Myths On Money

The other night, I was reading Get Rich Slowly, one of my favorite finance blogs. I would like to lift a few of his comments from this fantastic post that illustrate why I LOVE personal finance, and what is truly important in our financial lives.

Freedom

To lift a quote from Get Rich Slowly:

“To me, life was all about the Stuff. I had hundreds of CDs and thousands of books. I had a TV, a stereo, a house, and a car. I wanted more. Sparky had none of these, but he had something I did not. Sparky had freedom. His frugal lifestyle allowed him to save and invest….
For some reason, I could not see the connection between Sparky’s thrifty lifestyle and his financial success. I could not see the connection between my own profligate ways and my mounting debt. I was blind.”

What is freedom? I think the idea can mean different things to different people, so I guess a better question would be: What does freedom truly mean to you? To me, freedom means that I can do as I wish. There is nothing (besides natural law) holding me down or constraining my actions. Nothing preventing me from fulfilling my every desire. Financial freedom is relief from servitude and slavery. I structure and manage my finances so carefully because I know that I am a slave, and I wish to someday find my freedom.

But slavery ended over 100 years ago, didn’t it? No, it didn’t. One kind of slavery did end after the Civil War, the kind we associate with cruelty, cotton plantations, and the Underground Railroad. But there is another form of slavery that has, rather than being stamped out, has been promoted, endorsed, and even celebrated in this country. The slavery I speak of is financial slavery, and it is a rapidly growing problem.

Think about it. Do you ever feel like your “stuff” owns you, rather than the other way around? Ever wake up in the morning wishing that you could just hit the snooze button and forget about work? What prevents you from doing so? Isn’t that what you would like to do on those mornings? I know I have those mornings. I don’t hit the snooze button for one very simple reason: I need money. I have rent to pay, groceries to buy, high-speed internet to pay for, burgers to buy, a car to fill up with gas. In short, my “stuff” is dictating my actions. I am going to work, (quite against my natural inclination) because my “stuff” demands it. So who, then, is truly in charge of your life? If you can’t take a day off because the car payment is coming due, then who is in charge of your life? Is it you? The bank? The car? Debt and excess are slavery, plain and simple.

I have structured my finances in such a way as to allow the maximum amount of freedom. I could switch to part-time work if I wanted to. I would certainly enjoy the extra free hours. I would have to sacrifice some other things to do so, though. Maybe the internet would have to go (a terrible thought!!), maybe we would have to eat ramen noodles and macaroni and cheese every day. But we could survive. We could pay our rent, keep the car filled with fuel, pay utilities, etc. The reason I could do such a thing is because I have limited the powers of my financial slave-masters. My rent is low. I have no car payment. I have no credit card debt. By stripping would-be financial obligations of their power, I have empowered myself. To a degree, at least. I would still need to work to get money, regardless of what I want. So I am not totally free, yet.

Since I only need a part-time salary to maintain my lifestyle, why do I work full-time? It’s simple. I CHOOSE to work full time because I want to get rid of all the forces that restrict my freedom. By spending significantly less than I earn, I am building my financial power. One day, that power will be enough to set me completely free. One day, I will have a home that has no payment on it, and investments that work for me to earn the income I need for my daily upkeep. When my money is working for me, rather than me for it, then I will be totally free, and I can use my time as I wish, and not as my creditors demand. That’s my financial dream. I want the right to CHOOSE to work how I want, when I want, as much as I want, for any pay (including $0). If I want to go on a vacation, I will need no one’s permission to go. I will just pack up and go. If I want to sleep in, then I will. If I wish to rise early, then I will. To be the master of my own time, to use it as I wish, oh what a joy that will be.

One of my favorite quotes, to sum up:

“Normal is getting dressed in clothes that you buy for work and driving through traffic in a car that you are still paying for – in order to get to the job you need to pay for the clothes and the car, and the house you leave vacant all day so you can afford to live in it.”
- Ellen Goodman

My friends, BE EXCEPTIONAL.

Money is not Wealth

From Get Rich Slowly:

“Please, my friends, always remember that true wealth has nothing to do with money. True wealth is built from friends and family, from experiences and relationships — it is derived from a life filled with meaning. Without these things, money means nothing. “

To this I would add that “stuff” means nothing. It doesn’t matter how shiny and new your car is. It doesn’t matter how dented and “economical” your car is either. It doesn’t matter how expensive of a gift you give. It doesn’t matter when your home was built, how big the yard is, how nice the granite countertops look. These things are not the source of happiness. Happiness comes from “friends and family, from experiences and relationships – it is derived from a life with meaning” and a life of freedom. Own your own life. Take control. Tell the advertisers that you don’t care that the Jones’ drive a better car, have a bigger house, throw bigger birthday parties. Tell the credit card companies that you will not be their slave and tell the banks that you will no longer work for them. Tell the Jones’ to join you on your way out of slavery and into freedom. As one who is living the frugal and “uncool” lifestyle, I can tell you that it is worth it. The greatest rewards are the furthest away, but the rewards of peace of mind and, yes, even freedom, that you will find the first day and onward make the small sacrifice worth it all by themselves.

