The Debt Millionaire
Page 6
There is a 99.99% chance you are wrong, but keep thinking about it.
Well, it’s not any of the investments you mentioned—unless you have heard me speak
about this before.
The best place for the highest return is in your checking or savings account, or any
other liquid account!
Here’s why.
Let’s assume you invested that $50,000 as down payment into purchasing a $250,000
rental property. That money now is locked up for some time, say five years or more. Let’s
assume your return is X%. However, that money is now locked up, and you have no
liquid funds to invest, therefore your chances of obtaining another loan from a lender to
purchase another asset have declined significantly (due to lack of liquidity).
On the other hand, if you kept that $50,000 in your liquid account and brought in an
equity partner to put up the down payment for a piece of the upside, now you are a part
owner of the property and you still have your $50,000.
You are able to replicate an equity partner transaction multiple times. Your money in
the liquid account gives you a much better chance of obtaining more financing to
purchase more assets. If you offered your equity partner 50% and they accepted then you could have multiple deals while holding on to your $50,000.
Holding that $50,000 in a liquid account gives you the opportunity to do many more
loans, thereby significantly improving your returns from just that amount alone.
That is the difference between looking for a “return” and a “spread”. When you invest
your money, you are looking for a “return,” but you lock up your money and lose the
opportunity to make more money with it. Looking for a “spread” allows you to make more
money using other people’s money and you also have the ability to do many of them. So
in essence, that $50,000 in your liquid account allows you to generate many more
“spreads” than “returns.”
Let’s consider another example.
You deposit your paycheck in a bank. The money sits there until you pay your bills.
Assume it takes you 3 weeks to pay off all your bills. That means your money sits there
earning very little to nothing for up to 3 weeks out of every month (assuming you are
paid once a month). So your money is doing nothing for 75% of the time you have it. If
you work for 40 years, all the money you earn over the 40 years, up to 75% of the time is
doing nothing for you sitting in a checking account waiting to pay bills. That is up to 30
years (75% of the 40 years) of money doing nothing! It is however, making the bank
richer! What if you could make the money “earn” you 6% to 8% tax-free while sitting in
the same bank you use? And it was still liquid? This is lost opportunity cost, and the
difference is six to seven figures in your pocket without changing your lifestyle. And yes,
that is possible!
These were just two examples of lost opportunity cost. There are a lot more, and it is
costing you by you not doing something about it!
By the way, the last example mentioned is covered in The Wealthy Code book in more
detail.
So let’s add more to the two options from before.
We previously mentioned that you typically have 2 options to finance things: Either pay
cash and give up the interest you would have received on that cash, or borrow money to
purchase it and pay interest to someone else.
Now we can add another consideration.
How much more valuable is having cash than spending it? Another way of thinking
about it is how much additional borrowed money can we access for having the cash?
So by having the $50,000 in our bank, does that allow us to have access to an
additional $1,000,000 in loans, $2,000,000, or more? That depends on a number of
factors. I hope you can see the magnitude of leverage you can generate with that
liquidity.
How much more valuable is having cash than spending it? Another way of
thinking about it is how much additional borrowed money can we access by
having the cash?
So let’s expand on this and cover another aspect of it. When we decide to use other
people’s money, what type should we use?
Note that I used the term “other people’s money” here and not “debt” as I used
earlier. The reason is that the use of other people’s money can be structured in several
ways other than just debt.
For example I can structure raised money as equity. For example I can pay a money
partner a percentage of the income and/or profits from the investment in which they are
involved. They invest their $50,000 into an investment and I can offer them 50% of the
profit.
Another example is that I can structure the raised money as debt. For example, I can
pay the investor investing their money a specific return on their loan.
Another example is that I can structure the raised money as royalty. For example, I
can pay the investor investing their money a percentage of the gross income from the
investment they are involved in. This is different than an equity partner since equity
partner can have ownership.
There is also the option of structuring the deal as a combination of the above.
Furthermore, each of the above has various options to consider. For example, with
debt, we have various types of debt including:
· Installment loans
· HELOC
· Mortgage
· Credit cards
Let’s consider some specific examples to illustrate the above.
1. Instead of using your money for down payment on an asset, consider finding
someone as an equity partner. An equity partner is someone that invests money in
exchange for a percentage of the profit. The equity partner invests the down
payment in exchange for piece of the profit. You could be on the loan and you keep
your cash for liquidity.
