There are two ways to create wealth – we’ll share both the well-known and the less-known ways with you today.
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When we think talk about capital for a business, we usually think about money. One timeless wealth-building secret is to use other people’s money, commonly referred to as OPM.
We all know that the three essentials for living are food, clothing, and shelter. We definitely rent our food. Do we rent or own our clothing? Hmmm.
Part of the American dream is to own your own home. And there are good reasons to do so. For instance, a Federal Reserve study[pdf] shows that the average family that owns a home has a net worth of nearly $625,000 while families who rent have a net worth of just a little over $54,000.
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We’ve seen an interesting statistic bantered about, but we haven’t been able to pin down a reliable source. If this statistic is true, American homeowners move once every five years or so, on average.
So we thought we’d consider what that does to the buy vs. rent equation. We’ll use some averages and national statistics to create an example. However, what really matters is your own situation and your local real estate market. Only you, working with your financial advisors, can determine what’s in your best interest.
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When I was younger, one of my bosses in radio told me that I was just throwing away money by renting. I remember thinking that it made sense. I’d reached an age where maybe I should consider buying. So I did. As often happens in the radio business, less than a year later, I lost my gig. So I had to sell my house to move to a different market. I lost a lot of money by buying. If only I had had a crystal ball!
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We created a fictional purchase to see if we would be better off renting or owning a house for five years. We assumed that:
Over the first five years, 83% of our total mortgage payments would go for interest. In other words, for the most part, we’ve traded renting property for renting money. If the interest rate is higher, the portion that would go to interest would also be higher. Of course, the reverse is also true.
During this period, we would pay $2,171 per month as “rental costs” for our home. We call them rental costs because they have no value once they’re paid. They only allow us to keep owning. So if we could rent a similar property for less than this, we would be better off renting instead of buying.
Of course, if we had made a down payment of less than $63,000, our cost would go up because we would be paying even more interest.
We also looked at how it would take before we would break-even. After all, it costs money to sell a house. We would have to pay commissions to our realtor, closing costs, and the like. We assumed these costs would total 8% of the selling price.
Given our assumptions, we looked at what would happen if we sold after one year. Our house would now be worth $326,560. From that, we would pay $26,125 in selling costs. After a year, our mortgage balance would be $248,392.
So we would be able to take out $52,043 in cash. But remember, we invested $63,000. So we lose about $11,000 if we sell after one year.
We haven’t yet considered the opportunity cost of tying up that $63,000 in a house. Because if we didn’t invest it in this house, we could have invested in something else. We assumed we could have earned 6% by investing in some portfolio of financial assets.
That would have returned nearly $3,800. So by buying this house and selling it in a year, we would put ourselves in the hole nearly $15,000.
Even after 2 years, we’d still be about $3,500 behind, given our assumptions. Of course, one of those assumptions is that real estate prices are rising. It’s almost certain they will in the long run, but will they rise in the next year or two? They may not in some markets.
We concluded that if we didn’t plan to own a house for at least two years, we’d rather rent. We also saw that the longer our holding period, the better we would do. For instance, in the last five years of the mortgage, only 15% of the mortgage payment would go to interest. It seems like buy-and-hold is rewarded in real estate investing.
We have two friends who have been able to get around the short-term ownership problem. One of them is in the military, so he moves frequently. He only buys a house that he knows would make a good rental property. If he gets transferred, he hires a local property manager and rents it out. Until he decides where he wants to retire, he plans to hold a number of his houses.
Another friend doubled-down on this strategy. He moved quite frequently as he climbed the corporate ladder. Not only does he own houses in a number of cities, he bought additional rental properties, so he has a diversified portfolio across a number of cities. Now he’s retired living off the rents!
So you can get around the disadvantages of short-term ownership by having an alternative exit strategy!
Next time, we’ll discuss how a toy that you probably played with as a kid can help you manage your time. Until then, here’s to your bigg success!
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By Bigg Success Staff
03-11-08
Bigg Success with Money
This is one of the most frequently-asked questions we get here at Bigg Success. The question comes in a variety of forms:
Should you make a payment every four weeks? Should you include a little extra with every payment? Or perhaps, you’ve had a windfall and wonder – should you pay it off in its entirety?
