How to earn an extra $500 a month: Part 2

house-under-constructionIn part 1 of this article on how to make an additional $500 per month, FPO explored some rather capital intense methods for bringing in some extra income.  These methods are reasonably low risk, but they are also low return.  There are times, when tying up such a high amount of funds in not feasible.  In those cases, there is the opportunity to exercise some leverage by using the bank’s money.

Are there risks in this? Absolutely.  But there is in everything, including “risk free” savings accounts.  Preservation of principal is guaranteed, but so is loss due to inflation.  the risk of your money dropping in value is ever growing in this case.

The fundamental concept is to borrow at a rate less than your rate of return.  The classic example would be buying an investment property to rent out.  Using the $70,000 example from earlier, this same house can be bought with a loan at a current market rate of 4% with 25% down.  Now the initial investment is $17500 and the monthly loan payment for a 30-year loan is $250.  The net rent collected will be the same $500 as in the previous case, however the net amount after the mortgage payment is $250 extra per month.  In order to get the extra $500 per month, two houses of this type must be bought, or one house of approximately twice the cost.  Going with a single house would result in house that’s a little more than twice the cost as the rent amount versus the purchase price ratio decreases as home price increases.  It’s not a linear relationship.

The above example employs a reasonable 3:1 leverage.  More can be achieved.  In this example for the single $70,000 house, an additional $10000 is borrowed using a business loan at 10% for 30-years.  This rate is higher, but since it’s only $10000 of the total cost, the weighted average cost of debt is still favorable.  This 10:1 leverage scenario carries more risk, but only $7500 per house is needed.  The total income would be $500 per month, and the new payment would be $316 per month, leaving a net income of $184.  This is less than the last example since another $10k is borrowed.  In this case 2.7 houses would be needed to reach that $500 per month.  The total amount that the investor would need to bring to the table under such a scenario would be a little over $20000 to get the $500 per month extra income.  The added benefit is that the houses are also being paid off by rents collected over time.

There is a caution here. 10:1 leverage is very leveraged.  The above examples were done with rental properties, however this will work for most any asset class, including stocks.  In the Case of stocks, this is referred to as a margin account.

Part 3 will discuss some ways that an extra $500 a month of income can be created by making opportunities for yourself, both within your current job and various side jobs.

How does a reverse mortgage work? What determines the payment amount?

A reverse mortgage is a financial product using your existing primary residence as collateral.  The borrower must be at least 62 years of age in the U.S.  There are various ways the cash flows can be worked in a reverse mortgage.  The product is similar to the annuity.  One type of a reverse mortgage is where you “sell” your house today for monthly payments of a certain amount and remain in the house until your death.  The part of remaining in your house is what is different than an annuity.  In the case of an annuity, you won’t have access to the funds used to purchase the annuity once it’s purchased.  In addition, a reverse mortgage is not considered a sale, by standard sales definitions.

The key part of a reverse mortgage is staying the fact that the borrower will be staying in the house as their primary residence.  It is part of the terms and conditions.  Moving, selling the house, or dying all bring the loan due.  A reverse mortgage is also heavily loaded with fees.  Origination costs of 2%, upfront insurance of 2%, and your effective rate of borrowing are all higher than other products using your house as collateral.  The good news, is that there is a way to emulate the reverse mortgage using other financial products.

A reverse mortgage can be approximated by taking a “cash out refinance” on your house and using the proceeds to buy an annuity.  Using our previous example of an annuity of $100k paying $6250 a year:

  1. The homeowner has a house worth $100k and is completely paid off
  2. The homeowner takes out a $100k cash out refinance (or home equity loan) with interest only payments
  3. The $100k is used to purchase the example annuity
  4. The homeowner receives $6250 a year from the annuity, but must pay the cost of the cash out refinance
  5. The interest only payments at 3% would be $3600 a year
  6. Your net income from an arrangement equivalent to a reverse mortgage is $2650 a year or about $221/month.

There is one small concern on the above arrangement.  Interest only mortgages are not particularly common.  It is more likely that this arrangement would be worked with a 30 year mortgage instead, and the extra amount in house payment would start to build equity back into the house.

This arrangement can also be worked between a variable home equity line of credit and a variable annuity.

 

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