How to Avoid the Financial Mistake Millions of Americans Make

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Here’s a question for you. Which would you rather have: one horse working for you, or two horses? Can you have two horses working for you, even if you owe money on one of the horses? Of course.

This example may seem obvious, but when it comes to real estate and equity, somehow everyone can’t see it so clearly. Many people—and even financial experts—think one of the best ways to become financially secure is to invest in real estate and pay off the mortgage as quickly as possible. But just because it is common wisdom doesn’t mean it’s wise at all.

 

Picture yourself holding an empty drinking glass in one hand and a pitcher containing water in the other. The glass represents your house. For simplicity’s sake, let’s say it is worth $100,000. It’s an asset. Let’s say you have $100,000 of cash in the bank, credit union or an insurance company (the pitcher)—that’s liquid wealth. The glass is empty because you have not put any cash into your house, but on paper, on a balance sheet, you would still list it as a $100,000 asset. Meanwhile the pitcher of water represents another asset—$100,000 in cash.Real Estate Equity

What’s the total amount of your assets? $200,000. What happens if you pay 20% in a down payment, or you take the equity from your former property and put it into the new property in a bigger down payment, because you thought lower mortgages meant lower cost – and because you didn’t understand opportunity cost? What happens if you use your $100,000 of liquid cash to pay off your property? You have reduced your assets by $100,000. You’ve poured $100,000 in cash to a glass already listed as an asset worth $100,000, and all you have to show for it is $100,000. You have cut your assets in half!

 

On the other hand, when you separate the liquid cash from the glass-sized house that is free and clear, you double your assets. That’s what happens when you separate equity from your house and put it in a liquid investment. But you’re not finished. Assume the empty glass-house appreciates at an average of 5% a year. After one year, what’s the value of the empty glass? $105,000. If you pay off the mortgage on the glass (pour the water—or money—back into the house) what is it worth? The same $105,000—whether it is mortgaged or it is free and clear—because equity has no rate of return when it is trapped in a house.

 

Next, pour the water from the glass back into the big pitcher. You’ve just removed $100,000 from your house and put it into an investment earning—let’s say—10% (which is what I’ve averaged the last six years). At the end of the year, how much money will you have in that pitcher? Look at that! It’s grown to $110,000! In your other hand is your house, worth $105,000 at the end of the same year, thanks to appreciation.

 

Leave the water in the pitcher.

How much have you earned by separating your equity from your house in the course of just a single year? $15,000. How much would you have earned if you had left the water in the pitcher? Only $5,000—one-third as much. How much more is $15,000 when earned this way, versus just $5,000 earned with the house paid off? That’s three times as much, or 300%!

 

“But, but, but—the mortgage wasn’t free! I had to pay some interest.” That’s right, you did. Let’s say the mortgage was at 6%. That’s $6,000 subtracted from $15,000 for a net gain of $9,000, instead of just $5,000.You are still 80% ahead than if you had not removed the equity from your house. If the mortgage interest is deductible, then the net cost of the mortgage is really not $6,000, but it’s $4,000 in a 33.3 percent marginal tax bracket. So the net profit is $11,000 ($15,000 minus a net, after-tax mortgage expense of $4,000)—or more than twice as much as you made if the house was paid off!

 

When you borrow, you should borrow to conserve, not consume. If you separate equity from a rental property you own at 7.5% deductible interest (which is only 5% net), and if you were to earn 10% on that invested equity, on a million dollars you might be paying $50,000 but you would be earning $100,000. That’s 100% more. This is how you become you own banker. As a business owner, would you hire and pay an employee or invest in equipment that made you twice as much as the cost? Sure. That’s smart business sense.

The object of this demonstration is that no matter what else you do, when you separate your equity from your real estate, you increase your assets. Even though there is a charge for doing that—the simple interest you pay on a mortgage—it makes a whole lot of sense to take out (or keep) a mortgage and use it to make your assets grow in a compounding, tax-advantaged account. Employ this strategy each year, and the profits will compound and you can potentially create $2.3 million on a property within thirty years that today only has $150,000 of equity by simply repeating the process.

So as you can see, keeping your real estate equity separated, liquid, and earning a safe rate of return is worth far more than following the traditional methods of using liquid cash to pay off the mortgage as quickly as possible. In fact, you will get “out of debt” (have enough money to pay off your mortgages if you chose to) faster by using this method than if you paid extra principal payments against your mortgage, by keeping that money in a liquid side fund compounding with interest.

 

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