The Debt Millionaire

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The Debt Millionaire Page 8

by George Antone


  you decide to buy the asset.

  Figure 17: Starting with $1,000 cash. Coffee costs $1,000. Asset costs $1,000.

  Now, you have a bar of gold and no cash. You could have used the money to buy the

  cup of coffee, but decided not to. So a few years later, inflation doubles, and the bar of

  gold goes up in value to $2,000. The cup of coffee is now also $2,000.

  Figure 18: Inflation doubles. Asset appreciates to $2,000. Coffee costs $2,000.

  Now the bar of gold kept up with inflation. You think you can still buy the cup of coffee

  now… but can you?

  So you decide to sell the bar of gold and you collect your $2,000. But you purchased it

  for $1,000. So you have to pay taxes on your $1,000 capital gains. Assuming you are left

  with $700 in profit, you now have $1,700 in cash. But you cannot afford to buy the cup of

  coffee! It’s $2,000. So you purchased an asset that “keeps up with inflation” just to find

  out that after taxes, you really have not kept up with inflation. You actually lost

  purchasing power (real dollars), and yet you still have to pay taxes on “profit” (in nominal

  dollars)!

  The point here is that you pay taxes on nominal dollars, but there is no regard to “real

  dollars.” Why is this important? Again, because most people on the left side think in

  nominal dollars.

  Still, the “secret” of how the people on the right side of the Wealth Equation think is

  yet to be revealed. Keep reading.

  The people on the left side of the Wealth Equation are thinking about what asset to

  buy to keep up with inflation. Even with a great asset that keeps up or beats inflation,

  they will still have to pay taxes on the “profit”, which in turn reduces their purchasing

  power. In terms of “real dollars”, they are losing.

  Let’s look at another example.

  Let’s say you do have $1,000, and you could have purchased the cup of coffee for the

  $1,000, but decided not to. You decide to hold on to your cash.

  Figure 19: Starting with $1,000. Coffee costs $1,000.

  A few years later that cup of coffee costs $2,000 due to inflation doubling. You are still

  holding on to your $1,000 cash. By doing so, now you can purchase half of what you could

  previously. Your purchasing power dropped in half. Your $1,000 nominal dollars is now

  worth $500 in real dollars. You lost half your real dollars. See image below.

  Figure 20: Inflation doubles. Coffee costs $2,000. You still have $1,000 cash.

  Notice that holding on to the cash dropped your purchasing power. This will come into

  play a little later. Don’t forget this.

  So, let’s make this a little more interesting. You decide to buy an asset that beats

  inflation. You hire the smartest people in the world and they introduce you to an asset

  that beats inflation. You start doing cartwheels and decide, you will become rich with

  this. So, again, with the $1,000, you decide not to buy the very expensive coffee

  (represents goods and services), but to buy this fantastic asset that beats inflation

  (represented with gold bars in the image below).

  Figure 21: Starting with $1,000 cash. Coffee costs $1,000. Asset costs $1,000.

  A few years later, as inflation doubles, here’s what you have:

  Figure 22: Inflation doubles. Asset appreciates to $2,200. Coffee costs $2,000.

  Your asset is $2,200 and the cup of coffee is $2,000. Your asset indeed beat inflation.

  You look in the mirror and say to yourself “I’m so smart. I’m so good looking. I have this

  investing thing!” You sell your asset for $2,200 and now you have to pay taxes on the

  gain of $1,200. Assume this is 30%, you now pay $360 in taxes. You have $1,840 left

  altogether. Coffee is $2,000! You cannot afford it! Hmmm. What happened? You are

  thinking like the investors on the left side of the WealthQ. After taxes, you still lost

  purchasing power even when the asset beat inflation by a good margin.

  At this point, you are wondering why this is not “working”—am I doing anything weird?

  No. I am simply shedding some light on how investors on the right side of the WealthQ

  “see” things. You have been stuck on the left side of the WealthQ for too long.

  Let’s continue.

  So you decide to try something different.

  You decide to use your $1,000 to buy an asset that keeps up with inflation, but you

  decide to buy more of it using debt. You borrow $1,000 and use your existing $1,000 to

  buy $2,000 worth of this asset. Coffee at the time is $1,000.

  Figure 23: Starting with $1,000 cash. Coffee costs $1,000. You decide to borrow another

  $1,000 to buy $2,000 of assets.

  So a few years later, inflation doubles. Coffee is double ($2,000) and your $2,000 asset

  is $4,000. Here’s what things look like:

  Figure 24: Inflation doubles. Asset appreciates to $4,000. Coffee costs $2,000.

  You sell your asset of $4,000. You pay $600 in taxes on your $2,000 gain, and then

  pay off your $1,000 loan. You are now left with $2,400 in cash. Coffee is $2,000. You can

  finally afford to buy it and still keep some cash in your pocket!

  This might seem like it’s dragging on, but it’s so important you understand this,

  because I’m trying to make you think differently.

  What happened?

  Two things changed. You used a loan and you purchased more of the assets. Which

  one was the differentiator? Was it the loan or the fact that we purchased more assets?

  Let’s try the latter without the loan and see what happens.

