Making debt work in your favour

One of the key tenets of property investment is the principle of maximising compound interest using other people’s money.

It is in fact two principles, not one.

You could of course maximise compound interest using your own money, but it is the powerful combination of both elements that makes property investment so potent.

Put simply, if property goes up in value by 10 per cent a year, then in seven years the value of the property will have doubled.

Of course if you multiply 10 per cent by 7 and you should get 70 per cent, but compound interest, year on year increases, not just on the original sum but on the interest as well, means that 10 x 7 does actually equal 100.

If we do the sums based on a £100k property (I wish!) the numbers look like this:

Capital gain of £100K at 10 per cent a year

Year 1
£100,000 x 10%
= £110,000
Year 2
£110,000 x 10%
= £121,000
Year 3
£121,000 x 10%
= £133,100
Year 4
£133,100 x 10%
= £146,410
Year 5
£146,410 x 10%
= £161,051
Year 6
£161,410 x 10%
= £177,156
Year 7
£177,156 x 10%
= £194,871

 

OK, I accept it is just over £5k short of our target of the 100% capital gain but a few more months and it’s there. By the end of year eight we have sailed past our target and the property is worth over £214,000.

Now you old hands out there all know this. You understand that if you can borrow £100,000 to buy a property and get a tenant to pay the loan you are well on your way to making more money from your buy-to-let investment than from your nine to five slave job.

Now let’s look at this money-making principle in reverse. Let’s look at how compound interest can work, not for you, but against you.

Do you realise that if you borrow money to buy a “non appreciating asset” and you are the one paying off the loan then you are doing the exact opposite of the above.

The model I have described only works when 1. The asset appreciates and 2. Someone else pays the loan.

That is why over the years so much of this newsletter is dedicated to the concept of ‘bad debt’. Bad debt is when you reverse the money-making model and buy a non-appreciating asset and pay off the loan and interest yourself. It is surprising how few people understand this model.

I know many property investors who have significant debts on their credit cards. Come on guys. If you claim to understand how this works what the heck are you playing at?

I appreciate that those of you with a few wrinkles under the eyes wouldn’t touch credit card debt with the proverbial barge pole, but these days I am speaking to more and more young people who haven’t had these basic principles taught to them (probably because their tutors are as debt ridden as they are).

I was recently chatting to some American friends and their attitude to the concept of savings and of debt was simply beyond belief. These guys are up to their eyes in debt, maxed out as the Americans like to say, and if anyone would lend them anymore money they would still grab it with both hands.

Obviously they believe that at some point in their future something in their lives will improve dramatically and one assumes that at that point they will pay off their debts. But what exactly are they expecting to happen? I asked them what event would bring about such a massive change in their personal fortunes and all I got was silly laughs and mutterings about marrying some rich partner or winning the state lottery.

Although talking to four of my mates does not, by any standards constitute a serious poll, recent statistics show that they are not alone.

The International Herald Tribune has just reported that the savings
rate for people under the age of 35 is, wait for it – minus 16%.

That’s right – MINUS 16%.

You don’t need a degree in maths to figure out that their debt is doubling every four and a half years.

This isn’t clever, it is blindingly obvious, and yet people just don’t get it.

The banks get it though – they are making an absolute killing.

If you are thirty-five or younger there is every reason to believe that the future is always rosy. Over the last ten years easy credit has lulled an entire generation into thinking this is how it’s always going to be. Rich people buy designer clothes, drive expensive cars, and have luxury holidays. But it is not true to say that if you buy these things you too will become a rich person. It doesn’t work the other way round. You cannot spend yourself rich and that is something that a whole generation is yet to learn.

The lesson at the end of this is as obvious as eating healthily and getting plenty of exercise if you want to live longer.

Buying things you don’t need, with money you haven’t got, will only end in tears. Act now to clear your debts, cut back on consumer goods you cannot afford, and most important, take ownership of your financial future before it is too late.

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