Surviving self-employment: Ellen Hendrix confronts what it's really like to make it on your own.

IN LATE SPRING OF 2002, ELLEN HENDRIX lost her job. A video editor at the time, she had seen the "writing on the wall" in terms of business slowing down in the production division of the public relations firm where she worked. With the firm also undergoing a major reorganization, she felt her days were numbered.

Hendrix tried to prepare for the inevitable by purchasing rental property to generate another source of income. "I was thinking I would get two or three houses and build up some savings that way." At the time she lost her job, the 43-year-old Winston Salem, North Carolina, resident had only about $700 saved--a far cry from the three to six months' worth of living expenses most financial advisers recommend.

Although she reached her goal of acquiring a rental home for $25,000, "I was laid off literally two days after I signed the papers on the property," Hendrix recalls. After four years of service, she received one month's severance pay, roughly $3,000.

The $3,500 in closing costs and 10% down payment Hendrix used to acquire the single-family rental home came from a $15,000 home equity line of credit on the single-family home she already owned. She purchased that home in the fall of 2001 for $62,500. She has since used the home equity line of credit (which has a $9,000 balance at 5.25% interest) to sustain herself when she needs quick cash for quarterly taxes and other expenses. Hendrix was also helped by $8,000 in unemployment benefits for the 2003 tax year, which came in handy during a lull in freelance work.

Now self-employed, Hendrix grosses a combined income of about $35,000 a year from video editing jobs and unemployment, which closely matches her former salary. Single with no children, her expenses are relatively low--a little over $2,000 a month. She also has a fairly low debt load and very good credit. Her debt includes $2,500 in credit card balances and a $13,000 car note (at an interest rate of 5.79%) on a 2000 Toyota Ray 4 purchased this summer. The mortgage on her primary residence is about $62,500, after she refinanced in August 2003, lowering the fixed rate from 7.75% to 5.65% and shortening the term of the loan from 30 to 20 years. The mortgage on the rental property is $37,000 (after a recent refinancing) at an adjustable rate of 4% at press time. The combined equity in the homes is $42,500.

While her situation has improved from 2002, Hendrix has a major cash-flow problem. She still doesn't have enough cash on hand in the event of an emergency. She has $5,000 in checking accounts, another $4,000 in savings, $3,500 in a Both IRA, and $12,200 in a Rollover IRA--money from a 401(k) account with her previous employer.

In terms of the rental income, Hendrix has not made much of a profit. She still owes her mother $3,900 that was part of a renovation loan. "My mother decided to let her money ride; we made an arrangement that it would accrue 10% simple interest per year until I pay her back."

Right, now, Hendrix's positive cash flow from renting out the property is $120 a month. She is still ambitious about acquiring real estate to build up future sources of income. But more pressing she wants to know. "What can I do to decrease my debts and at the same time increase my savings?"

Financial Snapshot:
Ellen Hendrix

HOUSEHOLD INCOME

Full Time                     $35,000

               ASSETS

Checking                       $5,000
Savings                         4,000
U.S. Savings Bond                  25
Roth IRA                        3,500
Rollover IRA                   12,200
Primary Home Market Value      85,000
Rental Home Market Value       57,000
Car Market Value                9,000
Total                        $175,725

               LIABILITIES

Mortgage Primary Home         $62,500
Mortgage Rental Home           37,000
Home Equity Line of Credit      9,000
Credit Card Debt                2,500
Auto Loan                      13,000
Total                        $124,000

NET WORTH                     $51,725

THE ADVICE

Hendrix has made a number of strategic moves to insulate herself from a full-scale financial downfall. She has adequate health, life, and homeowners insurance. She has low interest rates on all of her borrowing. She is not living beyond her means. She has made the adjustment to being self-employed.

The biggest thing Hendrix has working in her favor is her credit score. "You can tell by Hendrix's low interest rates that she has a good credit score (above 700)," says Sterling Laylock, principal of Sterling Financial Advisors in Atlanta. Lenders use a credit scoring system not only to determine whether to give you credit, but how much you pay in interest for a mortgage, car loan, or credit card. Information from your credit report, including late payments, outstanding debt, and collection actions, are used to assign a score from as low as 300 to as high as 850.

The good credit score will significantly boost her efforts to reach financial independence, but there is much more for Hendrix to do. "She needs to increase her cash flow and protect her assets," says Laylock.

Use equity links of credit to build emergency fund. Since Hendrix has a good amount of equity in her real estate and excellent credit, this can afford her maximum equity lines at the lowest cost and serve as her emergency fund since her cash position is low. This doesn't mean that she should take money from the credit lines all at once, but she can access the cash, should she need to. Since the majority of her cash resources are tied up in her two IRA accounts, she can't access that money without paying tax penalties for withdrawing it. Laylock cautions Hendrix against resorting to charging emergency expenses on high-interest credit cards, and suggests she contribute the $2,000 prize winnings to her rainy-day fund.

Put an emphasis on "flipping" vs. buying long-term rentals. The equity line can also be used for closing costs on additional real estate. While Hendrix wants to build a stream of income by buying and keeping rental properties, Laylock suggests she "buy to sell" instead. Using a method known as "flipping," he recommends she purchase the properties, repair them to increase their value, and then put them back on the market. After roughly $7,000 in renovations, the rental home she bought for $25,000 two years ago has already appreciated in value to $57,000. She should look at homes in her neighborhood, which have an average sale price of $35,000.

With her credit, Laylock believes Hendrix can qualify for programs that offer 100% financing and no money down. Once she rinds a property and flips it, Hendrix ought to pay off the car note, the credit card debt, and begin contributing regularly to her IRAs to build up retirement income.

Set up a single member limited liability company to hold real estate.

Laylock says Hendrix needs to separate her video editing business from her real estate ventures. "You don't want to commingle that stuff," he cautions, noting that she may need to show the records of her real estate business in order to qualify for additional credit in the future.

An L.L.C. will shield Hendrix's personal assets. She currently owns the investment property as a sole proprietor. It something were to happen--say a tenant slips and fails that person could come after her home, car, and other assets in a lawsuit. An L.L.C. is limited only to those assets held by the company. Moreover, she could enlist her mother or other investors to help purchase real estate down the road. She would simply have to negotiate partnership interest, whereas with an S corporation or regular corporation, an investment is in proportion to the number of shares or stock ownership.

Create an estate plan. Since she is single, it is very important that Hendrix set up her estate documents to guard against disaster. She needs a power of attorney for healthcare, assets, and medical directives. She should also have a living will with an irrevocable living trust. This way, Laylock says, she will have designated specific people whom she trusts to safeguard her person or assets should tragedy strike Equally important, she needs to purchase disability insurance once her cash flow improves.