, 2001, 2006, 2007 John T. Reed

It is a basic principle of real-estate finance that lenders should not loan more than 80% of the value of an owner-occupied single-family residence. The maximum prudent loan-to-value ratio on rental property is even lower, typically 60% to 75%. Higher loan-to-value ratio loans are really a combination of a mortgage loan for the amount below the prudent loan-to-value ratio and an unsecured loan for the amount above the prudent loan-to-value ratio. So only borrowers with very good credit and income should be able to get 80% to 100%-of-value mortgages.

I keep getting emails from sloppy readers who quote the first sentence of the preceding paragraph and say I’m wrong because they got a 90%-of-value or some such mortgage. Read the whole paragraph for Chrissakes! If you or anyone you know got a 90%- or 100%-of-value mortgage it is because your personal credit or that of a co-signer or guarantor was good enough for the lender to make the loan amount above 80% of value on an unsecured basis. In other words, the loan is, in reality, a mortgage secured by the property for the first 80% of value and an unsecured loan for the balance. The documents will pledge the property as security for the whole loan, but no competent lender would rely on the propertty alone for more than 80% of the value of the propertty.

Many investors think lenders refuse to lend more than 60% to 80% because they are stupid and overly conservative. Wrong. Lenders do it because they have learned from a century of experience that failure to abide by that principle will bankrupt them. Lawmakers and regulators have banned banks and such making nothing-down or even above 80% loan-to-value ratio mortgages except under certain circumstances. Even private note investors won’t touch a nothing-down mortgage. If you really believe lenders are being stupid and overly conservative, become a lender and make nothing-down mortgages with your own money. You will almost have a monopoly and you will be able to charge very high interest rates. You will also go bankrupt unless you only make such loans to individuals who have such good credit that you can collect from them personally when the foreclosure auction does not produce enough to pay off the loan.

How legitimate nothing-down deals work

The reason it's bad to make loans above the loan-to-value ratios stated above, in the absence of additional credit strength above and beyond the value of the property, is that the equity above those levels disappears in a foreclosure. Many investors have gotten rich buying foreclosures. They buy them because they are cheap, which is another way of saying they sell for well below market value.

So in order for the lender to protect themselves, they must get additional security for the amount of the loan above 80% of value (or whatever ratio applies) elsewhere. In my 1973 nothing-down duplex purchase, they got that additional security from the VA. The actual wording of the VA guarantee is that they guarantee the amount of the loan which exceeds 80% of the appraised value at the time of purchase. FHA works the same and has similar wording. There is also private mortgage insurance which works similarly.

Nowadays, most lenders will do a nothing-down deal where the buyer is affluent, has good credit, and personally guarantees the loan. In that case, they recognize that they are making an unsecured loan for the amount above 80% of value, but the borrower is so strong that they would lend him that much money on an unsecured basis.

So basically, the only way a lender can loan 100% of value or any percentage above the prudent lending limit, is to get a guarantee from a borrower or co-signer or guarantor who is so strong financially that they would qualify for the loan in question on an unsecured basis. Who might that be? The VA, FHA, your rich uncle, a Fortune 500 corporation, a state or local government, and so forth, even you if your credit warrants unsecured loans. A visitor to this site said, “There are a couple of lenders out other than VA that will do 0 down payments to $300,000 with a very high credit score like 720 or better.” These are the exceptions permitted by government regulations and I am not aware of any such loans for rental property—only owner-occupied, 1-4-family houses.

If any guru is teaching you to do nothing-down deals in this manner, I have no problem with the ethics or legality of the deal. But the vast majority of nothing-down gurus barely mention these techniques, if they mention them at all. Primarily, they advocate seller financing or combinations of seller and institutional financing.

I explain how to do legitimate nothing-down and other high-leverage deals in my book, How to Buy Real Estate for Little or No Money Down.

What's wrong with nothing-down financing from a seller?

