Wednesday, December 16, 2009

Why do the Rich Get Richer?

I am sure that everyone has heard this line before: “The rich get richer while the poor get poorer.” Whether this comment is fact or fiction is a matter of opinion. Many self-made millionaires were once arguably “poor.” A number of “rich” people have also become poor, especially if they did not create their own wealth. That said, why is it that rich people like Donald Trump can go from broke to billionaire more than once while many people cannot seem to get past living paycheck to paycheck?One big reason is that rich people buy assets; poor and middle class people buy liabilities. The really rich buy assets with other people's money but that's a topic for another day.

Personally, I like the definition for both give by Robert T. Kiyosaki. Assets put money in your pocket; liabilities take money out of your pocket (or use cash). I received a letter the other day from my bank encouraging me to increase the limit on my secured line of credit. This letter from one of our big Canadian banks suggested that I could use the extra money to “renovate [my] kitchen, consolidate debt, or take the family on that much-needed winter vacation!” No wonder most of us get poorer. Even our esteemed banks that we look to for financial advice encourage us to get into debt so that we can buy liabilities!

Meanwhile, what do rich people like Warren Buffet, Donald Trump, and Robert Kiyosaki do that the poor and middle class don’t? While the general public punches the clock trading time for money so they can pay back that vacation (with interest!), the rich buy assets like stocks, businesses, and real estate. They make their money work for them instead of working for their money.

This strategy is not just for the rich. You and I can do it too. I know that it can be scary, especially since we were never really taught this concept in school. As kids, weren’t our parents always telling us to work hard to get good grades and a safe, secure job? Did your dad or teacher ever tell you how to buy a property or a business and let the investment pay for itself? If so, you are definitely one of the lucky few.

Not all debt is created equal. Good debt is where you borrow other people’s money and use it to create wealth. Bad debt drains your cash and forces you to work harder to pay it back. As an added bonus, the government generally allows you to write off interest when you borrow to purchase assets making your loan even less expensive. Be sure to talk to your accountant before making any assumptions though, and never make an investment purely for tax savings. After all, your goal is investing to make money – not lose it!

Personally, I would argue that debt to acquire a property that does not produce positive cash flow is NOT good debt (it takes money out of your pocket). How many of these properties could you afford to own? Negative cash flow can eat you alive! On the other hand, if you borrow to purchase a property that gives you a small amount of money in your bank account after all bills are paid each month, how many of these properties could you afford! As many as you can get! Negative cash flow can also force you to sell your “asset” at the worst possible time if you cannot afford to keep it. If you have positive cash flow each month (assuming you want to sell), you can afford to wait as long as you want to hold out for a better offer.

Do you have a plan that transitions you from working for your money to your money working for you?

Friday, November 13, 2009

Rental Property - Our Cash Machine for Retirement

About 4-5 years ago our family purchased our first rental property. You have likely heard the infomercials where you can pay “nothing down” and tenants take wheelbarrows full of money to your bank account every month. Isn’t being a landlord the easy path to a million dollars? In my experience, that would be a bit of a lie.

I could also tell you the down side and how this property drives us crazy with repairs and tenant issues. Landlords are commonly found with a toilet plunger in one hand or staking out their property as they wait for delinquent tenants to come home on payday. Again, this would be stretching the truth.

The reality is that being a landlord has its ups and downs. Not everyone is cut out to do it, and quite honestly I have days when I wonder why I got into property. You get an education on every reason why the rent is not available the first of the month. A few calls to the Landlord Tenant Board can also be a real eye opener. I have to admit that the first 2 years or so I routinely debated about putting a “for sale” sign on the front lawn.

So why do I still have the property? Thankfully, once you buy a rental property it is not something you can easily dump when you have a bad day. Selling your property can be a drawn out and expensive business. I say thankfully because if you buy right and you can “suck it up”, I know of no other investments where you can put so little money down and let someone else pay off your retirement plan. When I bought the property it was cash flow positive from day 1. This is the “golden rule” in my opinion. Although I didn’t make much more than my expenses initially, the property did not cost me anything out of my pocket after closing. Any pain I experienced as a landlord was more emotional than financial. Critics will say that in their areas you can’t find properties cheap enough to be cash flow positive right away. I once had that problem. We moved.

The other reason is that in spite of the challenges you might face as a landlord, and although it may not be an “easy” path to wealth, maybe it is easier than a lot of the alternatives. Preventative maintenance can cut down on your phone calls. You can also improve the property. Even if government bureaucracy limits your rent increases there is no law that says you can’t make improvements to better your cash flow. Our triplex had zero insulation when we bought it and the gas bill was murder. It was a cheap fix. Any reduction in expenses is an increase to your cash flow, and as a bonus the tenants looked a lot more comfortable too!

