Are you becoming Financial Ninjas like the Smiths are? I hope so. In my last blog, I outlined the process the Smith family used to retire their $300,000 mortgage in about eleven years. That was after they paid off a $12,000 credit card balance in about six months. All this was with the money they were already making and without changing their lifestyle. Today the Smiths are going to continue their journey to the wealth that the Financial Ninja enjoys by starting to acquire real, appreciating assets using the leverage that Velocity Banking has allowed them to create in their lives.
Home Equity Line of Credit, the HELOC, is a powerful tool in the hands of a Financial Ninja. With a credit card, the Financial Ninja can do amazing things to affect their financial position, with a large HELOC, the possibilities for increasing their wealth are nearly endless. Although there are many lines of credit available, for the average homeowner the HELOC is the most common and usually easiest to get. On a homeowner’s primary residence, most banks will extend a HELOC of up to 80% of the equity in a person’s home. The interest rates can vary but 1-2% above the prime rate is common. HELOCs generally have a variable interest rate and can fluctuate regularly. However, they often have a ceiling and a floor which means that they will never go above or below a certain rate no matter what happens to the overall rates. But as Financial Ninjas we know that for Velocity Banking the interest rate isn’t the most important thing to consider. HELOCs can also have a time limit, often ten years, at which time the bank can call them due. Although, this is something to keep in mind, a Financial Ninja will be proactive about their HELOCs, if they see that their HELOC may be coming to an end, they will be actively seeking the next solution. If you are actively leveraging the Velocity Banking strategy and using your HELOC every month there is a good chance that the bank will extend you if your HELOC is ready to come due. If not, you will need to go find a different HELOC or some other line of credit to replace it when the time comes. If you have become a Financial Ninja, this will not be a problem for you.
Remember, the power of a line of credit is found in fact that it is simple interest (based on an APR), it is liquid (money can flow in and out), and the payments are, usually, interest only (credit cards require a monthly principal pay-down, most other lines of credit do not).
The Smiths are ready to turbo charge their wealth creation. They have been using their credit card as their Velocity Banking tool and it has been working really well for them. Now they are ready to graduate to something more powerful. It’s time to really put Velocity Banking to work, time for a trip to the bank.
The New Assumptions
The Smiths have been working very hard to pay off their debts and they have made impressive progress. They currently have no credit card debt and their mortgage is paid off. They are now proficient with Velocity Banking so major purchases don’t cause any stress for the Smiths anymore. Using Velocity Banking they can buy a car and pay it off in a year or two, appliances and home repairs just get lumped into the Velocity Banking process and get accelerated and paid off. Now that they have retired their mortgage, they have added another $1800 to their cash flow, which brings the total to $3200 a month, and that’s assuming they still have a car payment, which I highly doubt. Overall, financial life has become very comfortable for the Smiths, becoming Financial Ninjas has reduced their stress immensely and has helped them create a peace in their lives they never thought possible. It is a great feeling.
All of these assumptions are leaving out some very important possibilities. We are assuming the Smiths have not increased their income, which I doubt would be the case. The financial journey of becoming a Financial Ninja has a tendency produce financial opportunities that snowball. Very few people who take this journey stay the same, most use the momentum they have created to improve all the aspects of their lives. It is very likely that the Smiths have found new, creative ways to retain more of their income and to create additional income. This is the way of the Financial Ninja, retain as much of the money you make as you can and then find ways to make more income. These two areas of your finances can create a compounding effect on your overall financial picture. The affects are amazing. More on that later.
For the sake of consistency, we are going to leave our assumptions alone for now. The Smiths bring home $5000 a month, they have $1800 in expenses a month (car payment of $600.00 and additional expenses of $1,200.00). They now own their house out-right now and it is worth $300,000. They meet with their banker and she approves them for a HELOC for 80% of the equity in their house, which in this case is $240,000. There is a variable interest rate which is a couple points above prime. For the sake of conservative calculations, we are going to assume that the HELOC has a fixed rate of 10%, this will take into account any possible fluctuations in the rate over time. This is high but remember the point here is to understand the concept, not the minutia, I’d much rather calculate high and be pleasantly surprised than the other way around, besides 10% is an easy figure to work with.
Let’s Buy Some Properties
I love real estate investing, it’s my passion. Real estate is by no means the only way the Smiths could be investing their money, but I believe it is the best way to go (my opinion). So, the Smiths are going to build their wealth using real estate, at least for now. There are many places to educate yourself on the process of properly purchasing rental real estate, there will be a lot of discussion on this topic in future blogs. For now, let’s just assume the Smiths have been properly educated and have a good community of investors and mentors guiding them through the process of building a rental real estate portfolio. Armed with their newly acquired real estate knowledge and the HELOC from the bank, the Smiths are ready to dive in head first.
The plan is to purchase seven rental properties. In the area they live, the Smiths can purchase nice rental properties for about $100,000 each that will bring in about $1200 a month in rent. Each property will cash flow $400 per month. These properties are in decent condition and can be purchased for about 10% down or $10,000, they each need about $10,000 in repairs to make them rent-ready. So, each of the seven properties will cost the Smiths approximately $20,000 out of pocket. They will get a conventional mortgage for the balance of the purchase price of the properties which will be about $560,000. The total debt will be $700,000. Of course, I am grossly over simplifying this example, let’s call it Ninja Math. The Smiths will use $140,000 of their HELOC to acquire and tenant these seven properties, leaving $100,000 in reserves.
