In our last encounter, I introduced the idea of becoming a Financial Ninja to the world. I’m glad you decided to join me as I dig deeper into the techniques the Financial Ninja uses to shift the balance of financial power in their favor. In the coming weeks, I will be going into little known strategies that can make huge differences in your financial wellbeing. We will be discussing what I like to call the “Five Points of the Star”; banking, credit, taxes, business ownership, and investing. These Five Points can drastically change the course of your financial lives. I want to start with banking and a strategy that is my favorite and one of the most powerful strategies in the Financial Ninja’s arsenal, Velocity Banking.
Welcome back to the Financial Ninja. Today I want to talk about the 800 pound elephant in the room and when it comes to money: the banks and banking. In today’s world, it is almost impossible to function without banks and banking. Without banks there would be no mortgages, no debit cards, no credit cards, no car loans, savings accounts, checking accounts, and the list goes on and on. It is really easy to villainize banks, banks decline loans, foreclose on homes, and charge exorbitant interest rates. If you watch the news, banks are often portrayed as evil, uncaring, and often times ruthless. Although there have been some instances where all of these things were true overall banks play an indispensable roll in our personal and business financial lives. Let’s face it, who could save up $30,000 to buy a car in cash or $300,000 to buy a house. Most people don’t even carry cash today, if it weren’t for credit or debit cards no one would buy anything anymore. We have grown so accustom to the services that banks provide most of us would be lost without them. The truth is that banks are not inherently bad, one could argue that they charge too much and take advantage of their customers with their fees, terms, and conditions, but banks are businesses and their goal is to make money for their shareholders and board of directors. While they are generally holding all the cards and can weigh most transactions in their favor we need them and I don’t see them disappearing anytime soon. That doesn’t mean we have to rollover and surrender ourselves to their mighty power, we are Financial Ninjas, we don’t surrender to anyone without a fight.
The best way to win the game is to know ALL the rules
Have you ever played chess? I love chess. I was in the chess club in grade school and my friend Brian and I used to play all the time when we were young. I was pretty good at chess, far from an expert but I could generally hold my own. I once beat a ranked chess player name Terence. It was a very proud moment for me. I stress the word “once” in that sentence because he beat me hundreds of times and I only eked out a victory that one time. The point of this story is to demonstrate that how well you play a game is usually based on how well you know the rules and strategies of that game. Brian and I were pretty well matched because we knew the game about as well as each other at the time. We both knew how all the pieces moved, we knew some simple strategies, and we played enough to basically know how each other thought. Terence used to kick my butt on a regular basis because although we both knew how all the pieces moved he studied complex strategies, he knew different openings and could think several moves ahead. I’m not sure how I beat him that one time, I guess even a blind squirrel finds a nut…. Imagine what it would be like for a guy like Terence to play a total beginner, someone who doesn’t even know how the pieces move. That is what is like when most people deal with the bank, like a newbie playing Terence, but for large sums of money!
It doesn’t need to be like this, the bank isn’t hiding the rules from us, however they aren’t actively explaining them to us either. The information is out there you just might need to dig a little to find it. Once you do figure out the rules and strategies to the game, the game changes dramatically. All of a sudden, the playing field levels. Instead feeling like you are playing Terence you feel like you are playing Brian. Eventually it feels like you become the expert and the bank becomes the average player in the game, that’s when things really start to get fun. You’ll know this change is taking place when the associate you are working with at the bank gets stumped and has to get help from the manager because you are talking over their head. When this happens, you will feel the balance of power start to shift and that feeling is amazing. All of a sudden opportunities become available to you that you never knew about before and you can start to positively affect your finances in a big way. Plus, once you start speaking the same language as your banker they know they have to up their game because you are now a force to be reckoned with, and that is very good for you and your financial future.
One of the most powerful tools in the Financial Ninja’s arsenal is Velocity Banking. Velocity Banking is my favorite banking strategy and once you wrap your brains around it, I’m guessing it will be your favorite as well. Velocity Banking was introduced to me a couple years ago and it blew my mind, now I try to explain it to as many people as physically possible. Velocity Banking is a strategy that improves your cash flow position, increases your leverage, and puts your money to work 24/7. Most importantly it can allow you to pay down huge debts faster than you ever thought possible. I will spell out a couple examples such as paying off a $12,000 credit card balance in six months or paying off a $300,000 mortgage in less than ten years all without making any extra payments or having to make more money than you already are. But first we need to define a couple things.