As net cash flow increases so does the value of your property. If you ever decided you wanted to cash out another investor would look at the condition of the property and the return on his/her investment. Every year that rents go up and every improvement you make that drives down expenses will add to the value of your property. Taxes on my net income so far have been zero thanks to depreciation. Definitely get yourself a good accountant who routinely deals with property investors. If and when we sell, we will pay capital gains tax, but this tax is a far better deal than income tax. I might change my mind, but right now I can’t imagine selling anytime soon.

Another real estate investor I know has told me that eventually you wake up and discover that the property you bought for X a number of years ago is worth way more today. The mortgages are paid off and you have a healthy stream of cash coming in each month. It’s a bit like buying an annuity, except you make only the down payment and your tenants make the rest of your contributions for you. You have gone beyond “paying yourself first”; your investment feeds itself each and every month.

So far I have limited myself to one property since I am also working very hard to eliminate personal debt (e.g. our personal mortgage). Our rental property has been a huge help on this quest as well. I also work full time and my family might get a bit annoyed if I spend all of my “off” hours handling my landlord responsibilities. These are my own personal excuses as to why I have not added any more properties to my portfolio so far.

One final point I thought I would mention. People joke about the toilet plunger when you become a landlord, but you won’t find me plunging any toilets outside of my own house. I have purchased and dropped off a plunger as a favor, but I have a clause in my rental agreement that specifies “toilet plunging” as a tenant responsibility!

Have you ever thought about taking the plunge as a landlord?

Thursday, November 12, 2009

Eliminating Debt - How Much RENT Do You Pay Every Month?

A home is one of the biggest purchases that you can make. Many people see it as one of their biggest and best investments, but for most of us it comes with a huge liability: a mortgage. Either way, we all need to live somewhere and many people argue that owning your own home is far better than paying rent. Although I am a fan of home ownership, maybe we should consider that we all pay rent of some sort. Everyone knows that a tenant pays monthly rent to the landlord, but few stop to consider their mortgage interest payments in the same light.

Mortgages are at worst a forced savings plan unless somehow you have secured one that is "interest only." Your principal payments get you closer to financial freedom, and the interest portion is the rent that you pay to the bank. In Canada, mortgage interest on a personal residence is not tax deductible, so the only real benefit you get from the interest portion is the use of your home for another month. Another portion of your rent is property taxes. You can potentially reduce your taxes with a reassessment but you will never entirely eliminate them.

There are many online mortgage calculators on the internet that will break down your monthly principal and interest payments. You can also get an amortization schedule from your bank or mortgage holder. Let’s look at an example based on ING Direct’s 5 year fixed rate of 4.19%. If you had a $200,000 mortgage with a 25-year amortization your monthly payments would be just over $1,072. A whopping 65% of your first payment would be interest paid to the bank. Add in your monthly property taxes and you have your total equivalent to rent payment. In this case you have $692 + property taxes. The good news is that your interest amount will shrink as you pay down the loan; the bad news is that based on 25 years it’s a slow process. Based on this amortization schedule, assuming the same interest rate holds steady, more than half your payment goes to interest until well into year 9. Keep in mind that this example is based on record low interest rates offered to people with the best credit ratings!

If the above example seems depressing, there are a number of ways you can get ahead of the game. You can do accelerated bi-weekly payments, lump sum payments, and even double down (pay twice your normal payment) depending on the lender and your mortgage terms. Let’s look at an example where you decide to set your payment at a higher amount each month and leave it there for the duration of your mortgage.

Based on our $200,000 mortgage (at a 25 year amortization) the first payment of $1,072 eliminates only $380 of the principal; $692 is interest! The good news is that you can skip payment 2’s interest payment forever by paying an extra $382 in addition to payment 1. Less than $400 buys you 1 whole month off of your mortgage! If you were to continue with this extra amount every month you would reduce your total interest over the life of your mortgage by just under $50,000 and you would be mortgage free in 15 years and 8 months!

Some critics may argue that they cannot possibly pay any more than they already are against their mortgage. My suggestion is to contact your bank and see what options are available. Often you are allowed to increase your payment at least once a year within limits set by the lender. Play with a mortgage amortization calculator such as the one at ING Direct and see the potential benefits of even a slight increase. A runner does not run a marathon on the first day. The trick is to DO SOMETHING. Maybe you only increase your payment a few dollars or add a portion of annual pay increases to your payments. The online mortgage calculator will show you how a few dollars early on can be huge over the long term. Before you know it this strategy will become easier and you won’t even miss the money. If you are concerned that you may not be able to maintain the higher payment, confirm with your lender that you can always drop it to the lower amount if the need occurs. If you have not yet bought your house, you might consider a slightly less expensive home (and mortgage) to help make these strategies less painful.

