Myths On Money

The Word on the Street:

I still struggle to convince people that paying rent is not a purely wasteful practice. I have already done several posts on this topic.

The Truth:

Paying rent can be cheaper than getting a mortgage, and the difference in the cost can be invested to your ultimate gain. While I support the idea that most people would benefit from buying a home, I want to emphasize that no one should rush to buy simply because they don’t want to “waste” their money paying rent.

• A Quick Distinction
• A Waste?
• A New Perspective
• Real Estate As An Investment

A Quick Distinction

First off, I want to make a quick point of clarification. Renting an apartment can be much cheaper than taking out a mortgage, but renting a full house may or may not be cheaper. Personally, I think renting a home is not a very good decision, and should only be approached under special circumstances or at necessity. Because of the square footage you are renting, the cost to you to rent a home cannot be much less than paying a mortgage, so if you are going to be paying that much, you may as well get some equity out of it.

That said, if your rent is less than what you would pay for a mortgage, then renting is a viable option that ought to be considered.

A Waste?

So, is paying rent a waste? People often ask, “I paid all this rent, and what did I get out of it? Nothing!” But is that really true? Do renters truly get nothing from their rent payments? To answer, let’s look at a similar situation.

Suppose your family pays $200/month for groceries. At the end of the grocery run, is your net worth increased? Nope. Your net worth has decreased because you now have less money in your checking account. So buying groceries is a waste, right? Please say no. For your money, you got food, and food is necessary to life, so you could argue that buying groceries is a fantastic investment ($200 invested and you get back a month of life for your family, how can you measure THAT return?)

So it is with rent. You may not be getting any DOLLARS back, but the need for shelter is as vital as the need for food. So, for your rent, you are purchasing shelter. So it’s not a complete waste, just as buying groceries is not a complete waste. It is simply a necessary purchase.

A New Perspective

In a very real way, you can think of your mortgage payment as consisting of two parts: one part covers the cost of providing shelter, the second part is an investment in real estate. The interest that you pay every month is exactly like paying rent, with only one significant difference (to be discussed later). The principal portion of your payment is exactly like depositing money into an investment, again with only one significant difference (also discussed later). So, if your interest is just like rent, and your principal is just like an investment, then why not pay rent and make an investment? In the end, the result would be very close to the same.

Examine the chart below for an illustration of what I mean:

Notice the amount of interest paid versus the amount of rent paid. In the earler months of the mortgage, the interest is higher, leaving less to invest. But, over time, the interest expense decreases, thus freeing up more of your money to be invested in your home as equity. This is the fundamental difference between rent expense and interest expense. notice that it takes almost 7 years (83 months) for the interest expense to become less than the rent expense. So, for 7 years, you are “wasting” more money on interest than you would have on rent. After that point, the situation reverses. This is one reason why it is so important to keep a mortgage long-term; you need the late years to make up for the high expense of the early years.

So, if a portion of your mortgage is going towards an investment, what investment is it? It is your home. You are putting money into your home as equity. Simply put, you are investing in real estate.

Real Estate As An Investment

From EzineArticles.com:

Have the historical returns on Real Estate Investment measured up to the confidence it has received?

The answer is a cautious yes. Between 1926 and 1996, the annual average rate of return on Real Estate was 11.1%. During the same period the rate of inflation was around 3%. So, it was obviously a better investment to buy Real Estate than to bury cash in jars in your backyard. However, the rate of return for small stocks checked in a bit higher at around 12% while the Dow Jones Industrial Average was a bit lower at 10%. These figures would suggest that Real Estate investments were right there at a par with Stock Market Investments.

So, you can see that real estate investments enjoy similar returns to the stock market, so either investment would be a good choice. However, there are some differences between them. Perhaps most important is that real estate investments are not as easily converted into cash; this convertability is calledliquidity. If you have a large store of home equity, the only ways to access that is to sell the house or to take out a home equity loan (which would cost interest and thus reduce your net gain on the home). On the other hand, stocks (and bonds for that matter) are generally quite easy to convert into cash. The downside with stocks is that they experience a much higher degree of volatility in the short term. So they may be temporarily low in value when you have to cash them in. Both investments carry risk. The type risk each carries varies. Both investment types carry expenses. Again, the type and magnitude of these expenses can vary.

The important point to carry away is that both renting and home ownership present the opportunity to provide shelter, and that they both have room in them for you to save your investment in some kind of investment vehicle. Bear in mind also that the rent vs buy decision is not a decision that you make only once. At some point, renting may be better for you, but that may change next year or the year after. The key factor in the rent or buy decision is your time frame. If you are going to live in a place short-term, then renting is likely the better choice. If you are settling in for many years of living, then home ownership is likely the better choice.

P.S. Thanks to my Facebook Group for the inspiration for this post! Anyone is welcome to join.

Question:

My bank is currently offering a 3 month CD that pays a 4% APR. Does that mean if I buy a $5,000 CD, it will pay me $200 after 3 months?

Answer:

• Short Answer
• APY Defined
• Other Rates
• Using Rates

Short Answer

The CD will not pay you $200. It will pay you $50.16.

