This strategy I like to call Integrated Cash System. I think this strategy will be unbelievably valuable to you as it has been for me.
It is important to understand how cash flows although there is nothing necessarily earth shattering about this but understanding the process will help lay out the principle.
As long as you have good fiscal habits everything is going to work out for you, ok.
Step 1: You need an emergency fund. Simply create a cash cushion of some kind to safe guard you from the possibility of Murphy’s Law. These type of things could be like your hot water heater breaking down, Your water pump on your car needing replaced, etc. How much do you need as a cash cushion? You only need about $3,000 – $10,000. No matter how much money you make you only need at the most $10,000. This is for short term type things and not a long term emergency fund.
Step 2: You need to eliminate debt. This means non-preferred debt such as credit cards, car loans, and basically anything that is not your mortgage. Your mortgage offers tax advantages where as all other debt does not and is considered non-preferred debt. Again remember hold on to no debt other than your mortgage.
Step 3: You want to have an element of liquidity. If you are an entrepreneur and you have an interruption of income you want to have enough money to carry you through. This applies to business or personal finances. You want to have one year worth of income or one years worth of expenses typically available to carry you through a tough situation.
You do not want to just plan for a small interruption in finances and that is what this liquidity step is about. This liquidity is not just for long term bad interruptions in income situations but for having money when you run into a good thing such as a new opportunity.
Again how much is good liquidity? One Year Salary.
Step 4: Pay Off Home. Free and clear. There are two ways to do this. You can pay it off to the bank or pay it off on your actual balance sheet. This just means you have an offset account equal to or greater than the mortgage is. So for instance, if you owe $350,000 on your home mortgage but you have $350,000 in assets then they basically nullify each other out. Some financial planners and CPA’s might tell you that there is a cost associated with this plan but you are not hearing the whole story.
For example lets look at two different people. Each person is a simple W2 wage earner. They each have $40,000 in savings and they are both going to buy a $200,000 house. We have Jim Pilgrim as example number 1. Jim believes in a more traditional way of paying off his mortgage. Jim wants to pay his home off as quick as possible and even send in extra money each month to pay off on principle above his set mortgage payment amount. He was likely told by mom, dad, grandad, and grandma to pay off your mortgage quickly.
In example 2 we have Susan Smith who believes in a money creation strategy of carrying a bigger and longer term home mortgage that is an interest only loan.
Jim takes on a 15 year mortgage at 6.38% APR while Susan goes with a 30 year interest-only loan at 7.42% APR. Note: The home mortgage interest rate has been artificially inflated to factor in the PMI which is the Private Mortgage Insurance.
Jim put down a big $40,000 down payment which is a 20% down payment and has zero dollars left to invest. His monthly mortgage payment is $1,383 and 57% of that is tax deductible the first year. His average monthly net after-tax cost is $1,227 because the deductions he takes on his taxes because of home mortgage interest reduces that mortgage amount when you look at the discount he gets on his taxes.
Jim also pays an additional $100 on top of his mortgage each month to pay off the mortgage a little sooner.
Now looking at Example 2 we see that Susan is going with a 30 year interest-only mortgage loan at 7.42% APR. She puts down a $10,000 tiny down payment which is only 5% of the mortgage. She keeps $30,000 in a side investment fund rather than pay a large deposit like Jim.
Susan’s monthly mortgage payment is $1175 and is 100% tax deductible the first 15 years. When calculating the money she saves from tax deductions she has a monthly net after-tax cost of $799 for her home mortgage.
Susan repositions $100 monthly to a side investment account plus $428 into this investment fund she is saving from the lower mortgage payment. She has her money put into a tax favored account earning 8% interest.
Now CPA’s might be hyperventilating at this point as they see that Susan is paying on an interest only home loan as they will say that she will never pay off that mortgage. If you look at her monthly net after tax cost she is only paying $799 for her mortgage compared to Jim who is paying $1,383 a month on his.
If you are self-employed you can actually reduce your quarterly tax payments to the government instead of waiting for the refund from the government at the end of the year. This means you don’t have to pay the full $1175 monthly mortgage payment because even though you are paying this you are reducing your quarterly tax payments to bring your cost to $799 a month.
Why give uncle Sam an interest free loan?
Now looking at the interest rates you see that Jim is paying a lower interest rate but it is costing him more than the higher interest rate Susan is paying on.
Now after seeing these two examples which person do you think made the right decision?
After 5 years what are the results.
- Jim gets $14,216 in tax savings
- Jim has $0 in his bank savings and investment accounts.
- Susan has received $22,557 in tax savings
- Susan has $83,513 that she has saved in a side investment fund.
Now what if both Jim and Susan lose their jobs or interruption in income?
- Jim has no savings to get him through income disruptions or loss of job
- Jim cannot get a loan because he has no job and home equity no longer helps to get a loan in this economy.
- Jim must now sell his home because he cannot make his mortgage payments.
- Jim likely will need to sell his Tyler home quickly for cheap and pay realtor commissions of 6% – 7%.
- Susan has $83,513 to keep her going because she lost her job.
- Susan doesn’t need to take out a loan.
- Susan can continue to make her mortgage payments no problem.
- Susan is not in panic mode because she has tons of cash.
Income results after 15 years with the Jim and Susan Examples
- Jim has gotten $25,080 in tax savings
- Jim has $30,421 in investments and savings. (From paying in $100 on mortgage each payment this is what he saved)
- Jim owns his home with no money owe the bank.
- Susan has $67,670 in tax savings.
- Susan has $282,019 in savings gained in the side investment fund.
- Susan has enough money to pay off mortgage and still have $92,019 sitting on the side.
Jim and Susan financial situation after 30 years
- Jim has $25,080 in tax savings
- Jim has $613,858 in investments and saving accounts.
- Jim owns his home with no money left to pay the bank.
- Susan has $107,826 in tax savings
- Susan has $1,115,425 in investments and saving accounts.
- Susan never plans to pay her mortgage off as she is happy with the liquidity, security, tax savings, and investment returns more than home ownership.
When real estate values go back up rather than letting that equity just sit ideally by you can use it to your advantage. You take that money and invest it when real estate values are up.
If there is any point to be made with all of this it is that you should separate your equity from the brick and mortar. When your equity goes up in your home you can do nothing with that money if it is tied up in the home. By separating that money from your home and investing it you are making the smarter investment decision with your money.
Step 5
Financial Independence. Houses are designed to house families not store cash. Investments are designed to store cash.
- You want to get to a point where you are not trading hours worked for dollars.
- Making enough money from the income your assets generate to have the lifestyle you desire.
Commit to conserve and not spend your equity from now on and forever! HAVE A CASH BUDGET ONLY! (Not literally but just that you do not spend more than you have)
In Summary
1. Have an emergency fund.
2. Become debt free
3. Liquidity (1 years salary)
4. Pay off Home (Paid off on balance sheet).
5. Financial Independence (No longer working hours to get dollars) Maintaining the lifestyle you want to live from the income your assets give you.
We recommend speaking to a Tyler TX financial advisor to see if this type of plan is right for you: Achieve Financial, Feliciano Financial Group