Yesterday, we introduced Scott, one of the creators and stars of the success documentary, Pass It On.

Scott wanted to know if his royalty streams (he is also a prolific inventor who teaches others how to invent) meant that he was a multimillionaire.

I’ll leave you to read that post, but the answer, as you may have guessed, is “yes … but” with the ‘but’ being that he has to guarantee his future income by building his own Perpetual Money Machine!

Unlike the world of Newtonian physics, where it is impossible to build a Perpetual Motion Machine (most closely approximated by those desktop ‘toys’ with the liquids or magnets that seem to rotate and swing ALMOST ‘forever’), it is actually quite easy to build a Perpetual Money Machine:

This is ideal – and, quite necessary – for anybody who has an income stream that they want to guarantee …

… and, isn’t that everybody with a job, or in business?

Our Perpetual Money Machine needs two components:

1. An income ‘energy source’ – a source of cashflow to ‘seed’ the machine

2. An income ‘capacitor’ – a means to store/recycle the financial energy until an excess is created

This ‘money machine’ becomes ‘perpetual’ when enough cash begins to spin off to become it’s own energy source …

… but, it becomes useful when it (soon after) also begins to spin off excess cash that we can spend!

Fortunately, this is a lot easier to ‘build’ (at least, in principle) than it is to describe.

Let’s take a simple example:

Joe is working at his job; he earns a income – that’s his ‘energy source’: his weekly paycheck.

Instead of opting to spend all of his money, he decides to ‘seed’ (i.e. save 15% of his gross salary) his ‘capacitor’ (in this case his 401k) until he has amassed $2 million. This takes Joe 30 years.

Joe then retires, reinvesting his nest egg into various ‘safe’ investments (as recommended by his financial adviser) that return 10% every year (in this Utopian world, there are no variances from ‘average’) which is 5% above inflation (ditto for inflation) and Joe can safely spend 5% of a pie that keeps growing with inflation, well, pretty much forever.

Of course, Joe had to work for 30 years to achieve this result and we had to suspend the laws of ‘financial physics’ to make it work, so let’s build Scott a ‘real’ Perpetual Money Machine:

Scott has a current income from his royalties: this is his ‘energy source’ and we can trust Scott to continue to build this energy source even further, but he realizes that all energy sources eventually dissipate.

So, instead of spending all of it, Scott puts at least 15% of his income from his inventions/movies/etc. towards his first capacitor (where he temporarily stores it is of little consequence; a bank is ideal).

Why 15%?

Well, we assume that until now, Scott has been spending all of his income in the belief that he already had a ‘perpetual money machine’ … if not, then maybe Scott can begin with even more than 15% 🙂

As Scott increases his income, now realizing that it is not ‘perpetual’, he also diverts at least 50% of the additional income towards building his Perpetual Money Machine … he sacrifices a little bit of ‘current increased lifestyle’ for ‘guaranteed future lifestyle’.

When Scott has ‘enough’ (and, that is up to Scott to determine) he ‘seeds his income capacitor’ by purchasing an investment property: if Scott wants a series of ‘small capacitors’ he buys residential (houses, condos, up to quadraplexes); if he wants a ‘large capacitor’ he buys commercial (multi-unit apartment complexes, offices, strip shops, etc.).

My recommendation is that Scott uses the largest ‘capacitor’ that he can afford right now … he can always trade up later, if he wants to consolidate into fewer capacitors/properties.

Now, does it have to be real-estate?

Of course not, it just needs to be anything that you can buy/hold that produces an income: it can be divided-producing stocks; Berkshire Hathaway shares (no dividends, but we’ll deal with that later); etc. … but RE is ideal because it can be well-leveraged, eventually produces a mostly-reliable income, but is stable over a long holding period: very handy attributes for a ‘financial capacitor’.

Scott repeats the above process until a  magical point in time … when the Perpetual Money Machine starts to wind itself up!

