In my last post, I had talked about how debt can be a very useful tool to help build real wealth as long as it is deployed shrewdly. There are some very specific rules to keep in mind however when you are considering taking on debt to purchase an ‘asset’. In this post, I will talk about one of my favorite assets to finance – Real Estate
- You need to make sure that the asset you are financing is an appreciating asset – Any time you take on debt, you can be rest assured that you will pay interest. Cars, mattresses and other things are sold at 0% financing and are exceptions because the interest is already built into the price of the car. No-one, and I mean no-one lets you have something today and charges you over time without getting more money from you eventually. I’ve explained this concept in another one of my posts titled ‘Time value of money‘. When you purchase an appreciating asset with debt, there is a potential that the appreciation will offset some of the interest you will pay on your debt allowing you to pay a lower interest than you originally signed up to pay. Ideally though, your asset appreciation will outpace your interest payment allowing you to build wealth. You can’t access this wealth until you sell the asset but it is yours to keep and it is like free money that you make using the bank’s money. The simplest example of this concept is purchasing a house. When you purchase a house and have a mortgage payment, you pay interest on your loan every month. However, in 10 years of living in a house, you may have paid $50,000 in interest but your house is now worth $70,000 more than what you paid for it. Essentially, you just added $20,000 to your wealth using the bank’s money. Let me demonstrate some mathematics on how you can use home buying to build personal wealth. Assume that below are details of your mortgage.
|Home Appreciation Rate||4%|
Below is a comparison of what you’d pay versus the wealth you’d build in terms of equity in your house.
So basically, if your home appreciates at the rate of the average US home, you would have added $145,000 to your wealth in 20 years. That is a pretty good amount of money to be adding to your retirement nest egg. If you managed to pay your house off quicker, the wealth building would also accelerate that much quicker.
Once you finance your initial purchase, keep an eye on market interest rates. If interest rates drop by more than half a percentage point, there may be value in refinancing your home. Crunch the numbers to calculate how long it will take you to break even on the refinancing costs using the money you will save every month on payments by refinancing to a lower rate. Long term, you will most likely save money on interest over the life of the loan as long as your loan has over 20 years remaining, and you can calculate that too. Usually, that number could be tens or hundreds of thousands of dollars depending on the balance on your loan and how long you had remaining on the term. Refinancing to a significantly lower rate can be another one of the ‘High Impact Money Moves (HIMMs)’ that I’ve talked about in my other articles.
One thing to keep in mind is to NEVER do a cash out refinance. Taking equity out as cash while you refinance is the exact opposite of building wealth and something that benefits the bank, not you. By cashing out the equity in your home, you are engineering a life that will forever be spent in debt.
When it comes to your finances, I encourage you to always have a long term perspective. If something promises to work in your favor in the long run, do not hesitate to take a small, calculated financial hit in the short run if you can afford it.
I can assure you from experience that this strategy can do wonders when it comes to building your net worth. You just have to be patient and disciplined. We are in an interest rate environment that our parents could have never dreamed of, and we owe it to ourselves to utilize the benefits of cheap capital to build our financial legacy.