In the previous four steps I had covered a few basic topics ranging from pursuing a career with income potential to minimizing consumer debts to harnessing the money growth factors to invest long-term in the financial market. By following the first four steps, it’s sufficient for the average person to develop a good grasp of his/her own finance and save a healthy amount of money by the time he/she retires. Of course, if one wants to get further ahead than the average person, there is no other way but to go the extra mile to improve one’s investment knowledge and finance. The truth is: wealth takes time and effort to built by those who made the commitment to manage their finances and plan for the future. If you are committed to building your wealth, this is the step to expand and broaden your financial horizon. It’s time to take a closer look at real estate and leverage.
A Word Of Caution
Before I go into further details, I would like to provide a few words of caution (this is to protect you and me). Too often, when people hear of an investment idea and it was brilliantly presented by the presenter, they start to think that it’s logical, easy to execute and they dive in. Big mistake. My advice is to take everything with a grain of salt and take your time to digest the information. Start researching for similar information sources to verify the concept and ask yourself, “Does this new idea fit into my long-term financial plan? Do I fully understand the risks? Can I realistic implement this new idea? How will it affect my finances if it doesn’t work out as I thought it would?” There are a lot more questions that you should ask, but those are the basic questions to get you started. Once you’ve honestly answered those questions, you’re ready to proceed.
Based on the last census survey conducted by Statistics Canada in 2011 (it’s a little dated, but these survey costs money and the government only do it about once every five years. The 2016 census information is not fully released yet.), 69% of Canadian households, or 9.2 million out of 13.2 million, owned their home. Surprisingly, according to Business Insiders, our neighbor south of the border, also had a very similar homeownership percentage at 66.7%. To me, this number means that two out of three Canadian and Americans invest in real estate in the form of a primary residence. While some people do not view their principal home as a significant investment, but the truth is, it can be and you can use your principal residence as leverage for building wealth.
Based on the Canada Mortgage and Housing Corporation, the minimum down payment for a property is at least 5% of the value of the property if it’s below $500,000. If the value of the property is higher, you’ll have to have more than 5%. So let’s assume that you have a $20,000 down payment and you want to buy a property for $400,000. So your equity in the property is 5% (=$20,000/$400,000) and mortgage loan will be 95% (=$380,000/$400,000). Your leverage ratio (loan/equity) is 19 times (=$380,000/$20,000). If you have a down payment of 20% ($80,000), your leverage ratio is 4 times (=$320,000/$80,000). As you can see, the lower your equity in the property the higher the leverage ratio. Hence, anytime when you have less than 20% of the equity in your property, you are considered to be in the high leverage ratio group and are required to buy mortgage insurance. The higher your leverage ratio is, the more risk you are taking, so use leverage carefully and with prudence.
Leveraging Your Home Equity To Invest
Assuming that 5 years ago, you put down the 20% down payment on a house that cost $400,000 and you took out a $320,000 mortgage. As of now, let’s say that the value of your house had increased by 40% to $560,000 (this number is definitely not outrageous if it’s located around the big cities in Canada) and you have paid down your mortgage to about $275,000. Hence, your leverage ratio goes from 4 times then to only 0.965 (=$275,000/$285,000) times now. What you can do is bump up that leverage ratio back to 4 (=$448,000/$112,000) times by refinancing your mortgage to $448,000 (80% of the value of $560,000). This means you’ll be borrowing an extra $173,000 (=$448,000 – $275,000). At this point, you still own your house, you have an extra $173,000 to invest and the interest that you paid for the $173,000 is tax deductible.
Real Estate Investments
With this extra $173,000, what should you do with it? The first option is to invest the money in the real estate market by purchasing an income property. Based on my how to buy an investment property: step-by-step guide, the rule of thumb is that your investment value should be no less than 25% of the investment property. By reversing the math, your investment property should not cost you more than $692,000 (=$173,000/0.25). If you haven’t noticed already, your interest in the 25% in equity is tax deductible and the interest on the 75% mortgage loan will also be tax deductible too. Hence, a 100% on the interest of this investment property is tax deductible. Is this awesome or what?
Financial Market Investments
If you already own a principal residence, do not have a large exposure in the stock market and you want to diversify your assets, the second option is to take the $173,000 to invest in the financial market. If you are not comfortable to pick your own stocks, then putting them into index ETF as mentioned in step four of this series will be sufficient. However, if cash flow is important to you, then you can consider building a dividend portfolio similar to the ones that I modeled in my “how I get paid when borrowing money from the bank” post. Depending on your personal income tax rate, the interest rate on the loan and the combined dividend rate of your dividend stock portfolio, your chances of achieving positive cash flow for this investment is quite good given today’s low-interest rates environment.
Diversify Your Assets
The third option is to do a combination of both. With this strategy, you are actually increasing your income sources in three ways: dividend income, capital gain income from stocks when you sell, and rental income for your rental property. Based on Thomas J. Stanley’s best-selling book, “The Millionaire Next Door” millionaires have on average seven sources of income. Hence, if you add these three sources to your main employment income, you’ll have four – more than halfway there, my aspiring millionaire friend.
Invest In A Business
The fourth option is to invest in a business. This can take many forms and the risks are different for each option. For example, you can invest in a new business or buy shares of an existing business. This will give you an extra income source. You can also buy a franchise of a successful business chain like McDonald’s or Tim Hortons. You can be the main operator or hire a manager to operate it for you. Though this is a feasible solution, I don’t have any information on how to guide you in this en devour as I don’t operate a business (in the traditional sense). Hence, it’s not suitable for me to recommend this option to build your wealth. So this
My Two Cents
To build a million dollars in savings is not easy, but it’s not that hard either. If you are willing to take the initial step by saving diligently and invest wisely, then slowly expand your financial knowledge, you’ll be setting yourself up for long-term success. Successful wealth builders learn new and innovative ways to add wealth-building assets to their investment portfolio to increase their income sources. You can do it too if you commit yourself, take the time and effort to plan and invest with a long-term horizon.
In The Final Step To Saving A Million Dollars, I’ll provide you with insights into how I saved my million dollars.