Line of credit vs. a loan
We all know what loans are and we almost all have a line of credit whether we know it or not, but we don’t always know the difference between the two. A loan is like your mortgage, car loan, or student loan. It is a sum of money you borrowed to purchase something that you are paying back in equal payments over a set amount of time. The payments are equal (except maybe for the last one), there is generally a set interest rate that is amortized over the life of the loan, there is a set amount of payments (there are ways of reducing or expanding the number of payments but generally there is a set payment schedule). We are all familiar with this type of financial vehicle and it allows us to purchase things we probably couldn’t buy any other way; a loan isn’t good or bad it is just a tool we use. A line of credit is a little different and has some extremely valuable differences if you understand how to use them. When I say we almost all have a line of credit I’m referring to our credit cards. Our credit cards are a line of credit. A line of credit differs from a loan in several important ways. First, most lines of credit are simple interest instead of amortized interest, which means the interest is calculated based on the average daily balance. The interest rate is divided by the number of days in the year and is applied to the balance of the loan on a daily basis. Of course, it wouldn’t make sense to pay your bill everyday so the credit card companies bill you every month. I’m going to show you why this difference in the way the interest is calculated is so significant in a little bit, but for now it is just important you understand that there is a difference. A line of credit doesn’t have a set payment or duration of payments like a loan does, meaning your amount due could be different each month and the payments could last as many months as it takes to pay it off. The other big difference is that lines of credit are “liquid” meaning once you make a payment towards the principal of the line of credit that principal is available for use again. For example, if you make a $1000.00 payment to your credit card today, by tomorrow you will have $1000.00 of available credit on that card to use toward something else. This is not an option on a loan. Imagine if you overpaid your mortgage by $1000.00 and your refrigerator breaks the next day, so you get on the phone to Chase and ask “Hi Chase, remember that extra $1000.00 I sent you last week, well I could really use that back, I have other expenses that I need to apply that money to….” I can assure you this conversation will not go in your favor.
Which is hotter?
If I asked which was a higher temperature 1 degree or 32 degrees, what would your answer be? Most people would immediately say 32 degrees and they would be correct. However, if I change the question a little and ask, which is warmer: 1 degree Celsius or 32 degrees Fahrenheit, now what would your answer be? After a quick trip to Google you would find that 1 degree Celsius is warmer than 32 degrees Fahrenheit. Of course, this is a bit of a trick question but it is meant to prove a point, we make a lot of assumptions without all the facts because we think we know the answers. Here is another one, at which interest rate will you pay more in interest, 6% or 21%? All other things being equal you would pay much more interest at 21% interest, but all things are not always equal. A mortgage calculated with amortized interest at 6% is going to cost you astronomically more in interest than a credit card at 21% interest. I can and will prove it. Hang in there, I’m going to turn what you know about interest on its head.
Amortized = Evil (at least when you are paying it)
Investopedia.com defines amortized interest as: “An amortized loan is a loan with scheduled periodic payments that consist of both principal and interest. An amortized loan payment pays the relevant interest expense for the period before any principal is paid and reduced.” The key to notice in the definition is that the “relevant interest expense” is paid before the principal is reduced, meaning the banks get paid first. Now there is nothing inherently wrong with the bank getting paid first they are in the business of making money after all, however when you see how much they get paid first you may no longer agree that there isn’t something wrong with the system. Below is an amortization table for a $300,000 loan with a fixed interest rate of 6% fixed for 30 years. I want you to notice the first three payments, specifically the amount paid to interest versus the amount paid to principal. Also notice the amount that principal increases and the amount the interest decreases each month.
As you can see of the $1800 payment, $1500 of that goes toward interest and less than $300 goes toward principal in month one. In month two you pay a whopping $1.49 more toward principal and $1.49 less toward interest, this continues at this rate throughout the life of the loan. The result, if you make all 360 payments on time you will pay $647,515 for your $300,000 house because of amortized interest. Does that feel like a 6% interest loan to anyone? I didn’t think so, it is more like 120%.