The gross rent for the seven properties each month will be $8400 with a PITI (principal, interest, taxes, and insurance) of $5600 per month. This leaves the Smiths a cash flow of $2800 per month to attack the principal of the HELOC. They are going to use the same process they used to pay off the credit card balance, just with bigger numbers.
At $1200 a month in gross rent from each property, $400 a month in cash flow sounds pretty high, even for a Financial Ninja. Anyone who is familiar with real estate investing will know right away that I am skipping over some really important details. I’m not factoring in things like vacancy rate, capital expenditures, and management. It is not impossible to find rental properties that rent for $1200 and have $400 in cash flow even with these costs factored in, however they can be rare. But we are Financial Ninjas using Velocity Banking, we have a plan, I will explain.
The Smiths are using the HELOC as their operating account for these properties meaning that all the money collected from the properties is funneled into the HELOC every month. All the expenses including the mortgage payment, taxes, insurance, repairs, management, tenant screening, capital expenses, etc., are paid out of the HELOC. Any money left over each month is paying down the principal, just like the credit card example that started this whole process. So, in this case we can lump all the other expense into this process. The speed in which the Smiths pay off their HELOC is depend on the expenses, more on that in a minute.
Let’s look at the numbers so far:
- HELOC – $240,000
- Starting balance in HELOC – $140,000
- Down payment/repairs for 7 properties
- Reserves in HELOC – $100,000
- Total rental real estate owned – $700,000
- Mortgages on rental properties – $560,000
- Gross monthly rental income – $ 8,400
- PITI for seven properties $ 5,600
- Cash Flow $ 2,800
Does this make sense so far? The Smith’s first goal is to pay down the HELOC. Let’s look at the math assuming no major issues or setbacks in the repayment of the HELOC.
|Month||Beginning Balance||Gross Rent||PITI||Ending balance||Average Interest per month|
Using the Velocity Banking system to pay down the HELOC brings the balance down to zero in about sixty-four months, that’s pretty darn good. This does not factor in any major expenses which will slow this process down a bit, but that’s ok isn’t it? It also doesn’t factor in any rent increases which will speed up this process. The Smiths always have a considerable reserve in the HELOC to cover anything that might come up. And all this is happening completely separately from their personal finances, they have not put one penny of their income or savings into this investment, they only used the leverage they created by becoming Financial Ninjas.
This process will cost the Smiths about $38,570 in interest which is a significant amount, let’s see what it would have cost them to go the traditional route. Let’s assume the Smiths purchased these properties using traditional mortgages. Let’s say they financed the entire $700,000 with a 6% fixed rate mortgage for thirty years, which includes the down payments and the repairs. This would be a very unlikely situation, banks will not usually take that much risk, the real estate investor would need to have some skin in the game, but let’s look at the example hypnotically.
The first big problem is there is no reserves, when problems arise the Smiths will have to come out of pocket. Notice I said “when problems arise”, not “if problems arise”, I said this because the only thing certain in real estate investing is that there will be problems. Don’t let this scare you away, all problems have solutions. Not having reserves dramatically reduces the Smith’s leverage position and could very quickly hurt their personal cash flow. I strongly recommend that anyone entering the rental real estate investing game have substantial reserves available to them.
The second problem would be a major change in the cash flow of the investment. The PITI would go from $5600 a month to $6440 per month because of the additional balance of the loan, but the gross rental income would not change. This would mean that instead of $2800 in cash flow per month, the Smiths would be down to $1960 per month. That $840 a month equates to over $10,000 a year in lost cash flow. With no reserves that lower cash flow is going to get eaten up by the other expenses like vacancy, capital expenditures, and management.
Here is the kicker, the amount of money the Smiths would pay in interest going the traditional route is enormous compared to using the Velocity Banking strategy. The principal and interest payments on the $700,000 loan would be $4197 per month (not including the taxes and insurance). Over the first sixty-four months of the mortgage, the Smiths would pay $268,608 in total payments but that would only reduce their principal by $52,408. $216,200 of those payments would go directly to interest. On the other hand, the principal and interest payments to the $560,000 mortgage would be $3357 per month, in sixty-four months the Smiths would have paid $214,912 in total payments reducing their principal by $41,926. If we add the total mortgage interest of $172,986 to the interest on the HELOC of $38,571 the Smiths will end up paying a total of $211,557 in interest going the Velocity Banking route. That doesn’t sound like a very big difference, but it is.
At the end of sixty-four months using the traditional method the Smiths have a principal balance on their properties of $647,592. Using the Velocity Banking strategy, at the end of sixty-four months the Smiths have a principal balance of $518,073 and they have $240,000 again available in the HELOC. That is almost a $130,000 difference in the amount of principal that got paid down in the first five years or so of the investment. Not to mention the peace of mind of always having money in reserves. And the Smiths still pay over $3,000 less in interest using Velocity Banking. Financial Ninjas indeed!
The Fun Is Just Beginning
The Smiths have some major decisions to make at this point. They have put themselves in a very enviable position financially. Next time we are going to take a deep look at several of the many choices the Smiths now face, the great thing is that they are all amazing options. The Smiths have drastically changed the course of their financial lives for the better. The have truly become Financial Ninjas and they’ll never go back to the traditional ways. In addition, they have created a solid retirement plan that is not dependent on what the stock market does. They have created a legacy for their children and possibly their children’s children. This is the true goal of the Financial Ninja, empowering people to take control of their financial lives for themselves, their retirement, and future generations.