Posts Tagged "cash flow"

Leverage Part 1: What is Leverage?

Posted by Preet on Aug 1, 2007 | 0 comments

Leverage: Think of it as using “other people’s money” to make money more quickly. Probably another topic that is best explained with an example.

Greg has $1,000 a year to invest for 10 years. Assuming a rate of return of 10%, at the end of 10 years he will have $17,531.

BUT, we know from the post on the magic of compound growth that TIME has a large effect on growth.  The philosophy is that if you could instead take all that $10,000 over 10 years and just put it in now, you will have more money than by putting it in over 10 years.

Okay, let’s look at a simple use of leverage: Greg only has $1,000/year, so he can afford a loan payment of $83.33/month (That’s $1,000 per year). First we have to figure out how much of a loan he can get. Assuming a 6% interest rate, $83.33/month for 120 months (10 years) will allow him to borrow $7,530.89. So he isn’t starting with $10,000 since we have to compare apples to apples (in the form of how much cash flow he is willing to dedicate to his investment savings).

Okay, so now let’s calculate how much $7,530.89 will grow to if invested and assuming the same 10% rate of return… My trusty financial calculator tells me $19,533. So in this case he has roughly $2,000 MORE through the leverage than with the yearly savings (which yielded him $17,531).

Now before you go out and get a loan to invest, remember that a lot of people get burned on leverages – as they magnify RISK as well as return. In Part II of “Leverage” I’m going to look at a negative scenario.

You know, the topic of leveraging is a big one – I envision that I could easily write a 10 part series of posts on it, and probably will. It’s glamorous, but please make sure to consult with a professional before getting one! This post is in no way meant to be taken as advice to get an investment loan.

Having said that, if you own a house and have a mortgage – you already have a leveraged investment! :) You have borrowed money to buy an appreciating asset.

Refinancing your home

Posted by Preet on Jul 27, 2007 | 0 comments

I’m going to offer up an example in a following post, but this post is to deal with the psychological aspect of refinancing your home to consolidate debt.

First, let’s just make sure we’re on the same page and define “refinancing your home”. This is basically when you have some equity built up in your house (after paying your mortgage payment for a few years or having put a large down payment on it) and you use that equity to pay off OTHER debts so that instead of having a mortgage payment, a credit card payment, a line of credit payment, a vehicle payment, etc you will only have one slightly larger mortgage payment and that’s it. I say slightly because you have taken all the other debt payments and in effect turned them into debts with longer repayment time lines, thereby reducing how much you pay monthly. So why do people want to do this? Cash flow – plain and simple. People can free up $1000/month in some cases which can be used for building up an emergency reserve, long term savings, and in many cases allows them to just breathe easier. (Refer to my upcoming post using a real life example with hard numbers.)

When you refinance you will generally reduce the overall amount of interest you are being charged on all of your debts as well. For example some credit cards are charging 19.9% per year, and department store cards are sometimes charging 28.8%. Once you refinance that debt into your mortgage you get a lower interest rate since the debt is now SECURED (by your home) as opposed to UNSECURED. Secured means that you basically agree that if you can’t pay your debts, the bank will get the value by selling your home, taking what you owe them and leaving you with the rest. Since the bank has a better chance of getting their value back when you secure your debt, they will lower the interest rate to reflect their reduced risk.

So the equity in the house is the total value of the house MINUS your mortgage balance. Example: you bought a $200,000 home and put $50,000 as a down payment.  That would leave you with a $150,000 mortgage. Your equity would be $50,000. After a few years, you’ve paid some principal and interest back in the form of your mortgage payments and now maybe the mortgage balance is $135,000. PLUS maybe the value of the house has gone up to $235,000. At this point the value of the house ($235,000) minus the mortgage balance ($135,000) leaves you with $100,000 of equity.

One reason refinancing has become so popular is that housing prices have really appreciated, in fact we are in the longest housing bull market in history. This has created a lot of equity, and to refinance to clear up debt and reduce the overall cost of borrowing is a sound strategy (until you look at the psychological aspect of it.)

People are doing this en masse these days as people are perpetually spending more than they earn.  Why do people put so many purchases on credit? Well, these days one of the main reasons have been the incredibly low interest rates – it makes the carrying cost seem very reasonable – and people became used to using credit, hence: they have a lot of debt!

So the only real problem of refinancing your home to consolidate debt? If you don’t correct the spending habits that created the situation in the first place you will start spending your new found cash flow similarly to before and end up even further behind within a few years. I’ve seen it happen and the next step will be bankruptcy! So make sure you can adjust your habits.  Use a financial advisor, set up a forced savings plan with the new money and stick to it!