2. Many investors that do short term deals (one year or less) tend to refinance to pull
money out for these short term loans. It’s actually better to have a HELOC instead
of refinancing if the money is for funding these short term purchases.
3. Always keep your financials looking strong to be able to obtain financing for
purchases. This includes your credit score, your debt-to-income ratio, liquidity, etc.
4. Consider having certain loans in your name and others under your partners’ or
spouses’ name. Avoid both of you being on the loan because it impacts your
borrowing capacity.
5. Use 30-year mortgages over 15-year mortgages.
6. Find the lowest annual loan constant for all your loans for as long as possible. Refer
to the book The Wealthy Code for more information.
7. Instead of using your credit card for large purchases, consider using your family
bank. This is discussed later in the book. By doing this, you are recapturing higher
interest payments and directing them into your pocket.
Calculating Opportunity Cost:
What about calculating lost opportunity cost? Well, this is where it gets interesting.
The calculation depends on the underlying choices, but many times, for investing, you can
use the “Future Value” formula to do so.
Here is the formula:
FV = PV (1 + r)n
FV = Future Value
PV = Present Value
<
br /> r = Rate (keep it simple, use annual rate)
n = number of periods (keep it simple, use number of years)
This formula will give you the value in the future of an investment today compounded
over a number of years. The opportunity cost is the difference between that future value
of one investment and the future value you expect to receive for the investment you
actually made.
Let’s consider an example.
Two brothers Emilio and Farid decide to buy similar cars.
Emilio buys the red car with $20,000 from his savings. He owns the car free and clear.
After ten years, Emilio sells the car for $1,000. His $20,000 saved him all the interest he
would have paid for the car.
However, Farid decided to obtain a car loan from his local credit union to buy the car.
His car loan along with interest payments cost him $X over the 5 year loan. He invests his $20,000 into an investment that pays him 12% for the next ten years. Farid ends up with
almost $62,117 pre-tax in the ten years.
The opportunity cost is the difference between the two scenarios.
Let’s use another example from earlier and give it some numbers.
Two sisters Amanda and Christine decide to each buy a $250,000 rental property. They
both have $50,000 in savings.
Christine invests her $50,000 into the down payment for her rental property. She has
no more savings. Assuming an appreciation rate of 6% over 30 years, her rental property
will be worth approximately $1,435,873. Her mortgage should be paid off by then.
Amanda keeps her $50,000 liquid and finds an equity partner to invest the down
payment for the rental property in exchange for 50% ownership. Assuming an
appreciation rate of 6% over 30 years, her rental property will be worth approximately
$1,435,873. Her mortgage should be paid off by then. But she has to pay her equity
partner half of that, which leaves her with $717,936 and her original $50,000.
It appears that Christine had a better deal. However, that’s for one property. Amanda
was able to do that four times all together.
Amanda really ends up with $2,871,746 in addition to her $50,000. Furthermore, with
the $50,000 in a liquid account, Amanda has piece of mind in case of emergencies and
her financials still look good. Christine doesn’t have that piece of mind and her financials
don’t look as good due to the lack of liquidity.
Let’s review where we are so far.
We previously mentioned you typically have 2 options to finance things. You can either
pay cash giving up the interest you would have received on your cash, or borrow money
to make your purchase and pay interest to someone else.
Then we added another consideration.
How much more valuable is having cash than spending it? Another way of thinking
about it is how much additional borrowed money can we access for having the cash?
Now we have to ask how we should structure a deal using raised money.
When we decide to use other people’s money, we have to know how to
structure the deal.
In my previous book, The Wealthy Code, I discuss how to structure financing for
various deals. It is important you match the financing to the type of asset and the risk
profile.
As an investor, you must set your guidelines to make sure money is used as efficiently
as possible, especially other people’s money. That depends on your underlying investments.
Here is a sample guideline:
· Considering you have Cash:
o $50,000 or less, use it to build liquid reserve.
o Between $50,000 and $300,000, use $200,000 for short term deals, especially
for private lending and buying under market assets.
o $300,000+ use anything above the $300,000 for longer term investments.
o These numbers should be based on your investment. The larger your
investment, the higher these numbers across the board should be. The numbers
above are for someone starting out.
· HELOC:
o Use for short term deals (one year or less), including private lending deals
among other things.
o Do not use for a down payment except for temporary use and only until you find
an equity partner and within 12 months.
