Creating Wealth vs Return on Investment

by Trader Travis
(http://www.learn-stock-options-trading.com/)

Before I had the fortune of being mentored by several multi-millionaires, I was brainwashed by modern day society to love debt and focus on return on investment (ROI). I didn't learn much about creating wealth.

During the height of the Real Estate crash of 2008-2009 I saved an article from a local newspaper to serve as a reminder of the bad kind of investment math to stay away from.

The article was written by a local realtor. A woman had written to ask the realtor if buying a home was a stupid move considering the mortgage crisis that's going on.

Here is a portion of the realtor's response: "The majority of Americans probably lost more money on a supposedly hot stock, their new SUV, or other must have toy than they did on their homes this year...Homeownership is a unique investment compared to others. Over 10 years, a $10,000 investment in the stock market at a 10% market rate of return would yield nearly $24,000. The same investment used as a down payment on a $200,000 home at an annualized appreciation rate of 5% would return nearly five times the stock market return, for a total of more than $110,000."

I "assume" that this is the Realtor's (society's) viewpoint of the transaction:

Profit or Loss ÷ Total Investment = (answer * 100) = Return on Investment (simplified version)

Stock:
$24,000(current value) - $10,000 (initial investment) = $14,000 profit

ROI Example: $14,000 (profit) ÷ $10,000 (total investment) = 1.4 * 100 = 140% return on investment

Real Estate:
$110,000 (appreciation profit) - $10,000 (initial investment) = $100,000 profit

ROI Example: $100,000 (profit) ÷ $10,000 (total investment) = 10 * 100 = 1000% return on investment, WOW!!! (spoken sarcastically)

Statements such as the one the realtor made, combined with my own ignorance, are why I set out to become a full time real estate investor. It just made so much sense, but here is what I learned in retrospect.

Return on investment and putting cash in your pocket are two ENTIRELY different things!

A $10,000 investment that earns $500 in interest generates more cash than a $1,000 investment that earns $200 in interest, but the $1,000 investment has a higher return on investment.

$500/$10,000= 5% ROI
$200/$1,000= 20% ROI

Yes it took a lot more money overall to make the $500 but still $500 is more than $200 all day, any day. ROI is great, but more cash is what will make you wealthy.

Here is how one mentor taught me to look at this transaction:

"TRUE" return on investment factors in your cost basis (how much you have invested in the transaction).

The stock trader only had $10,000 invested in the transaction (excluding commissions) and he/she made $14,000 in profit. The trader had no additional cost over the span of 10 years. Result: A 140% ROI and cash in his/her pocket.

How much did the home buyer have invested in his/her transaction?

In ten years the home appreciated $110,000 more than the purchase price BUT they had to pay out $161,680 of their own money ($1,264 mortgage payment for 10 yrs + $10,000 down payment).

They spent $161,580 to make $110,000! Sorry I like the stock example (spend $10K to make $14K).

Let's see, $110,000 (appreciation profit) ÷ $161,680 (total investment) = .68 * 100 = 68% return on investment, right?

NO, here is what really took place. The mortgage payment on a $200,000 home financed for 30 years at 6.5% interest is $1,264. After 10 years the mortgage balance is $169,206 and they've paid $122,166 in interest so far.

Something smells fishy...this person made $110,000 in appreciation (profit), but paid the bank $122,166 in interest. You can do the math. Was there REALLY a return on investment?

ROI Example: $110,000 (appreciation profit) - $122,166 (interest to bank) = $12,166 loss

-$12,166 ÷ $161,680 (total investment) = 7.5% loss

Seriously you don't even need to do all of these calculations to see who comes ahead financially in a real estate transaction where the home is mortgaged.

If you buy a $200,000 home, finance it over 30 years at 6.5% interest, you would pay the bank $255,092 in interest. You would pay the bank more in interest than it cost you to buy the home.

Who comes ahead financially in these transactions?

Geez why do we get sucked into these kinds of transactions? Or at least why did I get sucked into them for years? Even if I had sold my home five years later I would still lose money because the majority of my mortgage payment went down the toilet in the form of interest payments.

Yes, Yes, I know this is not how everyone looks at things and people will argue about the tax benefits of real estate, and how my calculations are wrong, but in the end people can argue all they want and poke holes in this example but as my mentor said, "At the end of the day who has more money in the bank? (Wealth Creation)."

Take Away: You should look at both return on investment and what puts more money in your pocket (wealth creation). They are both very valuable and neither should be ignored in exchange for the other. You can't take everything at face value and sometimes you really have to ponder what people tell you (including this example).

To Your Success, Trader Travis
http://www.learn-stock-options-trading.com/

P.S. Now imagine if the stock trader had taken the same amount of money as the house buyer and invested it.

P.P.S. Your comments and questions are welcomed. Please leave them below.