Condemning institutional lenders is quite widespread among nothing-down gurus. The truth is they hate institutional lenders because they are smart enough to see through their nothing-down scams. They claim to love seller financing because sellers are “flexible.” But in that context, “flexible” is just a code word for stupid.

The seller-financing aspect of nothing down is generally unethical and possibly illegal because it takes unconscionable advantage of an unsophisticated person and because it is often concealed from an institutional lender who is also making a loan in the deal.

In the securities industry, they call taking advantage of unsophisticated persons a violation of “suitability” criteria. I discuss this issue at length in my book How to Buy Real Estate for Little or No Money Down. Ethical securities firms prohibit their employees from selling sophisticated, risky financial instruments to unsophisticated investors. Such investments are designated “unsuitable” for the investors in question. That’s why those who bought limited partnership interests had to provide information about their net worth and so forth.

You may protest that you are buying, not selling, when you do a nothing-down purchase. If you pay all cash to the seller, you are a buyer. But when you seek seller financing, you are both a buyer and a seller. You are buying real estate and selling paper. You are asking the seller to trade all or some of their equity in the property for a piece of paper.

If the piece of paper is worth as much as the equity, no problem. But it’s not. Nothing-down paper is worth next to nothing. The amount of cash you can sell a nothing-down seller mortgage for is close to zero. The vast majority of professional note buyers won’t touch it.

So the nothing-down movement consists mainly of a bunch of slime balls running around trying to find unsophisticated homeowners, typically widowed little old ladies, and bamboozling them into trading valuable real estate equity for a near worthless piece of paper.

That is unethical. It violates the Golden Rule. You would be outraged if someone did it to your mother or grandmother. It also probably violates laws like the Texas Deceptive Trade Practices Act (Texas Business and Commerce Code Section 17.45) which prohibits:

“an act or practice, which, to a person’s detriment:

(A) takes advantage of the lack of knowledge, ability, experience, or capacity of a person to a grossly unfair degree, or

(B) results in a gross disparity between the value received and the consideration paid...”

One reader told me he had done a seller-financed nothing-down deal with a sophisticated seller: a real estate attorney. Fine. I have no problem with that. If you select a small enough sample size, you can prove anything. The reality is that you are likely to starve to death searching for another such sophisticated seller who will sell to a nothing-down buyer. And the various real-estate gurus certainly are not advising their readers to only seek out sophisticated sellers. On the contrary, they specifically say to seek out senior-citizen laymen home owners.

Misleading institutional lenders

Many of the nothing-down techniques, like Allen’s “second-mortgage crank,” require you to commit a felony. He does not tell you to break the law. But he tells you to do something which cannot be done without breaking the law. It’s as if I told you to drive from San Francisco to LA in four hours and admonished you not to break the speed limit. It is impossible. For example, Allen’s “second-mortgage crank” has you getting a new 80% loan from an institution and the seller taking back a second for the rest.

Simple, right? Wrong. Institutional lenders are generally not allowed to make such a loan and they will not knowingly do so. They ask where the down payment is coming from and “seller” is not the right answer. Allen says the key is finding “the right lender.” Joe Land, whom I debated on the 3/16/86 60 Minutes’ “Nothing Down” segment, said the same thing. Land said he had done these deals. I asked Land for the name of a lender who was willing to do such a deal. At my behest, Morley Safer and a Time magazine reporter asked Land the same question and even promised anonymity for the lender. Land refused to name one. He cannot. Neither can Allen or any other nothing-down guru.

No such institutional lender exists. [One reader of this page says he did fully-disclosed 80-20 nothing-down deals with institutions. I asked, “Which ones?” He said: “I have dealt with Family Bank and Medford Savings Bank (both of Massachusetts)]. In both situations, they would only do such a deal for a local piece of property that they were familiar with. They also stated they would only make the loan to someone experienced with rental property (to minimize the odds of foreclosure).”

