In a previous article, you met your friends CF (Cash Flow) and equity, which are the basis of wealth. You must increase CF to create equity and then turn equity into CF. These are tools that make rich people rich.
In this article you will meet two other friends, a bit ‘most difficult (you have to do some calculations), but definitely important to become financially free.
I present you: ROI & ROE!
ROI, or return on investment, how much does it make
Perhaps you have heard about ROI, at least as a word. Return on Investment means how much money you will get from what you invested.
In fact ROI is calculated as the ratio between PROFIT /TOTAL INVESTMENT
For example, if you invest 120,000 euros in a property and resell at 150,000, the ROI of this operation is:
30.000 / 120.000 = 1 / 4 = 0,25 = 25%
Now that you know how to calculate it, how much would a good ROI be or an insufficient ROI? Well, it is essential to take into account the time factor.
If for example we are talking about a real estate transaction I completed in 6 months then the ROI on a year would be:
25% / 6 months = X / 12 months = 50%
I gained 50% in a year, not bad. In this simplified case, it is gross, so assuming 30% tax still it would be a discreet 34% net per year.
Does it seem a lot?
Well, when compare it with the interest that banks offer ordinary people (ie: 5% gross) it looks like a lot.
But rich people consider a good ROI to be at least in double digits and possibly in three digits.
Indeed, the rich people consider the ROE, preferably endless!
Return on Equity, or ROE How much does it make compared to how much you put in of your own money
The ROE is the lesser-known cousin of ROI, but it is my favorite. Because I know, the secret of wealth is right in risking your money as little as possible. Are you confused?
Here is an example.
We will look at the same operation as before, only this time we will consider that, out of the 120,000 spent, only 10,000 are yours, the other 110,000 were put in by the bank.
In this case, the cost increase of the mortgage fee, let’s say 5,500 Euro, which subtracted from the original profit, and then subtracted the 10,000 you have invested from your own money.
Hence the new math:
(30000-5500) / 120,000 = 20% or, on an annual basis 40%
It is less than before, it would seem that taking out a mortgage is not a good choice, but here is how we calculate the ROE:
Profit / Your Money
24.500 / 10.000 = 245%
This is because you have put only $ 10,000, but you have received a profit of 24,500. Then Do you understand how can you get a triple return, quadruple? Or even infinite?
Oh yes, because if you put in zero money and take out a full mortgage, the denominator of that equation goes to zero and the ROE becomes indeed infinite.
This is the math that rich people do, and it is the math that you have to do to start your own financial freedom.
Now that CF, equity, ROI and ROE have become your friends, you have no excuse not to achieve your financial freedom plan.
To your financial freedom