To be continued … 😉

I received a great question/comment from an unusual source: Scott who is a prolific inventor, known actor (ever see Beethoven 2 and 3?), and movie industry ‘mover/shaker’:

I generate income through intellectual properties… Inventions, movie royalties and so on. I receive royalties every quarter (or so) from many sources, the total of which far exceeds the return on one million dollars in the bank. This is passive (royalty) money.

Irrespective of one’s actual money in the bank, is it safe to say that if one is realizing the income (passively) as if having the millions in the bank, that they are living the life of a millionaire?

Is it safe to assume that if someone were doing this for a living they’d be living as if having the million(s) in the bank?

Even though Scott seems comfortable in the continuity of the income streams (he has “many on the retail shelf and on T.V. with many more coming. It’s just what I do.”), I am not quite as comfortable.

As I said to Scott:

You need to look at the certainty and longevity of those royalties and incomes … unlike cash in the bank, your ‘Life of Riley’ lasts only as long as the income keeps coming in.

You see what Scott has is NOT passive income; it’s BUSINESS INCOME and business income is most assuredly not ‘passive’ … it’s ACTIVE.

‘Active’ implies risk …

Even though Scott can create a product, put a team around it, and set it free to generate ‘passive income’ via royalties, etc. it is not enough to say that Scott is as rich as, say, somebody with enough cash just sitting in the bank on CD’s generating the same income, merely from interest, as Scott earns from the fruits of his creativity.

The money in the bank will keep generating interest for ever … the capital NEVER changes (let’s forget inflation for now, which is the real risk for this ‘money in the bank’ strategy).

You see, each ‘product’ (be it a movie, an exercise bike, a kitchen gadget, or whatever) has a ‘life cycle’ – it will either make money from the get-go or flop … if it is a winner (and, it seems like Scott has the Midas Touch, here) it will sell for a period of weeks, months, years until eventually another product will take over and product sales will die … along with Scott’s royalties.

This may happen quickly or slowly, but it will happen!

Since Scott is great at what he does – and loves doing it – this isn’t a problem for Scott: he just goes ahead and creates the next product.

Financially, though, this means that Scott is like any other professional in private practice: once he does stop creating, either by choice or because of disaster, sooner or later the income will stop coming.

Now can you see the difference between the ‘passive income’ generated by a few million in the bank and a similar level of ‘active income’ generated by Scott’s creativity?

Great! So, what can Scott do?

Well, the same thing as anybody earning an income either through their own sweat/blood/tears or through a business:

Scott could try and estimate the future cash flows of each of his product streams and see how long they will take to die down/ disappear as if he never created another product as of today and basically tie his current life-style to the present value (smoothed) of that future income stream.

If disaster doesn’t strike, Scott can review each year and adjust his ‘smoothed’ income stream, accordingly … but, this doesn’t solve the fundamental problem, so Scott should also:

Build a Perpetual Money Machine …

To Be Continued … 😉

I wrote a highly controversial post a while ago about how dumb it really is to pay off your mortgage – especially if you have a goal of getting wealthy (which is the whole point of this blog).

Others, like Ric Edelman and a whole bunch of other ‘Dave Ramsey / Suze Orman Busters’ agree … in fact, when Todd Ballenger’s team saw my posts on this subject they sent me a copy of his new book, Borrow Smart Retire Rich, to review (I am reading it as I write this).

He makes the point very clearly, articulately and forcefully: sometime is Ok t pay off your mortgage, but ot if you want to accelerate your wealth.

However, not everybody agrees; Wealthy Reader wrote a whole post refuting my own post. The arguments basically boil down to these:

Real estate has appreciated at about 3.8% a year historically (excluding the bubble). This is also about the rate of inflation. So unless you are in a hot real estate market, there is no upside.

According to Todd Ballenger in Borrow Smart Rich “since 1945, the median house price in the United States has risen by an average 6.23% per year”. I used 6% in my post comparing R/E to your 401k.

But, would you settle for just average appreciation potential when buying an investment property (remember, we are talking about buying an investment instead of ‘investing’ that money into your own mortgage by paying it down early).

