(Author’s Note: Although the stock market returns illustrated in this article are an obvious example of Greenspan’s “irrational exuberance” of 1997-2000, the concept is still valid. However I would caution anyone against investing more than they feel comfortable losing and strongly urge investors to spread their investments among other classes of assets such as real estate, bonds, precious metals, etc.)
If you found an investment that would return 20% or more, would you take out a loan at 8% to invest?
Do you own a home? Are you paying a mortgage around 8%? Do you have equity in your home?
If so you may want to consider taking out a home equity loan and using the money to invest.
Since its inception, the New York Stock Exchange has averaged an increase of 11% per year (including the years of the crash of 1929 and subsequent depression). The last 20 years the stock market has seen gains well over 20% in some years. It has almost always returned more than the interest rate for an average home.
If you are making 20% while paying 8%, you are gaining 12% on your invested money. Is this more than your bank savings account or CDs are paying? Oh yeah!
Meanwhile what is happening with your home? It appreciates over the years, right? So if you purchased your home for $150,000 in 10 years at just 5% annual appreciation, your home will be valued at $244,000. (Home Value * ((1 + Appreciation Rate) to the Years power) or 150,000 * (1.05^10)). If your mortgage was for $120,000 you now have over $124,000 in equity created by appreciation alone. You will have even more equity based on the principal amounts paid through your mortgage payments.
So let’s say that for the next 10 years your home continues to appreciate at an average of 5% annually, and you have taken the $124,000 out through a home equity loan and invested it in mutual funds or stocks that average just 17% for the next 10 years.
At the end of the 10 years your home will be worth around $398,000, of which $218,000 will be your equity. That $124,000 you invested 10 years ago at 17% is now about $580,000. You now have a net worth approaching a MILLION DOLLARS!
You can easily pay off your remaining mortgage amount of $180,000 and still have a nice nest-egg to retire on. All in only 10 years. Or keep paying that 8% mortgage and earning the 17% on your investments.
Is this guaranteed? Absolutely NOT! No one can (or should) guarantee you a 17% return on investment or an annual 5% home appreciation. But is it possible? Has it happened in the past? Absolutely YES! Remember these are averages. Some years returns may be only 8 or 9% other years they be as high as 30%. The same holds true for your home appreciation rate.
But the possibility remains. If you do nothing, 10 years from now you could still have 10 years to pay on your mortgage and your home would be valued at almost $400,000. Or you can have the same $400,000 home, fully paid for, and an additional $362,000 in your pocket. You’ll be well on your way to a million dollar net worth.
But what if you do not have much equity in your home or if you have already taken out a home equity loan for debt repayment? What can you do? How can you invest your home?
You may want to look into refinancing your home. A lower interest rate can free up some of your monthly mortgage payment for investing. Or look into an interest only loan. An interest only loan could cut your monthly payment by up to a third.
If you can free up or reallocate just $500 a month for investing at the same 17%, after 10 years your investments will have grown to over $140,000. After 20 years your investment amount will be worth nearly $820,000. Time is always on your side when investing.
One aspect we have not looked at is taxation. The above examples are shown assuming your investments are not taxed on a yearly basis. Capital gains taxes can eat over 20% of your investment gains each year.
Looking at the investments outlined above the $124,000 that becomes $580,000 after 10 years, grows to only $434,000 after yearly taxation. The $500 a month grows to $117,000 after 10 years, and $540,000 after 20 years. Taxes take their toll.
Another aspect to consider is inflation. Inflation has averaged 3-4% for the last 30 years. This means that in 10 years that $434,000 is worth about $320,000 in today’s dollars.
One way to look at your investment rate of return is to subtract estimated inflation and then reduce the rate by 20% for taxes. Thus the 17% loses 3% due to inflation and the remaining 14% is reduced by 2.8% for taxes. The adjusted rate of return is now at 11.2%. But this is still greater than your mortgage interest rate and certainly greater than your bank account, CD and most money market rates.
Also, remember that the interest you are paying on your home mortgage and home equity loan is partially tax deductible. This effectively reduces your mortgage rate approximately 20%. Your 8% rate is now effectively 6.4%. The difference between the rate of return (11.2%) you are earning and the interest (6.4%) you are paying is called the “float” (4.8%). The float is where you make your money. The greater the float the more money you will be able to earn.
You CAN turn your home into a money machine! Spending your money wisely is only half of the formula for financial freedom. You also need to understand how to invest your money wisely and look for opportunities to make money on the float.
About the author
© Simple Joe, Inc.
David Berky is president of Simple Joe, Inc. a marketing company that sells simple software under the brand name of Simple Joe. One of Simple Joe’s best selling products is Simple Joe’s Money Tools – a collection of 14 personal finance and investment calculators. This article may be freely distributed so long as the copyright, author’s information and an active link (where possible) are included.