Sunday, February 19, 2006

Leverage Edition: $2.01 - Escape Financial Jail

Financial Leverage Continued ...

50 year old couple, limited savings, poor retirement prospects, so did equity take-out of $200,000 from their house, additional loan payments of $1,199 monthly, intend to invest in dividend paying Widow and Orphans stocks.

    So, carrying on, I was able to quickly go through the local paper, and find a number of large company names I recognized (Widow and Orphans Stocks), and looked for yields in the 4-6% range. Lower than that, it wouldn't provide enough immediate cash-flow to help pay the mortgage, and higher than that can indicate a smaller company, or a large one in trouble. And we want a reasonable amount of safety, so we're staying in that general range.

    I was quickly able to find 15 stocks (just from an abbreviated list) that met those criteria, then I went over to Morningstar to look at the recent dividend payment history. I was looking to eliminate stocks which decreased their dividend payment compared to five years ago, and also whose total annual return (dividend payment plus change in the stock price) wasn't greater than 2%.

    This left me with twelve big name stocks, who have an average market capitalization in excess of $50 Billion, with only one of those names below $10 Billion market capitalization. They produce an average current dividend yield of 4.8%. Not only that but, on average, those dividends had been increasing by 7.8% annually over the past few years.

    So this offers the very distinct possibility that the dividend payments in the future will more than cover the increased mortgage payment of $1,199 monthly.

    In fact, if we divide the $200,000 evenly in stock purchases among those 12 companies, we should recieve $9,600 annually in dividend payments for the first year, compared to our annual mortgage payment of $14,388 (12 x $1,199). So the first year, we'll have to cut our expenses and dig into our pockets to fund the difference of $4,788, or $400 monthly. However, there's also the matter of the tax write-off for the interest on the mortgage (about $12,000 is interest in the first year), which should help narrow that $400 monthly shortfall (talk to your accountant about the exact amount).

    Since the recent history is that these companies increase their dividends on average by 7.8% annually, we can reasonably expect that we'll get a higher payment in the future. Using the 7.8% increase per year, by the third year we'd be getting $11,148 annually, and by year five, our dividends of $13,968 almost cover the mortgage payment. If these companies continue increasing their dividends just like they have in the recent past, then by year six we be getting a positive annual cash flow of about $672.

    Fifteen years from when we took the loan out, at retirement age of 65, the positive cash flow (after the mortgage payment has been fully paid from the dividend) would be about $15,228 annually. This cash flow continues rising so that five years later, it should now be around $28,728 annually in positive cash flow. At the time we hit 80, the loan is then fully paid off, and our annual dividends are $91,368. SWEEEET!!

    And all because you decided to fund a small shortfall for a few brief years - and managed both your risk and leverage wisely.

    More later ...


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