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15

Arbitrage – How to Use Your Mortgage as a Wealth Creation Tool

I am going to contradict what I have said in the past about my views on mortgage debt to articulate why mortgages can be leveraged as wealth creation tools through simple arbitrage.

What is arbitrage? In the simplest terms it is the shuffling of resources from a less favorable outcome to a more favorable income.  For example, buying candy for .50 cents and selling it for $1, or borrowing money at a 4% interest rate and then lending it for 6%. Sounds like what the banks do?

For a long time I believed and preached not carrying any mortgage debt on a personal residential property – in other words your home that you live in. This is still true, but that message is mainly for those who lack discipline or the financial literacy to be able to leverage alternative arbitrage opportunities.

While paying off your mortgage has its benefits, not paying it off also has a significant amount of benefits which I will discuss in this post. The reason why I am specifying the home you live in is because I have been and still am favorable toward good debt incurred to purchase investment property that you can financially benefit from over the long haul.  Investing in real estate is one of my favorite ways to generate passive income and build long term wealth.

Mortgages totally make sense if you have alternative investment opportunities.  What stops many from considering the alternatives is the risk element involved, or potential loss of capital.  While to each their own, this approach in my opinion ends up costing the homeowner not only the opportunity to make exponentially more money on their equity, but also money out of pocket when income taxes and inflation are factored into the equation.

So while many people would rather have their homes paid off and be debt free, the wealthy on the other hand consider themselves debt free based on liquidity on their balance sheets and cash flow to pay off large loans such as a mortgage anytime they wish.  They understand that mortgages are one of the best wealth creation mechanisms and one that can get them to their goal of liquidity the quickest.

Think about it, why would you tie up your cash and eliminate potential tax benefits, often yielding zero net return on equity, when you can invest your money elsewhere?

Fee Simple Mortgages

Another benefit of many mortgages is that one can simply walk away from a mortgage at anytime. Sure you will take a hit on your credit, but who cares when you have loads of liquidity? Need a house next time? No problem, just pay cash. The cash you save on a home purchase today can be invested in instruments yielding higher return on equity.

Can the authorities come after you for the mortgage debt default? Not in most cases. Most mortgage loans are fee simple loans. The lender can ding your credit, but cannot come after you personally and liquidate your assets.  The credit can be repaired in seven years if I am not mistaken. I am not suggesting you draw up your life plan based on these facts, but they are good to know.

Corporations Love to Leverage Arbitrage

Even corporations understand this is the right way to do it. Many large companies have the cash to pay off debt but they do not. They understand the power of leverage. In fact, most companies are highly leveraged! Why? They raise public debt in the form of bonds at 8% and turn around to make 15% on that money. They have it figured out.

Why can’t individuals do the same?  They can.  Those who have invested in their financial literacy can by using  mortgages as wealth creation tools.  A mortgage is not necessarily a bad thing.  It can be used as arbitrage to leverage what you don’t have and yet benefit from compounding returns on equity and tax savings.

Arbitrage Case Study

I like to visualize specific scenarios when I am learning so let’s consider the following:

Let’s say you bought an investment property worth $250,000 with a 20% down payment of $50,000.  By putting down 20%, you have full control over 100% of the asset valued at $250,000.  Highly leveraged? Yes I think.  You cannot do this in the stock market as you can trade of a 50% margin at best.

You can depreciate investment property over 27 years, in this case resulting in a $9,259 deduction per year.  If you are in the 25% tax bracket, the depreciation deduction alone would save you $2,315 in taxes, or roughly 4.6% return on $50,000 of equity.

Assuming a modest 3% appreciation of the property, you will have made an additional $7,500 or roughly 15%, which now puts you at about 19.6% return on $50,000 equity.  Say you paid off $1,500 in principal payments and generated another $2,400 ($200/month) from positive cash flow from rent, you now have an extra $3,900, roughly 7.8%, which brings the total return on equity to a nice 27.4%.

These numbers could be “bloomier” but I have maintained a relative conservative approach for demonstration purposes.

Paying Off Your Mortgage vs. Building Wealth

Let’s walk through another scenario in a slightly different example.  Let’s assume you get a $200,000 interest only mortgage at 7% on a $250,000 property. Assuming you are in the 25% tax bracket, your effective borrowing rate is 5.25%.  Your annual interest expense therefore is $10,500 or $315,000 total cost of borrowing over a 30 year span.