· Private Money:
o Structure as equity partners for down payments on leveraged real estate.
o Use for short term deals as well including private lending.
o Use for safer principal-protected investments
· Mortgage:
o Use for acquiring properties by using 80% or less loan-to-value, fixed interest,
for as long as possible (preferably 30 year), with the lowest loan constant
possible. Use BER and DCR metrics to figure out the right LTV.
These are meant as sample guidelines.
They allow for efficient use of your capital, which in turn should translate well into six
figures or more over your lifetime, and for many investors, seven figures or more.
The Family Bank
In chapter twelve, we will discuss a concept called “The Family Bank,” which allows
you to have yet another option. For completeness sake, I will briefly mention how the
family bank is related to opportunity cost.
We started this chapter saying you have 2 main choices for any transaction. Buy it with
your cash and give up the interest or borrow the money and pay interest to someone.
Well, the family bank gives you a 3rd option. With this 3rd option, you can borrow money
from your OWN “bank” and buy a product and then simply pay your OWN “bank” back
plus interest. You end up gaining the interest while keeping your cash for investing. Very
powerful.
That is further discussed in chapter twelve.
Example
Recently, someone gave me a scenario and asked for my opinion. I thought it was so
interesting, I decided to share it in this book.
Four friends, Tom, James, Steve and Greg all work in the same company making the
same income. They all decide to invest. However, their investment style is very different.
They each decide to allocate $200 per month to invest, and they pick a horizon of 12
years to compare their investments.
Figure 7: Four Friends Decide to Invest
Tom decides to save the $200 at the beginning of every month in a savings account
paying 1% annually, compounded monthly. He decides that once he accumulates at least
$20,000, he will buy a $20,000 asset with all the saved cash and use no debt to buy this
asset. The asset appreciates 5% per year. He decides to also keep saving $200 per
month into the savings account after he buys the asset.
Figure 8: Tom’s Investment
James decides to buy this same $20,000 asset that appreciates 5% per year with
borrowed money today, and decides to use the $200 per month to pay down the loan.
The loan for the asset is a 30-year amortized loan at 4% annual interest rate,
compounded monthly. He also decides to keep saving $200 per month (beginning) into
the savings account after he pays off the loan.
Figure 9: James’ Investment
Steve on the other hand decides to use a similar strategy as James but buys a $20,000
asset today with the same loan as James, but the asset doesn’t appreciate at all. He too
decides to also keep saving $200 at the beginning of each month into the savings account
&n
bsp; after he pays of the loan.
Figure 10: Steve’s Investment
Greg decides to do exactly what James does, but instead decides to buy 2 assets of
$20,000 each today using borrowed money, using similar loan terms as James. He
applies the $200 per month towards both loans, $100 per month towards each loan
equally.
Figure 11: Greg’s Investment
Who would have increased their net worth the most in 12 years?
Let’s look at each of them carefully. I will include the calculations for those of you who
are interested in them.
* * *Tom’s Investment* * *:
Tom decided to save the $200 at the beginning of every month in a savings account
paying 1% annually, compounded monthly. He wants to accumulate $20,000 to use to
buy the asset.
It takes Tom eight years and one month to accumulate at least $20,000. He actually
has an additional $213.72 more which he can keep in the savings account. He decides to
buy the $20,000 asset all cash and no debt. It appreciates 5% per year for the remainder
of the time (three years and 11 months).
So Tom’s asset appreciates to $24,213.70 at the end of the 12-year horizon he and his
buddies were talking about. However, he keeps accumulating that $200 per month for 47
more periods into the savings account. Tom has an additional $9,812.67 in his savings
account.
So the end result for Tom after 12 years is this:
Table 8: Results of Tom’s Investment Decisions
* * *James Investment* * *:
James decided to buy this same $20,000 asset that appreciates 5% per year with
borrowed money today, and decides to use the $200 per month to pay down the loan.
The loan is a 30 year amortized loan at 4% interest rate.
James’ investment appreciates to $35,917.13 in 12 years.
With James applying the $200 per month towards the loan, he would have paid off his
loan in ten years and two months. He will still have 22 payments of $200 he can save
into his savings account in that period. So the final result for James is that he now has an
investment of $35,917.13 with $4,442.41 in cash in the savings account after 12 years.
Table 9: Results of Tom’s Investment Decisions
James is way ahead of Tom when they both started with $200 per month!
* * *Steve’s Investment* * *: