Nullifying Einstein’s 8th Wonder of the World: Compound Interest.
In the past few editions we touched on the mindset of the leveraged real estate investor and a method of evaluating an investment in two parts. Now, we land on what in my opinion is the ability to use economic circumstance to nullify the effects of what Einstein called the “8th Wonder of the World” — compound interest. Compound interest is basically calculating interest on the outstanding principal amount plus whatever interest has already accrued. Conventional wisdom says that you should pay down principal as fast as possible to reduce the effects of compound interest.
Because people are taught from a very early age to shy away from debt, purchasing real estate with financing can lead you to feel as though you are digging yourself deeper into debt. I disagree with the belief of the properly leveraged investment as debt. Even the commonly quoted idea of “good debt vs. bad debt” is not something I subscribe to. In this case, I believe “debt” is the entirely wrong word.
Properly leveraged, in the right environment, the financing becomes the greatest asset. We live in an inflationary environment. News outlets report government statistical data, indicating a tame two percent inflation rate according to the CPI (consumer price index). However, according to www.shadowstats.com/alternate_data/inflation-charts, we see that by adding back in everyday expenses that are not accounted for in the CPI, the actual inflation we all experience can be three times that of the “official” numbers.
Take the time to understand the inflation numbers. Understanding brings clarity on how compound interest does not harm the patient investor. Compound interest says the investor referenced in the October and November articles will pay $73,711.04 in interest over 30 years with a total repayment of $157,671.01 (loan plus interest). Many want to pay off the loan as quickly as they can to avoid becoming a “victim” of this 8th Wonder. I say ride that sucker out to the last day if you can.
The dollar’s buying power diminishes every year by the inflating cost of living. I feel very confident using a conservative inflation factor of five percent to see what the dollar would do for the next 30 years while the investor is using the rental income to satisfy the loan. To recall, on the date of closing the investor borrowed $83,960.00, resulting in a payment (principal and interest) of $437.98.
Over the life of the loan, the dollar’s value diminishes as the cost of living increases. Working with my friends in the accounting department of Kennesaw State University we put an algorithm to work that shows the individual value of each dollar as of the date it was used to make a loan payment compared to the value of the dollar from the date it was borrowed (inflation-adjusted dollars). Totaling the value over thirty years the $157,671.01 paid is actually equal to $81,586.71 when accounting for the decrease in buying power of the dollar from the date the loan was issued.
Could this be accurate? The real estate investor in this example borrowed $83,960.00, paid interest of 4.75 percent over 30 years totaling $157,671.01. With the value of the instrument they are repaying the financing, but they are really giving back $81,586.71 based on the full value of the dollar the day it was initially borrowed. That is, the investor locks in a payment of $437.98 at loan origination. However, over the life of the loan period, accounting for inflation, that $437.98 continues to decline month after month until it becomes worth only $98.03 in the final year’s dollar purchasing power.
Why would we ever want to pay it back any faster if there is no need to accelerate the re-payment! I encourage the investor not to. Paying more than the absolute minimum means you’re paying with your money, rather than letting your tenant pay the mortgage and provide you with tax and inflationary benefits. Keep what is yours and pay the leverage with less over time using OPM.
Separately, an investor would look at each of these items as a negative. Paying compound interest is definitely negative. Declining value of the dollar they hold due to inflation, also very negative. Couple them together and you have that rare case where we can use two negatives to create a compounding positive.
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