APR Defined

APR is an abbreviation that stands for Annual Percentage Rate. The key point to emphasize is ANNUAL. This is the rate of return for a given investment spread over a year. Since this particular CD is only open for 3 months, we have to convert the annual rate. We will convert it to a monthly rate, and then add up the interest earned over 3 months. To convert an annual rate to a monthly rate, simply divide it by twelve. This means that 4% APR is the same as a 1/3% monthly rate. 1/3% of $5,000 is $16.66 each month, and for three months that gives us a total interest earned of $50.

Other Rates

Anyone notice something strange here? In the short answer, I said that the CD would pay $50.16, but in the previous section we figured it would pay only $50. What’s the difference? The difference comes from the power of compound interest.

The calculation of $50 in the APR section was a calculation of SIMPLE interest earned, but our CD pays COMPOUND interest. What’s the difference? See, in the first month, the CD will earn $16.66. This means that starting month 2, our CD has a value of $5,016.66. 1/3% of $5,016.66 is $16.72. The interest earned went up because the interest from the first period also earned interest. In the third month, our CD is worth $5,033.38. 1/3% of $5,033.38 is $16.78. So after our interest has earned interest, we are left with $5,050.16. Pretty cool, huh?

But what if there were an easier way to calculate the effect of compound interest? Sure, $.16 is not a large amount to be off, but what if you were calculating your mortgage, or your retirement? The effect of compound interest is much stronger over longer periods of time. Fortunately, there is usually a very easy way to determine the exact effect of compounding. This is done through the use of effective rates. An effective rate is a rate that factors in the effect of compounding to allow you an easy way to figure your exact return from an investment. There are many types of rates, from nominal to real to effective, from yields to rates, and it can be very confusing to determine which number you should be most concerned with. Well fear not. Below is a quick list of the most common terms you will find used in the financial world to describe interest rates:

APR

The annual percentage rate is the interest rate that is used to calculate the payment on a loan or an investment. This number is based on simple interest, and does not include the effects of compounding interest. Therefore, it can be used to give only an estimate of interest earned/paid.
APY

The annual percentage yield is the annual rate that factors in the effects of compounding on your interest earned/paid. It is used to calculate the precise amount interest on an investment or loan. If you want to know exactly what your investment will pay, use the APY as your interest rate. In the case of the above example, you could use the APY of the CD (which the bank probably provides) instead of the APR and calculate the interest the same as we did in the “APR Defined” section. This would providde you the precise interest earning of the CD. APY is more frequently used for interest that you

EAR

You will usually see this one on the same page as the APR for a loan, credit card, etc. You may have noticed that the EAR is always higher than the APR. This is because the EAR is the effective annual rate, and it takes into account the effect of compounding interest, fees, charges, and time. This is the rate you should use when comparing two loans. And remember that the EAR is the true cost of the loan, not the APR. The APR understates the true cost of the loan.

Is everyone thoroughly confused? Well, don’t stress about all these terms too much. You don’t have to memorize all these terms and what they mean and how to calculate them. What you need to be focused on is just one thing: Effective rates tell you the true cost of a debt, and APY tells you the true gains of an investment. When looking at a loan, look for the effective rate. It will probably be listed simply as the EAR. A CD or savings account may or may not tell you the APY, but you can at least use the APR to get a close estimate of your investment gains. If you are fortunate enough to be given the APY of the account, then use that instead of the APR to get a much more accurate picture of exactly how much interest you will earn.

Good News!

If you follow the blog regularly, you know that posts have been a little scarce lately. There are two reasons for that: first is because the blog was getting a facelift (which is hopefully now completed [sorry Chrome users, you might want to use IE or Firefox to view the blog]), second is because I have been devoting considerable time and effort to creating a few new tools for you to use in your quest for financial empowerment.

Rent vs. Buy

Probably the most useful (and by far the most difficult to create!) is the “rent vs buy scenario analyzer”. As past posts have indicated, this is a difficult question to answer broadly for everyone. Well, if you struggle to make this very-important decision, then go to the
downloads page and download the “rent vs buy scenario analyzer”. I have tried to construct this calculator is such a way that it can incorporate nearly all of the variables that enter into a buy vs rent scenario analysis, without complicating it beyond the point of useability. So go ahead and give it a try. All the instructions are included in the spreadsheet.

Debt Snowball

Finally, my debt snowball calculator is complete! I am actually very proud of this particular spreadsheet. I spent MANY hours honing and polishing and perfecting it. You can choose from one of several methods for determining which debt to pay off first. Just enter your debts, then select the method that works the best for you. It will tell you how many months each debt will take to pay off, the total time it will take to get out of debt, and what your savings account will look like if you continue to invest what you used to pay towards your debts. Instructions included.

Retirement Accounts

The next new tool is designed to help you determine if it would be more profitable to invest in a Roth-type of retirement account, or in a non-Roth account. Enter your monthly deposit, current tax rate, and other info and it will estimate your total balance at retirement age. Don’t worry, I even did the research to help you find the tax rates for you! As always, all the instructions for this spreadsheet are included in the spreadsheet.

Free Cars

I updated the spreadsheet for the “free car” savings plan Mostly just polish and additional information to make it more user-friendly to improve it’s ease of use. Check it out.