In a previous post I showed you how you could use debt to increase your net worth over time. The examples that I used were essentially investing in a house, and investing in the stock market. Here I am going to look more in depth into investing in real estate, the stock market and other assets.

In that previous post I talked about what a bank does, that it essentially borrows money at a low interest rate and lends money out at a higher rate and makes the difference between the two.  The key difference between you and a bank is that a bank can borrow funds very cheaply while most people’s cheap borrowing options are limited. However, just because the interest rate on your debt is higher than the rate of growth of the assets you hold, does not necessarily mean you have a losing bet.

To show you why, in my previous post I showed the growth in value of a home while paying down your mortgage over time assuming home price growth of 4.0% annually and a mortgage interest rate of 5% of a home purchased for $400,000. Below is the breakdown of the annual return on the home investment vs. the amount of interest paid per year (I ignored the monthly principle payments here and just assumed the principal is paid at the end of the year).

You can see that after the first year, the equity return earned on the home was greater than the interest paid, which tells us that it is worth keeping the mortgage, because that debt is like rocket fuel to your equity. Below is the value and the growth rate of the original investment in the home.

 

You can see that there are 2 things happening here: 1. the growth rate of the original investment looks great in the beginning. Who doesn’t like a rate of return of 26.4%? 2. The other thing you notice is that the loan to value ratio (the loan balance as a percentage of the home value) is falling over time.

So why does this matter? Because the growth rate of the equity is the figure you want to compare to the interest you are paying on the debt to know whether the investment is worth it. As long as the home value increases enough to ensure that the equity increase is more than the interest you pay in a year, the investment is worth it.

So What Else Can I Invest In and How Much Should I Pay?

This also works for other types of investments, as long as you can cover the money you borrow, the only other money you have to put up is your own. If you can manage to borrow some portion of your investment with debt the rest is your own investment and having that debt can offer spectacular returns on your original investment.

Let’s take for example someone who has figured out a new idea for a website and she needs an investment of $100,000 to get it off the ground and that person only has $50,000 in savings. Let’s also assume this person doesn’t have the option to refinance their home, they haven’t won the lottery and their rich uncle isn’t about to pass away. Many entrepreneurs very sure of themselves tell stories of maxing out all their credit cards in order for their business to get enough cash to get going as well as borrowing from friends. Let’s assume this person gets money from credit cards and a friend. That friend wants a 12% interest rate because even as a friend she is a rational economic being and wants some compensation for the risk of not getting her money back. So our entrepreneur manages to gather $30,000 through credit cards and $20,000 through the friend. Interest on the credit cards runs at 20% and as we mentioned the friend charges 12%. Let’s also assume this person needs about $30,000 a year to live.

In this scenario, the returns were great from the first year. But the business income was only $24,000 in the first year, unless they were able to borrow more or cut their living expenses temporarily to $18,000, the business would not have survived this year. I would be willing to bet the first year or two broke a lot of startup businesses of all stripes. But ignoring those living costs, this shows that taking on the debt was actually worth it. The awesome return justified the high interest rates that were paid. In hindsight the idea of maxing out those credit cards didn’t seem so stupid did it?

I Don’t Have a Great Business Idea, Can I Still Use Debt to My Advantage?

Most of us are not going to become dot com billionaires with the next great idea, or maybe we have a family to support, so we can’t cut our expenses enough for a few years or take the risk our business venture doesn’t work out. Can people like this still use debt to their advantage? The answer is yes and all you need is discipline.

In the chart below I showed net worth increasing over time if, instead of buying a house for all cash, you took out a mortgage for $320,000 to buy a house worth $400,000 and invested the rest of your savings in the stock market.

In this example, we assumed you never refinanced your mortgage. At this point in time, why would you? Mortgage rates are at historic lows, the Fed has kept rates down near 0 since the financial crisis in order to bring the economy and the housing market back from the brink. What if we assumed however, that we refinanced the loan and took some equity out, even if the interest rate was a little higher?

Why would we do this? Because remember those growth rates in your initial equity investment of 26.4% above? Remember how the growth rate fell over time? This is because the debt as a percent of the home value was falling due to the normal repayment over time of your mortgage and the balance of the loan getting smaller compared to the value of the home (lower leverage). The growth rates like the 26.4% are only obtained by keeping the debt to value (or loan to value) ratio high (higher leverage).

