The Debt Millionaire
Page 8
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