In life there are indisputable laws that we have to contend with.

There are laws of chemistry and physics, laws of nature and there are also financial laws.

If you fight the laws of physics you will lose every time. Have you ever tried to fight the law of gravity? It’s painful when you land with a thud! Gravity wins every time. NB: While the law of aerodynamics supersedes the law of gravity… it does not do away with it!

Did you ever try to grow a plant that was totally unsuited to the local climate? No doubt, you didn’t have much success! How silly would it be to mix two explosive chemicals together… and no reaction?

People drown fighting rips… but anyone can swim with the tide.

LAWS GOVERNING THE FINANCIAL WORLD:

As there are laws governing most things about us… so too it is with the financial world. Two obvious laws that I want to consider here are (1) Time and (2) Inflation. In my experience, most people fight these financial laws like the swimmer in the rip. They drown financially… but it does not have to be that way!

Once we accept that there are laws governing time & inflation, we can learn how to harness them to our advantage; it’s that simple! It can be like having the wind at your back, rather than running into a headwind.

Therefore, my strong suggestion is: “Quit fighting natural laws; rather learn how they work… and how to use them to your advantage”.

TWO SIDES TO THE LEDGER:

There are two positions we can take:

1. The CREDIT side of the ledger – where your net cash position is positive; this is where you are investing your own cash.

1. The DEBIT side of the ledger – where your net cash position is negative; this is where you invest using other people’s money.

The CREDIT side of the ledger

While it is not commonly understood; using your own cash to invest will leave you fighting against the natural laws of time and inflation. Each year your nest egg will be eroded at the rate of inflation. Although the actual face value may not change the true value of your money has reduced. If you had $100 last year and the inflation rate was 3% you would still have $100 today but that $100 would buy you 3% less than it did last year. I am not talking about the face value or the actual dollar figure; rather the real value of what you have.

With this in mind when investing your cash you have to earn at least the rate of inflation just to stay in the same position. Using an inflation rate of 3% as an example you would have to earn 3% per year after tax just to break even.

When struggling against the “tide of time & inflation”… our forward steps are unlikely to result in any (real) forward movement.

So, Is There A Better Way?

The DEBIT side of the ledger

Personally, I have chosen to be on the debit side of the ledger. On this side, time and inflation work in your favour… because you are working in harmony with the natural forces. For every two steps forward you take, they will push you another step(s) forward. You are now running with the wind at your back!

Here’s how it works.

By using the bank’s money to finance your investments you are in a net debt position; i.e. you owe more than you have in cash. Obviously you don’t owe more than you own, that wouldn’t be good but you do owe more than the cash you have to hand.

Like most investors I use interest only loans for my investment purchases; I purposefully do not pay down the debt; but nevertheless, my debt does actually reduce! By not repaying any of the principal component of my investment loan the actual loan amount (i.e. the dollar figure) will remain the same. A $400,000 interest only loan today will still represent a $400,000 loan (productive debt) in a years’ time.

That part is pretty straight forward… but now let’s consider how time & inflation (my new found friends) can help…

Assuming an inflation rate of 3%… and looking forward 12 months; in real dollar value terms (or spending power), I now owe the lender $12,000 less! Talk about a “set ‘n’ forget” system to create wealth as you sleep.

What these new found friends of yours do is actually reduce the real value of your debt. STOP! That point needs to be absorbed… I am suggesting that the effect of inflation (over time) can increase your net worth, reduce the real value of your debt and work passively for you 24/7!

Wow, we have just seen how it is possible to finally appreciate inflation… instead of cursing it; bring it on!

For the person with a million dollars worth of borrowings (I am only referring to productive debt here), their wealth is increasing by (at least) the value of inflation… or $30,000 a year (assuming 3% inflation). Given that real estate values generally increase at a rate well above the rate of inflation (i.e. well researched residential real estate, where the supply is limited and the demand increasing) the real gain is probably going to be significantly more!!!

To further illustrate my point, let’s take a longer term example… using a story told to me by a friend recently.

In 1974 his parents sold their family home in Adelaide for $25,000. It was a fairly typical 3 bedroom home in the suburbs. $25,000 was a lot of money back then; given his dad was only earning $50 a week at work.

Now, if a smart investor had purchased that home and used an interest only loan… the (productive) debt owed would still be $25,000. We all know that while $25,000 was a fortune back in 1974… it is worth significantly less now. I know people with credit card limits bigger than that today.

The (productive) debt an incoming investor would have gone into to purchase this property would have represented possibly 105% of what the property was worth at the time (i.e. assuming they borrowed the stamp duty and the purchase costs); however, today it would represent just over 7% of the current value of the property (assuming the median price of a home in Adelaide is $350,000 as per REISA President, Robin Turner).

Another way of looking at your gain is to recognise that not only have time and inflation “paid down” your (real) debt, passively while you sleep, work & play… they have also pushed up the replacement cost of your asset(s). There’s no way you can build a house for $25,000 these days.

IN CONCLUSION:

• Not only has the real value of your (productive) debt been reduced, but the replacement value of your asset(s) have increased.
• The value of your asset and the value of the debt to purchase that asset start at about the same level… but then, thanks to time and inflation, they move further and further apart.
• Debt is reduced and replacement cost increases,
• The “gap” created between these two amounts is your profit; from inflation
• Add that to the natural capital gains from supply and demand and you are really getting somewhere fast.
• All the planets are aligned, and the universe is in harmony and, assuming you use the knowledge provided… there will be an inheritance for you to leave to your children’s children (after a comfortable retirement yourself)!

Don’t fight these natural laws; rather learn how they work and harness their power as fuel for your financial future!