Explaining Arbitrage

What this episode covers

Arbitrage is both misunderstood and misused. Explaining arbitrage can produce far better results over the short and long run, especially when it comes to retirement income. Download Audio Transcript: Today, we’re going to talk about what the heck arbitrage is. We hear that on the financial news all the time, and it sound incredibly sophisticated. It’s really not. You borrow money at four percent, you make five percent on your investment. You’ve successfully arbitraged the way it’s supposed to be. Here’s the deal. If you’re wondering how to get started, and you don’t have enough to buy real estate, or maybe you’re not into real estate right now. You want some notes at a discount because you know those are high yield. You can borrow $100,000 at say 4 and a quarter, and you can go get 10 to 15 percent yield, cash on cash on those notes. Remember, cash on cash doesn’t mean that the entire return is going to fall in that range of 10 to 15 percent. It means if you add your payments up, divide by what you paid for the note, and it comes out 12 percent, your cash on cash for that note was 12 percent. Since you bought it at a discount though, you make the profit that adds on, when it pays off to your 10, 12, 15 percent. Let’s do an example. John and Suzy have a $200,000 condo, and they have a way to borrow $50,000 at 4 percent. They borrow it. Then they come to me, and they put their money into a note. Maybe they buy a note for $70,000. They get payments on that note that end up being somewhere in the vicinity of say $8,000 a year total. They put $50,000 in it. They’re making 16 percent, so they did really well. That note pays and pays. Meanwhile, they’re paying a principle and interest payment of far below $8,000 a year. That note payment is not only more than enough, even after tax probably to pay their new house payment at 4.25. When that note pays off, they don’t get 50, they get 50 plus that nice $20,000 discount that they paid, minus a little principal that they’ve received. They can choose if they want to, to let it roll, and just keep paying off that loan, which is probably what most people will do, or they can pay off that loan, and maybe they have the ability since then to acquire more cash and they’ll just keep doing it. The key to arbitrage is simple. The cost of your money must be less than the yield on your investment. If you can continually do that for decade after decade, that will be a huge source of income for you when you retire.

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