What Is Arbitrage, and How Does It Fit Into Your Personal Wealth-Building Plan?
According to Investopedia, arbitrage is simultaneously buying and selling to profit from market inefficiencies.
While this definition is technically correct, it fails to explain how you, as an investor, can take advantage of hidden opportunities to increase your wealth using arbitrage and strategic debt.
In this blog, we expand on a simple, implementable, and accessible investment strategy that allows investors to create arbitrage opportunities using a simple line of credit.
Why do people invest?
People invest for one of two reasons, either for cash flow or for capital gains. Most wealthy people recognize the need for cash flow to pay for their living expenses and lifestyle. They also realize that capital gains are best used to buy more income-producing assets, thereby increasing their passive income and overall net worth.
On the other hand, most middle-class Americans invest for capital gains, using traditional assets such as stocks and bonds. Most of these investors are told that the safest way to build a retirement nest egg is to hold whatever assets and savings they can accrue during their working years over the long term, hoping that the value of their portfolio grows at a sufficient rate to out-perform inflation – which it rarely does.
Trying to “save” your way to retirement is not the best strategy because no matter how much money you manage to put away, the value of your savings will constantly be depreciating as inflation eats away at your purchasing power.
The reality is that when money flows, it grows, and the most effective way to build your wealth is to create cash flow.
So how do you generate cash flow?
Done right, cash flow is a result of using arbitrage correctly, which is basically creating a spread between the cost of borrowed money and what an investment pays. Arbitrage is nothing more than a leveraged strategy.
A leveraged strategy refers to the use of borrowed money structured and matched correctly with the right stable assets to increase the potential returns on investment.
The primary goal of leveraging is to amplify gains. Leveraged strategies can be powerful tools when it comes to building wealth. However, it's crucial to use these strategies in conjunction with a well-defined risk management plan. If you are considering using a leveraged strategy, it's a good idea to consult with an expert to ensure you understand the potential risks and rewards.
The role of strategic debt in arbitrage
Most hard-working, middle-class income earners have been indoctrinated with the idea that debt is the enemy of wealth.
This philosophy holds true when it comes to bad debt, where you end up using credit to pay for consumables, such as clothing, a car, or paying for services that will not generate income. You will end up paying far more than the value of the product or service you charge to your credit card because of the high interest rates associated with unleveraged debt.
However, using debt strategically can actually be a powerful way to build your wealth.
Find out more about how to use strategic debt to build your wealth in our upcoming blog on the topic.
How do you create an arbitrage opportunity?
To create an arbitrage opportunity, you need the following in place:
1. A stable income-producing asset (such as an apartment building, rental property, insurance policy, lending, an established business, etc.)
2. A lender that is willing to lend against the asset as collateral (obtain leverage)
3. The income must be larger than the loan payments and expenses related to the asset
That's the simple high-level formula to create passive income to grow your wealth.
Let us look at a few examples of how you can use debt strategically to create arbitrage opportunities to build your wealth.
An investor buying an apartment building can use the apartment building as collateral to obtain a bank loan. The investor puts some money down, but borrows the rest from the bank. The investor will need to ensure that the loan repayments and costs associated with managing the apartment building are lower than the income he will make from the apartment complex, creating the arbitrage.
For a business owner buying a car wash, the established business is an income-producing asset. Many lenders are willing to accept the business’s earning potential as collateral to assist the business owner in buying the established car wash. If you have done your due diligence and have a solid business plan in place, the business should produce sufficient income to cover the business loan, pay your overheads, and turn a profit.
While buying an income-producing asset such as real estate or an established business has the potential to create arbitrage that will enable you to build wealth, this is not truly passive income – because it will still cost you TIME – the one asset that will always be limited.
How to use arbitrage like a banker
Let’s suppose you could buy a black box from a retail store for $50,000 and place it on your shelf at home. Let’s also suppose that the black box generates $1000 per month in income for you.
Suppose that a lender is willing to lend you the money to buy it, with loan payments of $700 per month. This allows you to keep a difference (passive income) of $300 per month (remember, the black box is generating $1000 per month). This black box is headache free with no hassles. It just sits on your shelf at home and makes you money.
The point of this is to illustrate that the main reason we buy income-generating assets is for the cash flow NOT the asset itself.
"We do not buy assets for the sake of buying them or for the sake of owning them. In fact, when I hear people say how excited they are to own real estate, I realize they don’t own enough real estate to know what they are talking about. We own real estate or businesses for the sake of generating cash flow." – George Antone
Now the black box does not really exist, but the question is, what is the closest thing to this black box? Well, the answer may surprise you.
Suppose an investor borrows $50,000 at 10% from a lender and signs a mortgage to the lender. The lender now has an income-producing asset which is a piece of paper. This paper mortgage produces passive income in the form of interest. This meets criteria #1 in our simple, passive income formula.
Now the lender can borrow against this asset (the mortgage) at a lower rate. It is called hypothecation. Hypothecation is a legal term that refers to the practice of using an asset as collateral to secure a loan or other form of debt. This means that the borrower pledges an asset, such as property or securities, to the lender as security for the loan. If the borrower fails to repay the loan, the lender has the right to seize and sell the asset to recover the money owed. Hypothecation is commonly used in lending transactions, such as home mortgages or car loans.
In our example, the lender pledges this mortgage as collateral for a loan of $40,000 at say, 7%. This meets criteria #2. Now the lender receives payments at 10% interest, and pays 7% interest, leaving a 3% spread on the $40,000. This meets criteria #3.
Now let’s step back for a second and think about what just happened. To generate passive income, you need two things: an asset and leverage (borrowed money).
You use the asset to pledge as collateral to get the borrowed money. Most people have to find a physical structure or an established business (as the asset) to pledge as collateral to borrow that money. But the banker simply PRINTS the collateral, the piece of paper known as a mortgage, and as long as someone (the borrower) is willing to sign it, it is now an income-producing asset that can generate passive income!
So, when a banker has a filing cabinet of forty mortgages generating $300 per month each, that is equivalent to a landlord with a lot of homes generating $300 per month from each of them. This is the equivalent of having that elusive ‘black box’.
Today, with the crowdfunding sites everywhere, we can use this same strategy from the comfort of your computer. The speed in which we are able to implement this is so much more efficient and faster than what we did just 10 years ago! This is a strategy that we teach students to implement through the Amplified Approach.
Are you ready to build passive income faster, safer, and with more certainty?
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