Calculating amortized interest is pretty complex but there are tons of calculators online that allow you to plug in your numbers to get an amortization schedule so you can see for yourself just how much you are paying in interest on your loans. In Excel, you can search templates for “amortization” and you will find several pre-made spread sheets that you can download for free and start using right away. The kicker is that in amortized loans the interest is “front loaded” so the bank gets their money first. If you look back at our amortization table above you see that out of the first three payments equaling $5,400.00 (rounded), $4495.52 goes directly toward interest. As a matter of fact, in this situation the borrower will not start making larger contributions to principal until after payment 223, eighteen and half years into the loan. As you continue down the table you will quickly realize that you are barely making a dent in your principal for many, many years. But once you’ve reached the twenty-year mark you start making real progress in paying down your principal, but how many people actually get that far?
The “refi” dilemma
We have all seen or hear the advertisements, “refi now, the rates are the lowest they’ve ever been, roll your high interest credit card debt into our low interest mortgage rates”. Sounds great, right? Taking your high interest credit card debts and rolling them into a low interest mortgage, but is it really lower interest? Well, yes and no. The rate is definitely lower but is the amount you are going to pay overtime less? Probably not. Let me ask you this, do you want to pay for your $5000 in credit card debt for 30 or 40 years? I didn’t think so. I can hear heads exploding all over the place from that last statement, “I would never have a 40-year mortgage, that’s crazy!”. I agree it’s crazy but people do it all the time whether they know it or not. Statics show that Americans refinance their mortgage about every five to seven years. There are a lot of reasons where refinancing makes perfect sense, rates drop, you have an adjustable mortgage or an ARM that is going to expire, etc. However, now that we know that your interest is so dramatically front loaded, maybe we should dive a little deeper in the consequences of refinancing which unfortunately requires math.
So, let’s say you have a $300,000 mortgage at 6% fixed and you are ten years into paying it off. Your mortgage broker calls to tell you that he can get you a 4% interest rate for the remaining balance of your mortgage. Is this a good deal, on the surface it sure sounds like it and in some ways it is, but maybe not as good of a deal as you might think. Let’s do some math:
Current situation: Your mortgage balance is $251, 057 after your 120th payment which means you’ve paid only $48,943 in principal over the last ten years and you’ve paid $166,895 in interest, let that sink in a minute. Your current principal and interest payments are about $1800 per month. If you refinance to the 4% fixed interest mortgage for 30 years your payments will drop to about $1200 a month, which is great. Here is where things get complicated, if you carry this new, 4% mortgage to its 30-year term you will end up paying another $180,433 in interest, if you add the new interest to the interest you’ve already paid you will end up with a grand total of $347,328.79 over the 40 years you will now have had your mortgage. If you had carried the original mortgage to term you would have paid $347,514.57 in interest. Refinancing in this example saved you a whopping $185.78, a fraction of the money it will cost you to do the refi in fees and time. Bottom line for this example, does it make sense to lower your payment each month? Oh, and look, you now have a 40-year mortgage. Now imagine you were talked into rolling your car, credit cards, and student loans into that mortgage and paying for them for 30 years.
Of course, there are other scenarios we could discuss. If you refinanced into a 20-year mortgage you would save significant money. Your payments would only go down to about $1520 a month but you would save about $66,500 in interest over the life of the loan. But in our world of “how much are the payments” instead of “how much does it cost” how many people actually make that choice. And what about the credit cards? If you were to roll your $10,000 credit card into that mortgage at 4% you would end up paying about $4544 in interest on that balance which doesn’t seem horrible until you realize that you just paid over 45% interest on that debt. Seems kind of crazy when you look at it like that, doesn’t it?
Building a base for Velocity Banking
Wow, that was a lot of boring facts and figures, but you still don’t know how Velocity Banking works or why it is soon to be your favorite Financial Ninja strategy. Never fear, I am going to spell out Velocity Banking over my next few blog posts. It’s a big topic but don’t worry I’m going to make it so simple to understand and implement. My next blog will demonstrate how to pay off a $12,000 credit card balance in about six months with the money you are already making and without changing your lifestyle. All it takes is small shift in your mindset and you can be on your way to the financial freedom that Financial Ninja’s enjoy. So, see all you Financial Ninjas really soon!