  Let’s assume the following scenario. You start with $2,000 cash. You can buy $2,000

  worth of assets that keep up with inflation or 2 cups of $1,000 coffee (must be good

  coffee!).

  Figure 25: Starting with $2,000 cash. Coffee costs $1,000. Asset costs $2,000.

  After a few years, inflation doubles. Coffee is $2,000 and your asset is $4,000.

  Figure 26: Inflation doubles. Asset appreciates to $4,000. Coffee costs $2,000.

  You sell your asset and pay $600 in taxes on your $2,000 gain. You are left with

  $3,400. Coffee is $2,000. Previously, you were able to buy 2 cups of coffee. Now you are

  not able to buy 2 cups. Your purchasing power dropped even though you had purchased

  more assets!

  So going back to the previous scenario, the only reason your purchasing power went

  up was because of the debt! Yes, it was the debt that increased your purchasing power.

  Let’s keep going to understand why.

  Let’s analyze carefully what happened. NOW this is where things get interesting.

  Remember when we discussed the holding on to the cash and the coffee doubled due

  to inflation? I asked you to remember it. We observed that the purchasing power in real

  dollars dropped to half. Remember that a few pages ago? Well, here is why I

  demonstrated that. The lender is lending you the money to purchase the asset, their loan

  amount doesn’t go up (they are paid interest). This is similar to holding on to the cash in

  that example. A lender’s loan serves as cash for us. We receive the benefit of the loan

  and it allows us to receive the benefit of the lender’s money dropping in purchasing

  power. WOW!

  Your initial net worth was $1,000. You purchased the asset for $2,000 by borrowing

  the remaining $1,000 and using your $1,000 cash.

  Both the asset and the cup of coffee doubled, which means they are the
same in “real

  dollars”—they haven’t changed. Your $1,000 didn’t really increase your purchasing power,

  it maintained it.

  But your $1,000 loan that was used to buy the asset is now worth half the real dollars

  from when you purchased the asset (relative to the coffee). Refer back to the cash

  example mentioned earlier. Inflation doubled, but the loan amount stayed the same.

  So your profit in nominal dollars is $1,000 (you sold the asset for $2,000, and paid off

  the $1,000 loan). However, the $1,000 represents $500 worth of purchasing power (it can

  only buy half the cup of coffee).

  So by buying the asset with a loan of $1,000, you increased your net worth in real

  dollars by $500. When you purchased the asset with all cash, you ended with the same

  purchasing power—no increase in net worth in real dollars!

  Let’s consider one more scenario. The same as above, but with a loan we purchase an

  asset that doesn’t keep up with inflation.

  You start again with $1,000 cash. Coffee is $1,000. The asset is $1,000. You decide to

  purchase the asset (that doesn’t keep up with inflation but does indeed appreciate). You

  borrow $1,000 to buy it along with your $1,000 cash. You buy a $2,000 asset.

  Figure 27: Starting with $1,000 cash. Coffee costs $1,000. You decide to borrow $1,000

  along with your $1,000 cash to buy $2,000 of assets.

  After a few years, inflation doubles. Coffee is now $2,000. The $2,000 asset is now

  $3,900, but would have been $4,000 if it had kept up with inflation. But it didn’t keep up

  with inflation.

  Figure 28: Inflation doubles. Asset appreciates to $3900. Coffee costs $2,000.

  At first glance, it looks like the investment didn’t perform well overall. You sell the

  asset for $3,900. Your capital gain is $1,900. You pay $590 in taxes leaving $1,330 in

  after taxes profit. You pay off your loan and receive your initial $1,000 investment back,

  leaving you with $2,330 in cash. Coffee though is $2,000! You increased your purchasing

  power even though the asset didn’t keep up with inflation!

  Again, it’s the debt that makes you rich, not the asset!

  So what is the “aha” here?

  The PROFIT is not in the asset appreciation, it is in the LOAN. The LOAN is where the

  profit is. Debt is what makes you rich!

  The asset just keeps up with inflation; the loan is the secret sauce to profiting from

  inflation!

  So let’s go back to the Wealth Equation. The “investors” on the left side are looking for

  the assets to purchase, but the people on the right side are looking for the right financing

  for their assets. They know how to match the assets to the right loans. The key is picking

  the right LOAN, a well-structured loan. The investors on the right side understand that having the right loan is better any day over just having the right asset like those looked

  for by the people on the left.

  Let’s take an example.

  We have two friends Sandra and Kate. They each have $50,000 saved up and decide

  to invest.

  Sandra uses her $50,000 to buy an asset she believes will beat inflation.

  Kate uses her $50,000 to buy a $100,000 asset that doesn’t even keep up with

  inflation, and ends up borrowing $50,000 to buy it. She understands that the secret to

  wealth is in the loan, not the asset.

  A few years later, inflation doubles. A $1,000 cup of coffee is now $2,000. So the

  $50,000 asset Sandra purchased is now $100,000. The one that Kate purchased is now

  $200,000. Let’s look at the results.

  Sandra’s investment actually does beat inflation, and the asset is now worth $105,000.

