Content: Page 12, Becoming Your Own Banker, Fifth Edition.
Welcome back to lesson 2. It will probably be useful for you to understand just how this concept came into existence. We are all products of our prior understanding of things. First of all, my initial college degree is in the field of forestry, graduating from the University of Georgia in 1952. A large portion of the root thought of this concept is coming from the study of forest finance — the fact that you are dealing with compound interest over a long period of time with no taxation on the build-up. The reverse fact is that you must make an investment in planting trees and you won’t see any financial return for that same long period. In the forestry world one must think many years into the future.
Some of it is coming from the life insurance business. I made a good living in life insurance sales for 35 years. Knowing how dividend-paying life insurance works is an essential ingredient to it all. Most people have a minimal understanding of the subject, including the home office personnel at life insurance companies. That may seem strange to you, but it is very true. In fact, a case can be made that it is probably the most misunderstood subject in the world.
Lastly, it was strongly influenced by my experience in the real estate business. Recalling that I was educated as a forester, timber is real estate as well as the land on which it grows, so I have been around real estate for all my working life, and I developed a deep interest in the subject and studied many books on it. If you read those books, the central message is not about real estate at all – it is about the magic of leverage! Essentially, they all say, “Buy some real estate, borrow the money to pay for it (because you are always dealing with borrowed money — you either borrow money and pay interest or you use your own money and give up interest that you could have earned elsewhere) – pay interest for a while, then sell the property. All you have given up is the interest you have paid out. That leverage is wonderful.”
That is all true – as long as things are going the way the “financial geniuses” describe it in the books. But they never tell you what happens when the lever goes the other way! Frankly, I made some money in the late 70’s doing it the way the geniuses explained it. By the way, there have been a number of people who have observed that “financial genius” is a rising market. There were several successful ventures in a row, and it looked like there was no end to this bonanza. I could do no wrong! The ventures got bigger and bigger and I got more involved, buying a large number of acres of rural property.
And then I got into real estate development. With the profits from one small parcel, my wife and I went to Europe in 1977 and spent a month! Would you believe it – I have never seen that property yet? I don’t even know where it is! And I did it all according to the “book by the financial geniuses” – leverage – other people’s money. Just have your realtor find such a deal and attend to all the particulars for you – and then sell it for you. Marvelous!
There was no logical reason not to expand – and so I did. The interest rate (they called it “the prime rate” in those days – now called “base rate.” This is the rate charged to the bank’s most secure customers) at that time was 8%, but your must pay 1.5% over “prime” because you are not in that category. They are not lending you money because you have real estate – they are lending you money because they think you can make payments. Why else would they require personal endorsement on the loan? And you must renew the notes every 90 days (or pay off the loan) at the current interest rate.
I got accustomed to paying 9.5% and that was “normal.” And then, along came 1981 and 1982. The prime rate rose and peaked at 21.5%! Add 1.5% on top of that and you see my situation – 23% interest – and I owed them $500,000.00! That amounts to $67,500 of interest per year that I was not expecting to pay.
When this happens to you, what do you do? Go as the “financial geniuses” that recommended that you do this and ask, “What do I do now?” If you can find them, they may mumble something about “selling the real estate.” But where do you find a fool who will buy it under those circumstances? Of course, everything will sell if you get the price low enough – but losing five times what you paid for it is hardly a good way out.
You can see the predicament that I was in, but that is only part of my total situation. We will save that for Lesson 3. I’ll see you there!