Wealth Creation - Some Food for Thought
Do you ever think about your long term financial goals? Are the concepts of investment growth or wealth creation a regular part of your vocabulary and decision making? Or are you, like so many of us, blindly hoping that you ll make it through retirement? That somehow, it ll all just work out?
The goal of this post is to make you, the homeowner (or person considering homeownership) think. Think about what your financial decisions are doing to create wealth for you over the long term. Think about how traditional and seemingly common-sense ideas can actually stunt the growth of your wealth, and how you can begin to change the direction of your financial future.
A lot of people will tell you (especially real estate and mortgage professionals) that investing in real estate is a very safe form of investment (over the long term) with an excellent ROI (return on investment). Coupled with this is the long-standing sentiment that the more money you can put into your home, the safer your investment will be. The more equity you have, the more protected you will be from short term depreciation, if that should happen (let's hope not!s). We also have had the notion of mortgage bad, cash good passed down to us, and as a result, many American homeowners primary goals are to borrow as little as possible, and to pay off their mortgage quickly.
Important Questions to Ponder
Ask yourself the following question though how accessible is the money (equity) that is sitting inside your house? In other words, how liquid is it? Do you have the ability to access this wealth quickly in case of an emergency, necessary repairs, etc? This equity may be a combination of the money that you used for your down payment, and any appreciation that has occurred since you purchased.
Now, ask yourself this question does the amount of money that you used for a down payment have any effect on the value of your home in 10, 20, or 30 years? We are all hoping, despite current market conditions, that the value of our homes will appreciate over the long-haul. The common understanding is that by putting down $20,000 on a $100,000 home (20%) that appreciates on average 6.2% per year, that we are earning 6.2% on our investment (of $20,000).
In reality, that home will appreciate 6.2% (assumed scenario) a year whether you put 20% down or not. Now, imagine that instead of putting down that $20,000 on your home purchase, you had invested it in a diversified portfolio account with a trusted financial advisor. Let s say the interest rate on your mortgage (in this case, you re borrowing the full $100,000) is 7%. Depending on your federal tax bracket, your EPR (effective percentage rate)*** on your mortgage might be around 4.750% (read below).
What It Really Comes Down To
Now, listen carefully people want to borrow less money from the bank because they will save money on interest. But, in the above scenario, you would only have to average 4.750% in your investment account with your financial advisor to come out ahead. Let me sum that up for you if you had invested the $20,000 in an investment account with an average return of 4.750% or greater instead of making a down payment, you would be creating more wealth long term. Do you think this kind of rate of return might be possible? A conversation with a financial advisor would show you that over the long term, with sound investment strategies, this would be a reasonable goal.
In fact, what do we mean by come out ahead ? Well, let s look at the numbers. That $20,000, invested for 30 years at an 8% rate of return will grow to $201,253.14 (assumed scenario). Now, remember that you still own the home. It has appreciated, after 30 years, to a value of $400,000, and would have done so whether you made a down payment or not. However, because you invested the $20,000 instead of making a down payment, you now have an additional $201,253.14, and your total net worth is $601,253.14 instead of just $400,000.
Wait a Second
So now what you re thinking is, this woman is saying that investing in real estate isn t a good idea? If I can get a greater rate of return elsewhere that s where I m going to put my money! Hold on a second. The missing piece is an important concept called leverage. Have you ever tried to walk into the bank and ask them for a loan of $100,000 to put into your investment account? Well, no, you probably haven t! And if you have, you didn t succeed!
The difference is just this a lender will lend money against an asset like a home, giving you the power of leverage to watch that asset grow, even though you didn t have the means to purchase it. As your home appreciates, you even have the ability to draw some of that equity out, and invest it elsewhere with a greater rate of return. At the end of the day, this will only increase your net worth and help to prepare you for retirement and other goals that you may have.
This is just a very basic introduction to these concepts if any of this rings true for you, or tugs at your curiosity, I would love to talk with you about what your options may be.
**Keep in mind that I am not accounting for any additional investments being made. I am also not accounting for inflation. The goal of this post is just to introduce you to the concept there are many other details involved, and you should always consult your financial advisor and tax advisor/CPA
***Your EPR is determined by multiplying the interest rate you are paying by your federal+state tax bracket, and subtracting the difference. Example 7% interest rate, 34% tax bracket (25% federal, 9% state). 7 x 34% = 2.38. 7 2.38 = 4.62. EPR = 4.62%
These ideas are not just mine they have been developed and practiced by a trusted colleague of mine. Trevor Hammond is the CEO and Founder of Makena Financial Strategies, a mortgage planning and financial education company here in Portland. Trevor co-wrote a book called Borrow Smart, Retire Rich , and it is full of wealth creation strategies using real estate as a tool. I highly recommend Trevor and his team as financial partners on the homeownership journey. www.makenafinancial.com