So now I am going to assume that every few years or so, we refinance the loan above back to the 80% loan to value and after fees we keep the proceeds. I am going to go one step further though, I am going to assume we are being smart with our money and investing those proceeds in the stock market and not touching that money for a very long time. I assume $5,000 for refinancing the mortgage in fees to the bank. I also assumed rates have gone up and we are refinancing into a higher rate of 6% from 5%. In this scenario, we can see even more impressive returns over time, for simplicity I am just showing the net worth and the investment balance of the stock market investment.

The calculations are from the chart below, as you can see, we came out ahead of when we simply paid down the mortgage.

We actually came out 24% ahead of the example in the last article (or $228,219) by refinancing the home and investing the proceeds long term in the stock market. This can be very lucrative over the long term but there is always a drawback.

The Drawback

There are a number of words of caution before planning to take on something like this to grow your net worth. The first is that you must be extremely well disciplined financially in order to carry out this plan. It takes someone with a lot of faith in their discipline as well to make a plan over a period of 10 years and stick to it, but it can be done. We also assumed that there was no job loss here, the person stayed relatively healthy, that there were no big personal financial events like a divorce. In essence they were able to make their mortgage payments and they never had to touch their stock market savings for any life events. For these reasons it is always good to keep 6 months living expenses at least on hand in order to take care of any of the unforeseen things that life can throw at us.

The other big assumption in the above example is that growth rates moved in a smooth line over time which is almost never the case when it comes to the housing market and especially not the stock market. However this is why I wanted to use the long term annual growth rate of the stock market (7%) and a slightly above average house price growth for the US (0.5% above the median). Although the house price growth rate is above the median, I am assuming here that we picked a slightly higher growth market, maybe in a large northeastern city, a southern city or somewhere on the west coast. If we had picked a city in the Midwest we may have had a different picture.

The timing is also important, I would normally not advise one to put all their savings in the stock market at once, dollar cost averaging is usually the best bet over time and will smooth out your returns hopefully towards something that is closer to 7%. The stock market can be very volatile in the short term but when invested over long periods of time, trends towards a constant rate of return. I also assumed this was a financially astute long term investor who invests in the wider market through products like index funds. The type of person that would use strategies like dollar cost averaging in order to invest a large sum of money. However, if you only invest a portion at a time, then it will be almost impossible to achieve the 7% growth target for all of your invested capital. In the example where we refinanced the loan and invested the proceeds though, this approached something similar to dollar cost averaging.

For Those That Would Like to Know the Underlying Math

If you are interested, there is a very simple equation to predict your return based on the amount of debt to value you of the asset you are borrowing to buy. This equation is:

Return = Growth Rate of the Asset / Percentage of the Equity Held

For example, in the case of the house above, we assumed a 4% growth rate in the value of the home and in the first year we assumed a typical 30 year fixed rate mortgage with a 20% down payment. Using the equation above we would arrive at a return of 4% / 20% = 20%, the growth rate falls because the debt to equity is falling in the subsequent years as the debt is paid down gradually at the normal rate for a 30 year fixed rate loan.

This is important to note because leverage (or debt) is an important feature of real estate investing. When real estate investors factor in their assumed returns they count the current income, which is usually a small percentage of the investment and the return from price increases in the value of the real estate. If they have a high debt to equity ratio, they have the potential to increase their return dramatically. This is one reason I believe that commercial real estate has done so well over the long term. Investopedia claims that commercial real estate over the past 20 years has returned 9.5% annually and residential and diversified real estate has returned 10.6% annually over the same period. You can easily invest in these sectors through low cost indexes such as the Vanguard REIT ETF or Vanguard REIT index.

The key to using debt for any investing is to make sure you can make the interest payments and that you invest in an asset that increases in value. If this increase is over the long term, be prepared for some short term swings and be mentally disciplined to stay the course when the market turns against you, just remember that those that are in it for the long term are not watching TV and the daily price swings of their investments. Peace of mind goes a long way towards sound investing.

 

The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.