If the average appreciation is truly 6.23%, I could do better than that with my eyes shut … I would just tell a Realtor to buy me anything near the water or in a yuppie area in any major US city – as long as I was prepared to hold it for long enough.

[AJC: Yes, any discussion of RE today says: “well Florida boomed, now look what’s happening!” … yet if you look at quality Florida real-estate over a 20 or 30 year period, you’ll achieve average growth far in excess of the nation’s average … they simply don’t make any more ocean-front land … even my 13 y.o. son knows that. He tells me that land on the lakes in Wisconsin sell for many times higher prices than the land even one block in: one has a rare commodity – access to put your boat in/out of the water – and the other doesn’t!]

If that’s too risky, I would just avoid buying anything in the dust bowls of the US countryside, or in any of the run down ghettos in most major cities – these properties are also included in the average growth rates.

[AJC: Yes, people will say: “But look at Harlem … it was a ghetto, now it’s booming”; this is true of SOME of the dust bowls and run-down ghettos some of the time … if you want to have a better-than-average chance of finding the next ghetto-turned-to-gold find the area/s where the artist colony is … invest there and wait 10 years. You’ll be sitting on gold!  Again, do you think the returns might beat the 6.23% average?]

The bottom line: you should have no fear of meeting or beating 6%+ returns in well-chosen real-estate over a 10 – 20 year period.

The interest is compounding so you don’t just pay 8%. That’s why you pay so much interest over the life of the loan. That 8% is compounding each month (at .6%) on the entire balance. So again there is no convincing argument.

Well, hang on a minute, by paying down your 6% – 8% mortgage to avoid the compounding nature of loans, aren’t you simply avoiding putting your money into another form of investment where the increase will also compound?

I mean, we aren’t planning to spend all that extra money that we could be putting into our mortgages into drinking more beer and eating pizza (yet)!

A simple example would be to put that money into a low-cost Index Fund; don’t they appreciate at over 11% annually – and, at no less than 8% (break-even) – over a 30 year period. And, didn’t I write a whole post showing that investing in real-estate could do even better?

The majority of tax payers either can’t or choose not to itemize.   According to the Urban Institute, only 35% itemized in 2004. Also, there are limitations on deductions.  So the famed mortgage interest tax deduction is mostly irrelevant here.

One Wealthy Reader reader (!), Jeff, jumped on this one saying:

Although trivialized by this blog, the mortgage interest tax deduction is a substantial benefit received by millions of Americans each year. You appear to argue since only 35% of Americans itemized their deduction, that this tax benefit should be completely discounted. This statistic, however, is not persuasive and it provides no insight into the number of homeowners that have mortgages that cannot or do not take advantage of this tax break.

But, if you truly feel that there is no tax-advantage to the 8% claimed benefit of either keeping or paying down the mortgage, what about the 25% – 35% tax-advantage that you would get by ‘investing’ that money instead into a tax-advantaged account such as a 401k?

Or, what about using it instead to fund a fully tax-deductible loan on an investment property (preferably one with depreciation benefits and/or good rental returns as well)?

Finally, Wealthy Reader throws in his ‘trump card’:

There is no investment that is as secure as a paid off mortgage and that also returns 8-12%.

How the hell is a paid off mortgage secure?

Is it because your money is now invested in your house? If so, how is it any less secure if some of it is in your house and some more of it is in the house next door and the one next door to that one?

Is it because the bank can’t touch you once it is all paid off?

Well, if that takes you 15 years to accomplish that (instead of the usual 30 years), what will the bank do if you lose your job and can’t keep up with the house payments in Year 12?

Guess what, they will still foreclose on you whether your equity is 20% or 40% or 60% or even 80%.

Surely the only thing that matters here is investment risk and investment return, after tax?

Like everything else, just run the numbers through a spreadsheet, it doesn’t take a rocket scientist to see that an 8% return is not as good as a 12% return (both must be on the same pre-/post-tax basis) …

… and, if you really can’t find an investment that will safely return 12% over 30 years, I agree: go ahead and pay off your mortgage, because you sure ain’t no investor 😉