Can you do better by investing the $200,000 in cash elsewhere assuming you had it instead of paying off the mortgage?  Let’s have a look.

$200,000 invested at 8% compounded over 30 years yields a total interest income of $1,812,531. Assuming the same 25% tax bracket, you will have $1,359,398 in your pocket.  I know I know I am assuming an 8% compounded rate which you may have an opinion on despite what all the historical charts say.

I understand that the bitter reality can state otherwise.  That said, there are alternative opportunities for those who have invested in their financial education, such as investing in equity indexed annuities that can realistically yield 8% fixed interest on $200,000 of parked cash or investing overseas at higher risk free interest rates with the understanding there is forex and geopolitical risk.

I purposely did not factor in appreciation of property because this would equally apply to both scenarios. So what is the rush in paying off your mortgage? Would you rather pay it off early or have a few extra million in your bank account down the road?

Let’s look at this in a slightly different way.  If Person A is interested in a interest only mortgage and person B doesn’t believe in mortgages, assuming they have the same net worth today, who will come out ahead financially if both were to purchase a $250,000 property?

Person A

  • Current net worth: $250,000
  • Buys a home for $250,000
  • Pays $50,000 down
  • Takes a interest only mortgage for $200,000 at 7%
  • Invests the remaining $200,000 of net worth
  • Assets = $250,000 home
  • Liabilities = $200,000 mortgage loan
  • Investments = $200,000 at 8% interest per year

Person B

  • Current net worth: $250,000
  • Buys a home for $250,000
  • Pays $250,000
  • Assets = $250,000 home – no debt

Let’s make the following assumptions:

  • Appreciation:  4% annual appreciation on property for both homeowners
  • Tax bracket:  25% for both homeowners

Let’s have a look at where each Person stands at the end of 30 years.

Person B

  • Beginning net worth: $250,000
  • 4% annual appreciation over 30 years: $560,849
  • Current net worth: $810,849

Person A

  • Beginning net worth: $250,000
  • 4% annual appreciation over 30 years: $560,849
  • 8% ROI on investment, net of 25% tax:  $1,359,398
  • Total mortgage interest paid after 25% tax deduction / benefit:  ($315,000)
  • Mortgage payoff: ($200,000)
  • Current net worth: $1,655,247

Person A is better off by $844,398, or almost a $1 million dollars over a 30 year horizon.

Arbitrage can be so powerful that sometimes you can borrow at a higher interest rate than what you earn and still make money in the long term. Why? Because of the power of compounding. Let’s have a look how.

Say you borrowed $100,000 at 8% interest rate. Assuming you are in the 25% tax bracket, your effective borrowing cost is only 6%.  Your annual interest is therefore $6,000 or $180,000 over 30 years.

Say you are able to earn 6% return on the $100,000, this amounts to a total return of $474,349 over 30 years.  Assuming the same 25% tax bracket, you will keep $355,762 in your pocket after paying uncle Sam. Take out the interest payments of $180,000 and you will have benefited by $175,762 from this simple investment arbitrage.

WOW ? ? ?

Yes I know. The problem is that many just do not view mortgages a wealth creation tool, therefore many financial planners simply don’t include mortgages in their client’s financial strategy. I personally think it is one of the best tax advantaged strategy to create wealth.

I understand this information can take some time to digest and accept, especially if you have never been exposed to this type of an analysis.  We are just not accustomed to view mortgages under this light. Are we missing out?

Can You Still Make Money in Real Estate?

You can arbitrage your way into tons of opportunities in real estate yesterday, today and tomorrow.  It is my opinion that one can make money in real estate in any type of economy or era.  Majority of our Nation’s wealthiest have created more wealth from real estate than any other type of endeavor.

We currently have over 300 million Americans, and this number is projected to surpass 400 million by 2050, which is “just around the corner”.  The demand for real estate is likely to only increase and just like our historical past, real estate will AGAIN be the underlying basis for a heavy bulk of the wealth creation that will take place in the coming years.

I personally love real estate because of the leverage factor, the tax advantages through depreciation and what have you, potential capital gains through property value appreciation and short term cash flow resulting from rents collected.

How do I personally create wealth in real estate? Arbitrage, arbitrage, arbitrage.  You can read my approach to value investing in real estate here.

Concluding Thoughts

When the $hit hits the fan you are actually safer if you have a large mortgage balance relative to someone who has paid a lot into their property.  Why? Banks foreclose on those who have the most equity in their properties first because that is where they can recoup the most amount of their money.