Maybe you are torn between paying down your mortgage and investing. Consider that your existing interest rate on your mortgage is your guaranteed return when it comes to debt repayment. Even better, the government will never penalize you with taxes on the money you save. These are essentially "after tax" returns. In non-registered accounts, a guaranteed rate in the form of interest is taxed at the highest possible rate, and in an RRSP you will still pay CRA a chunk in income tax when you withdraw the money. Again this will be at the highest tax rate based on your income. I am not saying that you shouldn’t invest or put money into RRSPs, but definitely consider these points when you look at the benefits of debt elimination and investment. If you are really savvy, you might want to google a strategy known as the Smith Manoeuvre. This alternative can help you take advantage of the best of both worlds.

There is one final thing to consider before you go ahead with this strategy. If you have credit card or higher interest debt these amounts need to be eliminated first. When it comes to debt elimination the general rule is to pay off the highest to lowest rate. As you pay off each debt add the payment amount you were making to the next debt. Once higher interest debt is gone you can move on to your mortgage.

Again, the key to moving towards your goal of financial freedom is to TAKE ACTION. Analysis is good, but if you spend too much time analyzing and never put your strategies into action you may know more but you are no further ahead then before.

What actions have you taken to eliminate your consumer debt?

Sunday, November 8, 2009

The Financial Treadmill of Life

Does lack of money hold you hostage? Here’s a clue. If you don’t absolutely love your job and yet you show up to work religiously every day…the answer is probably yes.

A job can be like a drug. We grow up in an educational system that is generally designed to turn out wage slaves. Go to school, work hard, and get a good JOB! A good job means more money and supposedly a good future for you, your future spouse, and the 2.2 kids you will eventually have. So you follow the age-old advice and work your tail off in high school. Good job! You move on to college or university so that 2-4 years later (with a little more hard work) you can leave with your ticket to a solid, entry-level position at a great company. It’s a good thing you got your education but there’s just one more snag; now you’re going to have to work some long hours to pay back that monstrous student loan you took out!

Life goes on. You impress a few people at work and maybe get a couple of pay increases under your belt. Good thing too, because now you have that car loan to pay. Hey, you have to get to work somehow, right? A bit more time passes, and you make the biggest investment of your life. Your parents always told you that a house was the best investment they ever made so you decide to make the move to home ownership yourself. Nice house, shame about the big 25-year mortgage attached to it. The credit cards also get a little workout as you add furniture. After all, who wants to live in an empty house? The Big Box stores always have those “don’t pay a cent” events on anyway. It’s practically free money, right? Then the “no payment no interest” party ends and is replaced by “monthly payments, high interest.” It’s a good thing that you have that job.

I could go on but I think you get my point. Life can seem like a financial treadmill, and yet somehow we are ill prepared to deal with it. It seems odd to me that basic money management never made it’s way into the high school curriculum.

This blog is dedicated to exploring ways to break free from wage slavery. Maybe you like your job. If so, that’s great! Maybe you always wanted to write a novel but figured out that the only way you were going to get ahead was to stick it out in engineering. You may hate it, but people depend on you, and you depend on your paycheck.

I am not going to tell you that you should quit your job tomorrow. My goal is to explore some ideas that will hopefully give you some more options. A job is an option, but so is starting a business, saving money, investing, and digging yourself out of consumer debt. It’s probably going to take some time. Personally, one of my biggest challenges has been a lack of patience so I am always looking for ways to reach financial freedom sooner. There are always trade-offs with each potential solution. Is it worth the sacrifice? You could work 60-hour workweeks and commute 1 ½ hours each way to make more money. Many people do it every day. The price? You may never see your family. I did this for a time until I realized it was killing my home life and me in the process. My 4 year old daughter begged me every night not to go to work the next day. We found another way. There are always options; you just have to be open to them.

The ultimate freedom is to be able to choose the work you want to do without regard for compensation (in some cases this choice may be no work at all). To get to this point we need a plan that will answer two basic questions.

How much money do you need?

The amount of money you need depends a lot on lifestyle and where you live. If you live in Toronto and like to vacation in Europe frequently you are going to need much more than someone living in Northern Ontario who likes to read and maybe camp on occasion. If you can cut your expenses the amount of income you will need goes down accordingly. Then again, if you want to shoot for a million it sounds like a nice round number. This goal may not be as out of reach as you think.

How can you acquire this amount?

Right now you may be earning this amount by putting in a lot of hours at work. Once you stop working your incomes stops along with it. This is one way, and in many cases the only way that Canadians know. We work hard and maybe put some of our money into a RRSP with hope and a prayer that this will see us through a traditional retirement. If a traditional retirement where you live off of a fraction of your "pre-retirement" earnings is not good enough for you, then you need to find a better way to transition from a life of working for money to one where money works for you.

I expect that this blog will evolve over time but these two questions should remain as its foundation. I look forward to sharing my thoughts with you and invite you to share your own thoughts on each topic as we go along.