How Real Estate Fortunes Are Made

Your ability to earn an income is a valuable asset. And it has a value. When you apply for credit, the prospective creditor will decide whether or not to extend you credit based on a couple of factors. One is your credit history and the other is your income.

Credit history is easily determined by simply referring to any of the major credit history reporting agencies. Income history is not as readily determined.

One aspect of income history can be established using proof of present income such as paycheck stubs or bank deposit records. Income tax records can also be used to establish income history.

The third aspect of the equation is debt to income ratio, which is a measure of solvency and discretionary income. Discretionary income is that amount of monthly income that is in excess of the total of your monthly expenses and debt payments.

For example, if you take home $2,000 a month and your monthly expenses and debt payments total $1,800, you have $200 of discretionary income. Discretionary income represents a measure of buying power and your buying power will weigh heavily in the company’s decision as to whether or not to extend you the amount of credit you have requested.

One final consideration taken into account will be your cash assets such as money in savings or other cash equivalent accounts such as Money Market accounts and certificates of deposit.

Now, this last aspect of determining credit worthiness is not much of a factor until it exceeds a certain amount of money. Even if you are unemployed, you are almost certain to obtain credit if you are in the position to provide cash or a cash equivalent as collateral. Certain other assets can be used to collateralize loans, as well.

Mortgages and home equity line-of-credit are two common examples of an asset used to secure credit in the consumer credit market. Automobile loans are usually secured by the asset underlying the loan, the vehicle, itself, and are another example of how the extension of credit can be wholly or partially based on collateral.

It has been said that if you can’t afford to pay cash for a purchase, you can’t afford it. I will make the case that, in fact, spending large amounts of cash for consumer items is the wrong financial move in most cases for most consumers.

Instead, I recommend that you leverage your income to increase your standard of living.

Let’s take a common purchase, as an example. Let’s say you want to acquire an automobile and that the total cost will be $20,000. Let’s also assume that you have $20,000 available as savings to make the purchase with cash.

Should you? The only aspect of this transaction that would favor doing so would seem to be the interest charges you would avoid by paying cash. But, in fact, that is not as important a consideration as is commonly believed.

If we assume an interest rate on the loan of 8% and a term of five years, the total interest over the life of the loan would be $4,331.80. Meanwhile, assuming an after-tax return of 5% on that $20,000 over that same length of time, five years, you will have earned $5,680.06.

Now, at the time you are reading this, a 5% interest rate on a cash investment might be high or low but the point I am making is still valid. And, in this particular case, the wiser financial move is obvious.

But there are other factors that make the decision to leverage your income wiser still. One of those factors is the fact that when you pay cash, that $20,000 disappears, sunk in a depreciating asset. The car for which you paid $20,000 is worth less than that every day, day after day. The rate of that depreciation depends on several considerations but the fundamental concept is the fact that its value is going down.

On the other hand, if you had left that money in the bank, its value would be steadily increasing. And, then, there is the value of having $20,000 in the bank. Large sums of cash can go along way towards enhancing your financial peace of mind. You should always be reluctant to part with large, hard-to-come-by, chunks of cash; particularly to acquire a depreciating asset.

One final consideration will be the effect of either action (cash purchase or financing) will have on your bottom line, that is, your net worth.

When you purchase a car with cash, your net worth will immediately go down and continue to decline as the value of the vehicle depreciates. When you finance the acquisition and leave the money in the bank, you net worth will not take the same hit. Your balance sheet will reflect a much more solvent financial condition.

Purchase Paying Cash Versus Financing

If you can afford to pay cash, you can afford whatever financing period is most efficient;

An interest rate of 5% on savings is assumed;

Acquire Via Financing:

Net Worth the Day Before Vehicle Acquired: $20,000

Net Worth Computation the Day After You Finance the Vehicle (100%):

Assets Liabilities (day of purchase)

$20,000 cash $20,000 auto loan

$18,000 value of vehicle

$38,000 $20,000

Net Worth the Day After Vehicle Acquired: $18,000

In other words, your net worth went down $2,000 the day you bought the car! Why? Because a new car depreciates the minute you drive it off the lot. That drive off the lot is the most expensive drive you can make! IS it worth that new car smell? That's for you to decide but at least, now, you have the information you need to make a more informed decision.

Here's some more for you to think about:

Acquire Paying Cash:

Assets Liabilities (day of purchase)

$18,000 value of vehicle

End of Year One: Finance

21,000 Cash $15,000 (balance of loan)

$16,000 value of vehicle

$37,000 – 15,000 = $22,000

End of Year One: Pay Cash

$4,200 Cash ($350 x 12)

$16,000 Value of Vehicle

$20,200 Net Worth

You lose money paying cash and there is the lost opportunity cost, as well. Think about it, are you more financially solvent with $20,000 in the bank or without it? No brainer, right?