How sad but true.  Those who are fully leveraged (i.e. zero down mortgages) essentially shift all the risk from their personal balance sheets to the banks.  With that said why would one put equity in their home?  Think about it, if you lose your job and don’t have the cash flow coming in any more, no bank will lend to you no matter what kind of equity you have in your home. So what good is all that equity after all? Why are you rushing to pay so fast?

Most people view paying off mortgages as the more conservative approach, but ironically it’s just the other way around. Having the cash, or liquidity to cover emergencies is what sounds more conservative to me.  I’d rather have that cash liquid.

If you are interested in running some numbers, and particularly if you are interested in real estate investing either now or later, I highly recommend two effective tools that will help you crunch the numbers such as ROI return on investment, cap rates, pro forma financials, sensitivity analysis (if/then and “what if” analysis).

These are software packages that are very reasonable in cost and ones which I highly recommend.  They are well worth their nominal cost.

http://www.realdata.com/

http://www.ianalyzerei.com/

Readers: Do you agree or disagree with me? Why? What are some of the pros and cons involved in this kind of arbitrage? Is the risk worth the return in your opinion?

0

Home Warranties Can Add Value to Your Property

The concept of a home warranty is a little misunderstood. It is not homeowner’s insurance; it is a comprehensive plan designed to protect home systems and appliances against wear and tear, aging, and defects. For the first year of a brand-new appliance’s lifespan, it is protected by the manufacturer’s warranty. This offers limited coverage, since there are few, if any defects that crop up in the infancy stages for appliances and systems. However, after the first year, repeated and regular use of systems and appliances leads to wear and tear on the moving components, electro-mechanical elements, and general functionality of systems.

There is no doubt that home warranties offer coverage against eventualities that will crop up. The more important question is how homeowners can benefit from home warranty plans? At a cost of $300 – $500 per year, home warranty plans can offer the necessary safeguards to protect against the breakdown, malfunctioning or need to replace systems in the home. These systems include a wide range of items such as microwaves, refrigerators, garbage disposals, HVAC systems, boilers, garage motors, swimming pool motors, dishwashers, and other electro-mechanical devices. The question is not so much about what a home warranty can provide; it’s more about what the home warranty provider offers you. Before you rush off to decide about choosing this or that service, it’s important to evaluate home warranty providers based on merit. Several factors determine whether you should buy a home warranty plan for your home. These include the following:

  • The Cost of the Home Warranty Plan
  • The Type of Coverage Offered by the Home Warranty Plan
  • The Reliability, Credibility, and Reputation of the Home Warranty Company
  • Whether You Need a Home Warranty Plan or Not (New Home New Appliances, Old Home Old Appliances)

There are many other factors that come into the reckoning, notably the responsiveness to your requests for service, and the approval rate of work order requests. Some home warranty companies instruct their technicians to deny as much as 70% of all requests for repair or replacement. The only way to guard against such nefarious activity is to conduct a comprehensive analysis through an aggregator platform of home warranty companies. For example, consider the case of Select Home Warranty reviewed by RHW .

Review Home Warranties is an internationally respected home warranty review site. All home warranty companies such as Select Home Warranty (Shield Your Wallet) are scrutinized at the deepest level. All aspects of the home warranty company’s services are evaluated including payment delays, unexpected costs, tricky terms and conditions, and professional contractors, claim denial rates, repair delays, communication problems, quality of work, professionalism of the contractors, communication, types of repairs that are performed etc.

The in-depth reviews conducted by RHW indicate that this company offers a wide range of comprehensive coverage on home appliances, electrical systems, plumbing systems and AC units/heating systems. Coverage is limited to $400 – $2,000, and the coverage term is 12 months with a service call fee of just $60. Various plans are also available including the bronze plan, the gold plan, and the platinum plan. These are designed to offer increasing coverage to homeowners. Aggregator platforms that evaluate the reliability of home warranty companies are an invaluable resource when choosing between plans and providers.

How Can a Home Warranty Improve the Value of Your Real Estate and Can It Help You Sell Your Home Faster?

It’s better to have insurance coverage and not need it, than to need insurance coverage and not have it. This holds true for home warranty coverage as well. The costs of replacing, repairing, or maintaining all the aforementioned systems and appliances can quickly spiral out of control. The replacement costs of refrigerators, ranges, washers, dryers, and other appliances grow every year, making a home warranty plan a valuable addition to your umbrella coverage for your home.