9 questions to determine if you should pay off your mortgage early
#1 – Do you have any other debt?
It’s highly likely that you pay less, after taxes, for your mortgage than you pay for any other debt. So pay that debt off before you start funneling additional money into your mortgage.
Look at it this way – you could put your money into an account that pays a guaranteed 20% after taxes or one that guarantees a 5% return after taxes. That’s an easy decision, isn’t it? You’re going to invest in the guaranteed 20%!
When you pay off debt, your return equals your after-tax interest cost. So pay off accounts that cost you the most first.
#2 – Do you have an emergency reserve?
Financial planners disagree on exactly how much you should have in reserve for emergencies. However, there seems to be a consensus of between three and twelve months of living expenses.
It depends somewhat on the source of your income. How secure is it? A stable job with a stable employer (is there such a thing these days?) means you need less of a reserve. For business owners and commissioned sales people, twelve months may serve you best.
#3 – How good is your credit rating?
Depending on how you do it, paying your mortgage off faster is great unless you end up with a month where you’re short on cash. Then you’ll hurt your credit rating. So consider building up money into a separate account that you use to pay your mortgage. As that account accumulates extra money, pay a little more on your mortgage.
At its essence, paying down your mortgage early is an investment in a very illiquid asset. If you don’t have good credit, you may be restricted in getting a home equity line-of-credit should the need arise. You’ll be better off building up your reserve account before you start paying down your mortgage.
#4 – How do you feel about debt?
Some people just can’t be happy as long as they have any debt. If you’re one of those people, and you’re satisfied with your answer to the previous three questions, by all means pay off your mortgage early.
If you have enough cash sitting around to pay it off in full, do it! If that’s not the case, start plowing any additional money you have into it. You’ll feel better just seeing your outstanding balance going down faster.
#5 – What’s your interest rate?
That last question considers your personal psychology. There’s no right or wrong – it’s solely your attitude.
If you can live with debt, then you look at this decision solely from the financial point-of-view – what’s your best financial move? Start by looking at your interest rate:
You’ll end up with the after-tax cost of your mortgage. Now you’re ready for the next three questions.
#6 – How disciplined are you?
How well do you do with extra money? If you tend to spend it, you’ll probably be better off paying off your mortgage early. That guarantees you the after-tax return you just calculated in the previous question.
However, if you’re a good money manager, your options are still open. Look at the next two questions.
#7 – When do you plan to retire?
Time is a wonderful thing. The longer your horizon, the higher your return will likely be on your portfolio if you invest correctly. That’s because you can invest in assets that may be more volatile in the short-run, but provide higher returns in the long-run.
In general, the longer it will be before you retire, the less likely it is that you should pay off your mortgage early. Now you’re ready for Question #8.
#8 – What could you earn if you didn’t pay off your mortgage early?
Most likely, you would invest in some combination of stocks and bonds (or mutual funds that invest in the stocks and bonds). In general, the longer it will be before you retire, the higher your stake can be in stocks.
Stocks tend to earn higher rates in the long run, but are more volatile in the near-term. Financial planners generally recommend that you should subtract your age from 120 (it used to be 100, but we’re living longer) to determine the ideal mix. Then look at historical returns on those assets as a barometer of your expected returns.
Now compare that to your answer from Question #5. It’s highly likely that your answer to Question #8 will be higher than your answer from Question #5. If that’s the case, you’re better off investing the money than paying off your mortgage.
#9 – Will your portfolio support your desired lifestyle?
Even if you’re better off investing, look at your current portfolio. Will it generate enough passive income to completely support your desired lifestyle costs? If so, why take any additional risk? Do the safe thing – get rid of your mortgage debt!
Once your mortgage is paid off, you can use that extra amount every month to build up your portfolio even more (if you want). Or you can just enjoy life – you’ve earned it because you’ve done a great job managing your money!
The advice we’ve given here is general. We recommend that you talk with a financial planner or CPA about your specific situation. Just be sure you find one that doesn’t have a stake in your decision. That way, you’ll know you’re getting the best advice for you, not them!
Pay them a reasonable fee for the advice they give you. It will be worth every penny!
Hear today's lesson and laugh on The Bigg Success Show.
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