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When I give seminars, this is the moment that I
introduce the most memorable visual aids I have ever
used. Picture yourself holding an empty drinking
glass in one hand and a pitcher containing water in
the other. The glass represents your house. For
simplicity's sake, let's say it is worth $100,000.
It's an asset. Let's say you have $100,000 of cash
in the bank (the pitcher) -- that's liquid wealth.
The glass is empty because you have not put a penny
into your house, but on paper, on a balance sheet,
you would still list it as a $100,000 asset.
Meanwhile the pitcher of water represents another
asset -- $100,000 in cash.
What's the total amount of your assets? $200,000.
What happens if you pour the water into the glass?
You have reduced your assets by $100,000. You've
combined $100,000 in cash to a glass already listed
as an asset worth $100,000, and all you have to show
for it is $100,000. You have cut your assets in
half!
On
the other hand, when you separate the liquid cash
from the glass-sized house that is free and clear,
you double your assets. That's what happens when you
separate equity from your house and put it in a
liquid investment. But you're not finished. Assume
the empty glass-house appreciates at an average of 5
percent a year. After one year, what's the value of
the empty glass? $105,000. If you pay off the
mortgage on the glass (pour the water -- or money --
back into the house) what is it worth? The same
$105,000 -- whether it is mortgaged or it is free
and clear -- because equity has no rate of return
when it is trapped in a house.
Next, pour the water from the glass back into the
big pitcher. You've just removed $100,000 from your
house and put it into an investment earning -- let's
say -- 10 percent. At the end of the year, how much
money will you have in that pitcher? Look at that!
It's grown to $110,000! In your other hand is your
house, worth $105,000 at the end of the same year,
thanks to appreciation.
Leave the water in the pitcher.
How
much have you earned by separating your equity from
your house in the course of just a single year?
$15,000. How much would you have earned if you had
left the water in the glass? Only $5,000 --
one-third as much.
"But, but, but -- the mortgage wasn't free! I had to
pay some interest." That's right, you did. Let's say
the mortgage was at 7.5 percent. That's $7,500
subtracted from $15,000 for a net gain of $7,500,
instead of just $5,000. You are still 50 percent
ahead than if you had not removed the equity from
your house. If the mortgage interest is deductible,
then the net cost of the mortgage is really not
$7,500, but $5,000 in a 33.3 percent marginal tax
bracket. So the net profit is $10,000 ($15,000 minus
a net, after-tax mortgage expense of $5,000) -- or
twice as much as you made if the house was paid off!
Here's another quick analogy: Would you rather have
one horse working for you or two? Can two horses
work for you, even if you owe money on one of the
horses?
The
object of this demonstration is that no matter what
else you do, when you separate your equity from your
house, you increase your assets. Even though there
is a charge for doing that -- the simple interest
you pay on a mortgage -- it makes a whole lot of
sense to take out a mortgage and use it to make your
assets grow.
Do
you recall the president of the bank I mentioned at
the start of this chapter? What you've just done --
taken out a mortgage and used the money to make more
money -- is what he did. You didn't make billions,
but you made a profit in the same exact manner. By
separating equity from your house, you give it the
ability to earn a rate of return. Employ this
strategy each year, and the profits will compound.
Copyright 2007
Douglas R. Andrew
The above is an
excerpt from the book The Last Chance Millionaire by
Douglass R. Andrew. Published by Warner Business
Books; June 2007; $24.99US/$31.99CAN;
978-0-446-58053-3.
Douglas R. Andrew is
the owner and president of Paramount Financial
Services, Inc., a comprehensive personal and
business financial planning firm. His previous two
books, Missed Fortune and Missed Fortune 101, are
national bestsellers.
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