Unless you are socking away $500 – $1,000 per year in a fund exclusively for your home systems and appliances, a home warranty plan provides a cost-effective alternative when things take a turn for the worse. Once you’re ready to sell your home, the buyer to be will be appreciative of an existing home warranty contract good for a year after the purchase. This is quickly becoming the go-to option in the real estate world. It is perceived value and real value at the same time. Home warranties should work in tandem with homeowner’s insurance to provide complete coverage and better value for the buyer.

34

How to Increase Rental Income Effortlessly and Instantly

DON’T MISS MY $1,500 CASH GIVEAWAY AS WELL AS AN APPLE IPAD 2

Rental income is one of my favorite forms of passive income because it allows me to benefit from the ongoing cash flow, long term equity build up resulting from a decreasing mortgage over time, potential long term appreciation and significant tax deductions.

Real estate is where I invest a lot of the profits generated by my niche websites and other passive income endeavors.  What is rental income? Simply put, it is the money generated by rents received from tenants who are living in my rental properties.

If you are in a similar situation wherein you enjoy investing in real estate and benefiting from rental income, here is one strategy you can implement to quickly increase rental income without much effort on your end.

How to Increase Rental Income

Providing that the areas where you buy investment properties have the appetite for this approach, consider renting out your place for a shorter term (example: 6 months) instead of a year. Fully furnish the property and demand a higher monthly rent.

Some of the areas where I own rental property are perfectly conducive to this model, but other areas are not. You will have to determine if you can make this work where your rental properties are located.

This approach may lead to more vacancy, but will still put you in a better position in terms of total income from rent. How so? Let’s have a quick look.

If you own a unit that you typically would rent out for $1,200 unfurnished for a 12 month term, consider fully furnishing the unit and renting it out for $1,600 for a 6 month term instead to increase rental income.

Let’s guesstimate that your unit, if rented for $1,600 and only for 6 months, only stays occupied 70% of the year, therefore an average 30% vacancy or just under 4 months vacant during the year. Now let’s assume that at a lower $1,200 rate but unfurnished and a 12 month term, you experience a 90% occupancy, therefore a 10% vacancy or just over 1 month each year.

Let’s do the math. $1,600 per month at 70% of the year equates to $13,440 whereas $1,200 per month at 90% occupancy equates to $12,960 per year. Revealing isn’t it? The difference can be more favorable if you can reduce vacancy from 30% to 25%, 20%, 15% or even less.

The Flip Side of the Coin

I have one property that I have been renting out on these terms for years now and knock on wood, the property has yet to go vacant for even a full week!  This single simple strategy alone will increase your return on investment (ROI) from rental income.

Many shy away from this approach because they prefer the security of a steady cash flow, knowing that their properties will be rented out for a full year. They’d rather lock in a lower rent at 12 months than taking a higher rental income only for 6 months and worrying about replacing the tenant. Well, it just comes down to risk reward I suppose.

Personally this strategy has worked really well for me on several properties that I know. You can streamline the tenant search and replacement process significantly over time as you gain more experience investing in rental properties. I like to start advertising well ahead in advance so that I can screen tenants, get the leases signed and transition them quickly when time comes.

Added Tax Advantages

This strategy comes with some other ancillary advantages as well. First of all, it is my opinion that furniture and appliances are cheaper today than ever before – whatever happened to inflation? At least you get a lot more value for your dollar today than you did in the past.

That said, not only will you hoard quality furniture at affordable prices, but you also get to depreciate your furniture over time and benefit from tax advantages. Some even go the more aggressive route and claim the IRS Section 179 deduction and deduct the FULL price of the furniture in year one instead of depreciating it over time, therefore further benefiting from tax advantages.

So not only are you benefiting from an increase in rental income, you are also benefiting from not paying as much in taxes, or potentially even getting money back from uncle Sam depending on your personal situation.

Concluding Thoughts

If you are not doing this or feel that this strategy will not work in your rental neighborhood, try to at least increase income from rent by adjusting the rent payments.  Tenants expect rent increases over time, especially in a period of inflation.

You may be able to justify a rent increase even without inflation playing a factor. Regular maintenance, wear and tear can all lead to rent increases over time. Regardless, make sure you are charging a fair amount and taking your fair share as well.

Readers: Good way or bad way to increase rental income?  I’d love to hear your thoughts. Do you have rental property? What have you done to increase rental income over time? Any additional tips on how to increase rent?

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