Life as a young adult can be very confusing and chaotic. In the midst of completing your formal education and beginning a career, there is a constant level of uncertainty concerning what will transpire in the future. At the Jason Hartman Foundation, we are specifically concerned with helping young adults develop the necessary skills for financial success. These principals are encapsulated in the three C’s of Financial Success; Credit, Capital, and Competency. These principals serve as the fundamental building blocks not only for financial literacy, but for creating long-term success.
The 3 C’s of Financial Success (Credit, Capital, Competency)
The achievement of long term financial success will require the development of three key attributes. The first is Credit, which will be necessary for obtaining loans, lines of credit, and can even have an impact on your insurance rates and employment prospects. The second is Capital, which is the money to invest in future opportunities. The final and most important factor is Competency or financial literacy. The first two C’s can be developed over a few years, but competency and financial literacy must become a lifelong endeavor if you wish to achieve long-term success.
The First C – Credit
Credit represents your ability to borrow from banks and financial institutions at attractive interest rates. Most people only pay attention to their credit for the purposes of buying a home, but there are many more important roles that your credit score plays. One of these roles is to influence your insurance rates. Insurance companies frequently use credit scores as a proxy for the risk profile of customers, since there is a higher correlation between customers with poor credit engaging in risky behavior than customers with good credit. Furthermore, some employers will also pull the credit score of applicants to gauge the extent to which they are responsible with their finances.
Then we get to the “real” advantage of strong credit . . . namely the fact that it allows you to purchase leveraged investment properties with an interest rate that is fixed for three decades. The reason that this is such an advantage is because leverage allows you to control a much greater asset base than can be purchased with cash alone, and a fixed rate mortgage protects you against price inflation in the future. With that being said, let’s take a look at how leverage and inflation work.
The way that leverage produces benefits can be demonstrated with some relatively straightforward arithmetic. Let’s suppose that you purchase an investment property worth $100,000 with cash. If the value of that property increases by 10%, you will have earned $10,000 on the $100,000 that you initially invested. Now let’s say that you purchased the same $100,000 property with $20,000 (20%) down and $80,000 borrowed from the bank. If the value increases by the same $10,000 (10%), but you only have $20,000 invested which means that your return on investment jumps from 10% to 50%!
There is a very important thing to keep in mind with leverage though, and that is the impact of large negative cash flow or price disruptions. When properties are bought for speculation, and not rented out to tenants for income, it means that the owner of the property must “float” the interest payments until the property can be sold. If market values decline, and the property is no longer worth what you paid for it things can get very sticky. Consider what would happen if you purchased a $100,000 property with 100% financing and the value went down by 10%. Not only are you on the hook for your monthly mortgage payments, but you owe $10,000 more on the mortgage than your property is worth! One of the best ways to mitigate these risks is to choose investments that generate cash flow to cover your mortgage payments. This will give you the flexibility to “wait out” declines in market value while the tenants pay for your mortgage with their rent revenue and you can choose to sell when values are high instead of being forced to sell when values are depressed.
Now let’s think about inflation for a bit. The way that inflation comes about is when the government expands the supply of money in circulation faster than the rate of productivity growth for goods and services. What happens in this scenario is that the amount of “money” circulating goes up while the amount of products and services stays the same or goes down . . . more money chasing less goods can only result in higher prices. When the prices for goods and services go up, it frequently results in higher interest rates as investors become unwilling to purchase bonds at rates of low rates of interest that are being eroded by inflation. When you take out a fixed-rate mortgage on an investment property and inflation strikes, it results in higher home values, higher rents that your tenants pay to you, but exactly the same mortgage payment that you pay to the bank!
The Second C – Capital
When talking about business and investments, the term “capital” is used to describe the money, equipment, or other tools that are used to produce products and services. In the context of personal investment, capital represents the amount of money that you have available to purchase assets that can generate cash flow and appreciate in value. There is an old saying that states “It takes money to make money” and in many situations, it is very accurate. Any investment you make will require some form of capital. In some cases it will be your money, in other cases it will be money that you have borrowed, in many cases it will be your time, and in certain situations it will be funds from investors. Banks and investors typically want you to have some of your own money at risk so that they know you have a vested interest in success.
So what is the best way to build-up capital? If your surname is something like Rockefeller, Vanderbilt, Hilton, Carnegie, or Kennedy then capital may not be much of a problem. However, for the other 95% of us out there we will need to figure out ways to build capital on our own. The most straightforward way to build a base of investment capital is to save a portion of your salary (frequently 10%) and place it into a separate account that will be used exclusively for investment. Another thing that many people do is use the equity in their home for investing.
Taking out a line of credit on your house may give you the necessary capital to begin an investment program after you have become educated in different investment options and strategies. A third option for building capital can be to borrow it from friends and family or take on partners. This is frequently the most tenuous of strategies, since partnerships can be difficult to manage. Jason Hartman is fond of saying that the hardest ship to sail is a partnership. In the end, this is for you, the investor to figure out. Each person needs to find the solutions and strategies that are best suited to their situation.
Another thing that many people frequently ask is how much capital they need to accumulate. The answer to this question is highly dependent on the type of investments you will be undertaking. In many cases, packaged investments with low capital requirements such as mutual funds tend to offer relatively average returns. Conversely, investment “deals” such as foreclosure rehabilitation may require more capital and will definitely require more expertise. It is also important to bear in mind that some phenomenal deals require very minimal capital and some deals with large dollar requirements can be big losers. Ultimately, it is your responsibility as the investor to evaluate which investment opportunities are best suited for your level of expertise, experience, and capitalization.
The Third C – Competency
The third and most important of the three C’s is competency, or your financial literacy. In practical terms, this represents the most valuable capital that anybody can possess . . . namely the brain sitting behind their eyes and between their ears. Credit and Capital are necessary tools, but they have no inherent wisdom, no soul, and no creative intelligence. Both of these ingredients require a competent person to build them into investments that produce things people value. The person who builds these deals could very well be you.
Another way to communicate the notion of competency is financial literacy. Specifically, the knowledge of how financial products and processes work. Becoming educated in the workings of investment and finances allows you to make intelligent decisions. It will allow you to quickly determine what kinds of deals represent the best opportunity and which are too risky or generate returns that are too low for serious consideration. It will help to guide your everyday decisions toward financial success. Financial literacy helps to significantly limit your risk of failure. This does not necessarily mean that you will never lose . . . investments involve risk, and sometime luck aligns against you. What it does mean is that you will be investing with full awareness of the risks and rewards so that intelligent decisions can be made.
Thus, the most import concept to internalize is that one should become educated before engaging in an investment program. Deals come and go, but the knowledge necessary to assemble and execute deals is crucial to successful investing over the long-term. Practically speaking, this means that you will probably be doing a lot of studying, research, and reading before initiating your first investment. Sometimes it can be difficult to be patient while absorbing the necessary education, but always remember that there are two components to success . . . knowledge and action. Knowledge without action becomes nothing more than expensive infotainment. Action without knowledge is extremely risky, and likely to produce spectacular problems. Those who realize financial success build their knowledge base, and then act on it.