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I came across this article which was originally posted on I Make Money Building Iphone Applications and it essentially separates the people who are financially literate from the illiterate and the impact that can have one a persons personal finance. As time passes you will see that one financially smart individual can create alot more wealth in the same as someone who doesn't have the slightest clue on how things really work.
Enjoy the Read
The Money Saver
The saver is someone we’re all familiar with. He likes to save a certain amount of money every month into investments so he will have a nice nest egg when he retires. He likes to avoid debt at all cost because that is what everyone who don’t know squat about finances tells him.
Let’s assume our saver socks away $500 per month, every month for 20 years, into long term investments (stocks, bonds, mutual funds, etc). Let’s also assume our saver average a return of 10% per year. Some years will be up, some will be down but over the long term, 10% is about what the stock market has returned to investors.
At the end of the 20 year period, and after socking away $120,000, our saver has a nice retirement nest egg of $378,015. Not too bad!
The Leveraged Investor
In this scenario, our investor wants to be like the saver and put $500 per month into long term investments. However, instead of putting the $500 directly into investments, he goes to his bank and sets up a home equity line of credit for $120,000. He takes the $120,000 and uses it to buy the long term investments. So, instead of spreading the $120,000 out over 20 years like the saver did, the leveraged investor borrowed $120,000 to invest everything right now.
Every month, our investor needs to make a payment to the line of credit. Payments can be as low as interest only to as high as the entire outstanding amount. Interest on a line of credit is generally done at Prime. Let’s assume it’s 5%. Prime is a lot lower than that right now but over 20 years, it will average out. If our investor pays interest only on the line of credit, he would need to pay $500 every month to maintain the line.
Because the $120,000 was used to buy investments, the $500 interest payment is tax deductible so our investor can look forward to a $6,000 tax write off every year. That will result in a $3,000 tax refund if our investor is in the 50% tax bracket. If our investor was smart, he’ll put this refund back into investments. But let’s assume he’s just blows it on women instead.
Comparing The Numbers
If we assume our leveraged investor makes the same 10% return as our saver, that $120,000 will turn into $807,299.99 in 20 years. At this point the investor can take out $120,000 to pay off the line of credit and will be left with a net of $687,299.99.
By taking average of good debt, our leveraged investor manged to build a nest egg nearly twice the size of the saver, with the same $500 per month. In addition, the $500 per month the investor paid was tax deductible, while the saver got no tax benefits. Had our investor put the $3,000 yearly tax refund back into investments instead of blowing it on women, he would have made $996,307.49 at the end of 20 years. Women are expensive!
Most financial planners won’t tell you about leveraged investments because they are prevented from doing so. Unless you’re an Accredited Investor (net worth
over $1 million or income over $200,000 per year for the past two years) a financial planner cannot legally show you some of the more sophisticated investments available to people with money. This access to higher yielding investments vehicles is one more reason why the rich get richer. It was never a level playing field.
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