  She beat inflation by $5,000. What used to be $50,000 is now $100,000, but she has a

  $105,000 asset! She sells it, and has a nominal profit of $55,000. Remember, she pays

  taxes of nominal dollars, not real dollars. Assuming she pays $16,500 in taxes, she is left

  with $88,500 altogether. She lost in real dollars, but profited in nominal dollars. With that money, she cannot buy the goods and services she was able to buy when she had the

  $50,000 even though her asset beat inflation!

  Kate on the other hand has a very different result. Her asset did not keep up with

  inflation. Her $100,000 asset only appreciated to $175,000 even though inflation doubled.

  With that, she cannot buy the same goods and services that also doubled. But let’s keep

  going.

  She sells the asset, and has a profit of $75,000 of nominal dollars even though she lost

  in terms of real dollars. She has to pay taxes on her nominal dollars profit. She pays

  $22,500 in taxes. She is left with $152,500, from which she has to pay off the $50,000

  loan. Now she has $102,500. She started with $50,000. What used to cost $50,000 is now

  $100,000. So she actually beat inflation by $2,500 in nominal dollars even after taxes and

  even though the asset didn’t keep up with inflation!

  Why? Because of the loan!

  So let’s summarize the deal with Sandra and Kate.

  Sandra purchased an asset that beat inflation and she wound up losing real dollars

  (purchasing power).

  Kate purchased an asset that didn’t keep up with inflation, yet she wound up making a

  profit in real dollars!

  Again, Kate understands how to think like the people on the right side of the Wealth

  Equation!

  What people on the left side don’t realize is that the people on the right side are

  SHIFTING profits to themselves by knowing HOW to use the system then making it work

  for them.

  Let’s take this to another level.

  Many people on the left side continue to “invest” in various assets such as stocks,

  bonds, mutual funds, and real estate among other things by focusing on the asset to earn

  for them a “good return.” They take huge risks in their investments for a good return.

  The people on the right side of the Wealth Equation know that they can take a lot less

  risk by using the right tools (debt) to increase their net worth without taking high risk like the people on the left.

  Regarding inflation and depending on which side of the WealthQ they are; people see

  things from an entirely different perspective.

  Table 13: Comparing Left Side and Right Side of WealthQ in regards to Inflation

  Let’s keep digging.

  Turning Inflation to Work For You

  So it’s clear from the previous pages that loans help you build your net worth and

  buffer you from inflation. Now, let’s try to understand a little bit more about HOW that

  happens.

  Debt allows you to buy an asset today, but pay for it in the future. The reason this is

  important is that this is where nominal dollars and real dollars come into play. When you

  buy an asset today using well-structured debt, you are buying it with real dollars today,

  but paying for it in nominal dollars in the future!

  Read that again. Slowly.

  When you buy an asset today using well-structured debt, you are buying it

  with real dollars today, but paying for it in nominal dollars in the future!

  Let’s expand on that.

  Say you buy a $100,000 asset today with a $20,000 down payment and $80,000 debt.

  Your debt terms are 5% interest amortized over 30 years, with monthly payments of $429.46. Assume today the $429.46 can buy you an iPad. In 30 years, $429.46 will

  probably buy you the iP
ad case that you buy for $50 today. So you are paying $429.46

  monthly for 30 years (nominal dollars). However, you own the asset in terms of real

  dollars today.

  Over time, the asset maintains its “real value” (meaning rising with time) but you are

  still paying in nominal dollars. That gives you a spread that allows you to automatically

  increase your net worth. So in essence, you are paying back with devalued dollars.

  Not Just Any Debt

  Now knowing debt is good for you against inflation, the key then is what is the best

  type of debt to fight inflation?

  Simple. Fixed interest-rate loans with as long a period as possible, which translates to

  the lowest annual loan constant.

  Well-structured debt for inflation should have a fixed interest rate, be for as

  long a time period as possible, with the lowest loan constant you can

  negotiate.

  For example:

  · Buy a property with a 30-year fixed-interest amortized loan over a 15-year fixed-

  interest amortized loan.

  · Pick fixed-interest loan over an adjustable-interest loan.

  · If you have to pay $5,000 in loan fees in today’s dollars (real dollars) versus $5,000

  in future dollars (nominal dollars), pick the latter.

  Who Are The Losers From Inflation?

  In an economy where inflation is rising quickly, there are many losers. Everyone on the

  left side of the WealthQ is losing.

  Here is a list of people losing the most:

  Savers: People savings money in checking accounts, savings accounts, certificates of

  deposits, etc. The interest rates do not keep up with inflation.

  Retirees: Many retirees have their fixed income payments coming in from their “nest

  egg” and their “safer” portfolio. Inflation erodes the value of both their “nest egg” savings and their “safer” portfolio.

  Credit card debt holders: Most credit cards have a variable interest rate tied to a major

  index such as the prime rate. This affects them negatively. Credit card holders end up

  experiencing quickly climbing rates and higher payments.

  Consumers: Consumers on a set salary will feel the crunch right away from

  dramatically higher inflation.

  Investors: Investors in long-term bonds. In a high-inflation environment, bonds work

 

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