So what’s the greatest invention in human history…
The internal combustion engine?
All those are pretty darn good. But one of the smartest guys ever called this invention the “8th Wonder of the World” and “The Greatest Invention in Human History.”
The guy? Albert Einstein.
The Greatest Invention: Compound Interest.
And when you use this ‘Greatest Invention in Human History’ the right way in your real estate deals? Well, historic things happen to your wealth.
The E=MC2 of real estate
E = MC squared may have bored the socks off you in H.S. But as a private lender, you can’t afford to fall asleep on how this powerful formula applies to finance. Especially when it comes to compounding.
In physics, energy equals mass times the speed of light squared. In finance, interest is calculated on the initial principal, and also on the accrued interest of previous periods of a deposit or loan.
Simply put: This compounding principle lets a deposit of $1,000 when you’re 18 send you on a luxury cruise around the world when you’re 50.
It’s no different for real estate.
Property values appreciate over time in a compounding fashion when combined with the right kind of leverage.
In general, a wise property purchase in the right market will appreciate in value over time. Real estate prices in hot neighborhoods go up, improvements to the property add exponentially to its value, etc. This is especially so for single family homes. In California, for example, the property appreciation rate over the past year has been over 12%.
Now if you use leverage to buy this property, you’ll see the 8th wonder of the world in action. The leverage has fixed payments. But the equity in the asset grows at a compounding rate. And it keeps on compounding. Wonderful!
How can you harness this explosive power in real estate?
The trick to maximizing the explosive power of compounding rests in getting the right leverage interest rate. To do that you need to get an interest rate that is equal to or less than the projected appreciation rate of the property.
When you use a Simple Loan Leverage Calculator [available here], you can assess the rate at which net worth grows. When the interest rate is greater than the appreciation rate, it takes years and years before the leverage becomes positive. It will happen, but after a loooong amount of time. Albert would probably stick his tongue out at that.
So did Johnny Carson. Back in 1980, when everybody was talking about the neutron bomb and the ridiculously high interest rates, Johnny came up with a great line: “Scientists have developed a powerful new weapon that destroys people but leaves buildings standing — it’s called the 17% interest rate.”
But when the interest rate is equal to or less than the appreciation rate, the leverage becomes positive pretty much right from the start. Now we’re talking quantum power. Just look at Albert smile!
OK, Einstein, give me an example
Somewhere in Princeton, chalk in hand, Albert would point you to the following.
Let’s say you have a property valued at $100,000. Its appreciation rate is 5%. Because the mortgage broker is a friend, he lets you take out a mortgage for the full 100K value, for 30 years at a 7% interest rate.
While he can do it in his head, Einstein lets you take out your calculators.
After one year there is an appreciation of $5000, But the mortgage payment (principal and interest) comes to $6347.46. Negative leverage. And a loss of almost $3K in equity. It takes 11 years before leverage is positive and you see a profit.
Compare that with the same loan at a 5% interest rate (same as the 5% appreciation rate).
During the first year you pay $4530 in interest but already earn $5000 in equity. In the end you pay $92,000 in interest for an increase of $332,000; a gain of more than $239K!
If the interest rate is 5% and the appreciation rate is 8% – that same $92K will generate $900K in equity.
Pretty brilliant! (“Thank you,” says Einstein humbly).
But wait… don’t I want to just end my mortgage as fast as possible?
Now hold on a second, Al. Isn’t the conventional wisdom that it makes sense to not hold on to debt… that we should be paying off our loans as fast as we can?
Well, Einstein was anything but conventional.
And he would probably point you to a wiser use of your money.
Rather than spend it all paying off one mortgage, if you use those funds to get leverage for multiple properties (at the right interest rate and right appreciation rate), well, the compounding makes those gains exponentially greater.
Compound your way to historic profits
Did Einstein really say that about compounding interest? That it’s “The Greatest Invention in Human History”? That’s the subject of debate. But the value of compounding in real estate is not.
Property values appreciate over time in a compounding fashion when combined with the right kind of leverage. This makes your profits compound and keep on compounding.
The right kind of leverage? If your interest rate is higher than the property appreciation rate, your leverage will be negative for a loooong while. Time will drag on for years until you see profit. But if your interest rate is equal to or lower than the property appreciation rate? Your profits will grow at the speed of light!
You don’t have to be an Einstein to harness this great invention. If you want your profits to grow exponentially, harness the quantum power of compounding. How? Make sure that the interest rate is equal to or lower than the property appreciation rate. Then you too will see your profits reach truly historic levels.