The only way an institutional lender will do a nothing-down deal, other than where there is a guarantee from some person or entity with strong credit, is if you mislead the lender as to your down payment. In fact, that is what is done in virtually all nothing-down deals involving institutional lenders. The president of the Robert Allen Nothing Down Club of Atlanta literally went to federal prison for lying to lenders about the amount of the down payment in some nothing-down deals. I suspect many others who tried to follow the advice of nothing-down gurus have lost their credit and/or gotten in trouble with the law.

Where’s the profit?

I acknowledge that it’s possible to do nothing-down deals legally and ethically, even though it’s darned difficult. But what’s the point? Isn’t there supposed to be a profit? When you buy for nothing down, you have a mortgage amount which is 25% to 33% larger than normal. That, in turn, means your mortgage payment and interest expense are 25% to 33% higher. That will cause huge negative cash flow in the vast majority of deals. Heck, the vast majority of 20%-down deals in single-family rental houses have negative cash flow.

True, the gurus offer a few tricks for either deferring the payment or for persuading the little old lady who is already being screwed big time in terms of risk to get screwed even worse by agreeing to a below-market interest rate. But deferring the payment has no effect on profitability. Pay me now or pay me later. And compounding your crime by getting a below-market interest rate brings the deal close to purse snatching, which I understand is also profitable.

Nothing-down gurus say you should try to get a good price or good terms. Baloney. Good terms have no value in the absence of a good price. If you pay market value or more than market value, which is common in nothing-down deals, and burden the property with a 100% mortgage, you are almost guaranteed to lose money. All the deals that Allen did in his nothing-down publicity stunt with the LA Times were money losers by his own admission.

Here’s a letter I got from a guy who was hurt by trying to do nothing down deals:

Dear Mr. Reed,

I have been waiting for information like yours for years. Thank God for the internet!

I first tried RE investing when I was 18 & in the Navy. Unfortunately, it was through Bob Allen's Nothing Down Course. But it got me started. As time went on, I invested my way right into bankruptcy with several "killer" 0 down deals. Whether it was lack of a formal education or naivete, it was a painful experience nonetheless. That was nearly 20 years ago. Through lots of hard work and discipline, I own a home in San Diego free and clear and am debt free. (WITH a wife and two children!)

I am starting to look into RE investing again, this time with much clearer eyes. Thank you for your straight talk and diligence in this area. I'm sure that you could have left the field a long time ago, leaving us truth seekers to fend for themselves. I am hopeful that your advice and instruction will eliminate much of the trial and error I would otherwise have had to go through.

For instance: Instead of looking for apts. to invest in, I would first like to make ONE profitable investment in an SFH. This decision was due to your bringing to my attention the potential management headaches of an early investment in apartments.

I will study diligently for the next few months before jumping in.

Thanks,
Christopher T. Rollins

Summary

If you follow the nothing-down advice of the gurus, you will generally find that you have to take unconscionable advantage of an unsophisticated person and/or lie to a federally-insured lender to do the deal, and that after you have done the deal, you are losing money on the property and probably your good credit rating as a result. The nothing-down movement does not exist to help people like you become financially independent. It exists to enable unscrupulous gurus to overcome the sales objection, “I don’t want to buy your real estate investment seminar (book, cassettes, whatever) because I have no money to invest.” It is a scam perpetrated on unsophisticated investors to make the gurus rich. As Morley Safer so well put it on the 60 Minutes program where I appeared, “Americans have long wanted something for nothing, now they want something for nothing down.”

There is no free lunch.

Because there is so much bad information out there about nothing down—and it is growing by the month—I decided to write a book on the subject: How to Buy Real Estate for Little or No Money Down.

Buying real estate for little or nothing down is possible. It is also difficult and not advisable for many people. The four legitimate techniques are:

• specific government and private programs to make high loan-to-value-ratio owner-occupied mortgage loans

• loans from sellers for whom the mortgage is a “suitable” investment

• 100% loan-to-purchase-price-ratio mortgages on bargain purchases where the loan-to-value ratio is 80% or less

• loans where the borrower or a guarantor has such good credit that the lender is willing to make the top 20% of the loan on an unsecured basis

See my book for details.