Equity Strategy

 

 

Equity Strategy

 

The good ole’ days when steady pay raises made expensive debt look cheap aren’t coming back any time soon. Those in science, medicine, and technology may be the exception, doing better than ordinary people doing ordinary jobs. But, ordinary people doing ordinary jobs are the backbone of the country.

In the Old Normal, the overall strategy was to lock in the price and let a rising tide help people grow into the payments. It was okay to pay compound interest expense in order to buy time. This was the “debt strategy.”

There’s no time to waste in the New Normal, however. That’s why Millennials need to reverse direction: Instead of paying compound interest, they need to earn compound income. In other words, they need to get the time-value of money on their side. Getting on the right side of money is the “equity strategy,” in a nutshell.

The difference in financial security between the debt and equity strategies is astonishing. The former hopes to make payments seem cheaper and appreciation make up for all the interest expense. The equity strategy aims to build real saving and investment accounts and earn compound income. The former might look good on paper but the equity strategy produces a real nest egg, hard-dollars.

This is how Millennials can create a safety-net in the New Normal.

 

Illusions
The facts are clear. Even so, people act according to their beliefs, more than facts. In this instance, they believe they have little choice but to chase the lowest interest rate and smallest monthly payment. Both are illusions, however. They imply low cost but actually result in the exact opposite.

Smallest monthly payment puts the time-value of money to work against them. Instead of earning compound income, they must pay compound interest. The smaller the payment, the longer it must go on. The more spent on monthly payments the less time and money for saving and investment accounts. Time flies, before you realize it, your career is used up.

Low interest rates also fool people. They’re not what they seem, it’s not pennies on the dollar. It only represents the annual cost keep the debt afloat, not the total cost to repay principal. A cheap 5% mortgage, for example, could cost about $10 of interest for every $1 of principal during the first five years of a 30-year mortgage, which is a true cost of 1,000% (10 to 1). It’s virtually impossible to pay 1,000 percent in cash and come out ahead, especially when economic prospects are so dismal.

All of this explains why Depression Generation reduced monthly payments, cut down on credit, paid off debts, minimized interest expense, saved money and paid cash. Until recently, that was deemed old-fashioned. Turns out they were quite sophisticated – they stopped the time-value of money from working against them.

 

Buying Back Time and Money
It’s completely understandable why people feel they have little choice but to pursue the lowest interest rate and smallest monthly payment. Given the pressure on their monthly budget it may be the only way to buy anything new. Good news is people may start with the time-value of money against them but they don’t have to live with it. They can undo most of it by simply giving back the money as soon as circumstances improve.

Sooner the better. Accelerating repayment of $1 in principal against the aforementioned mortgage eliminates $10 of interest, a return on investment of 1,000%, risk free. Furthermore, the sooner you give back the money the more time you recapture. More time for saving and investment accounts means a bigger nest egg. A win-win!

 

Safety Net 
The equity strategy is not a formula, per se. It’s a shift in the trajectory of personal finances over the long term. It’s a move away from keeping the largest amount of debt afloat by virtue of finessing the monthly payments, and toward building real equity and a cash nest egg, i.e. a solid safety-net.

The size of this safety-net will vary from person to person. The basic template is five-times their annual income when taking out the mortgage. This can be accomplished by devoting one-third of career, or 15 years, to saving and investment accounts. Provided that deposits are 25 percent of income, which is typically the same as the mortgage payment. Hence, why the Nest Egg Strategy calls for liberating 15 years of mortgage payments.

For some, the mortgage payment is less than 25 percent however because their income has grown while the payment has not. They can simply adjust the formula and increase their deposits to 25 percent of income, irrespective of the mortgage payment.

For many, the mortgage payment was more than 25 percent when they started out. Subsequent pay raises brought it back down to 25 percent, so the ratios of the Nest Egg Strategy are back in balance.

Others may want to supercharge their nest egg by letting compound earnings work for 20 years, for instance. Pay off the mortgage by age 50 but don’t start withdrawals until age 70. This way, they can withdraw more every month or stretch it out for 25 years, until age 95 for example.

Tinkering with the ratios keep the time-value of money on their side and produces the safety-net that Millennials need to enjoy comfortable and secure retirement.

 

A Last Word
Many would like to believe the good ole’ days will be back, if they bide their time. That’s what “everyone” is saying, even their parents and grandparents. The facts say otherwise, but Human Nature is to take a chance.

People tend to gamble when they wish things were otherwise, even taking a chance on losing it all. Which is why Las Vegas is so successful. It’s a “gamble” because they don’t know all the factors, nor have control over them. Odds of winning aren’t on their side.

In contrast, it’s a calculated “risk” if one knows all the factors and has reason to believe he or she can influence them in their favor. The result might not be their fondest wish but it’ll reflect reality. Better a known outcome than the uncertainty of an unknown factor turning against them at the last moment.

In this instance, it’s a calculated risk that liberating 15 years of former mortgage payments for saving and investment accounts will produce a cash nest egg big enough to pay half of living expenses in retirement. It’s not a gamble. Arithmetic will produce the same answer every time. This is why it’s a safety-net that Millennials can count on.

Anything else is a crap shoot, and Millennials don’t have time to come up “snake eyes.”