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.

This post is written in response to a question that a friend of mine asked. Here is his question:

Question:

When I think about rent VS buying I often think back to those dental students in [Ohio]. They bought condos, lived in them for a few years and then sold them. In most cases they sold them for a lot more than they paid because some of them made improvements to the property. Even the ones that didn’t were able to sell them for about 5-10k more than they paid. Rent would have to pretty low to make it better than buying from limited perspective.

Please show me where my thinking is wrong on that. I’m going to be in a position to make the choice between buying and renting quite soon. I always thought buying was the answer, but now I’m confused.

Before reading on, you may want to reread the post that illicited this comment. It may also be useful to consider all the cash flows.

Answer:

• Don’t Rush
• Consider All the Costs
• An Example
• The Nutshell

Don’t Rush

First off, do not think that I am trying to convince people not to buy a home. That’s not my point at all. Buying a home is a great way to build your wealth, and over the long term will almost certainly be better than renting. The point I am shooting for here is that people should not RUSH into buying a home just because REALTORs are advertising that renting is a waste of money. Rushing into any decision is a great way to make the wrong one. If you buy a home without considering every cost associated with buying a home, then you may find yourself overextended.

Homeownership is a great financial decision. But, it also happens to be the single biggest financial decision you will ever make. The reason that my posts seems in favor of renting is because there is no end to the people who are willing to promote homeownership, regardless of the cost to you. I think that buying a home is the best decision for most people. But it must be done under the right circumstances and at the right time, with a careful eye for the terms of the loan. More on the terms of the loan in a later post.

The problem with most people’s financial decision making process is that they limit their perspective. If you only look at the gain at the time of sale of the home, and ignore all other expenses and gains, then you will make a poor financial decision.

Consider all the costs

So what are the extra costs that people do not usually think about? First, closing costs. Closing costs typically will cost the buyer 3-7% of the amount of the loan. Next, selling costs. Selling costs vary a lot, and sometimes do not even exist, but if they do exist, then they will cut into your gains when you sell the home. Finally you have expenses that you incur while owning the home. These include property taxes, cost of maintenance and repairs, homeowner association fees, mortgage insurance, property and liability insurance, etc. Most experts agree that these costs usually amount to about 40% of mortgage payment.

An example

A hard, numbers-oriented example. Suppose a dental student buys a $150,000 condo, and lives in it for 5 years. He pays 9% interest on his mortgage. His condo appreciates at a rate of 6% per year. His monthly payment is $1,200, so his property taxes, condo fees, insurance premiums, and other expenses total $480 (40% * $1,200) each month. He has no selling costs. So, after 5 years, what did he gain? His condo’s appreciated value is $200,000, so he has gained $50,000 in only 5 years! If you ignore the costs, then you think, “Wow, he just got $50,000. I’m never renting again!” But what did he pay? He has paid $67,000 in interest, $29,000 in monthly expenses, and $4,500 in closing costs. So his total cost of owning the condo is $100,500 for those 5 years. So, did he make $50,000? Nope. He LOST $50,000.

But wait, we’re not done. You think, “$50,000 lost? I’m never buying a home!” But that’s not true. What would you have lost if you had rented? Suppose the student could have rented a comparable apartment for $1,200/month. So what did he gain? Nothing. No income. What did he spend? $72,000 ($1,200/month * 60 months). So the renter LOST $72,000.

So the student should buy, right? Well, if you limit your perspective to just that, then yeah, he would want to buy the condo. But there is a problem with this analysis. The problem is that the condo buyer has spent $1,680 a month (mortgage payment plus other expenses), while the renter has only spent $1,200 a month. Making a financial decision based upon different expenses like that is like comparing a motorcycle to a car on the basis of horsepower. A motorcycle will have less horsepower but be faster, right? The difference is in the weight of the vehicle.

Same thing here. So, what if the renter also spent $1,680? $1,200 in rent, and $480 to be saved. Even if his saved money earns no interest, he would have $29,000 in the bank. So, the renter would have lost $75,000 in rent, and gained $29,000 in savings, so his total loss would be $44,000. So, in this case, the renter would be better off than the condo owner.

But that only applies to THIS EXACT SITUATION. What if the appreciation of the condo were higher? Then buying is the better decision. What if the renter can earn a good interest rate on his savings? Then the renter wins. What if the monthly expenses of ownership are lower than 40% ? Then the buyer might be better off. This is why finance is a 4-year degree. This is why they offer masters and PHds in finance. Every situation is different. Every situation needs to be carefully analyzed. And it can get very complex, very quickly.

The Nutshell

You probably should buy if:

1. Real estate prices are appreciating at a high rate.
2. You can afford to pay more than the mortgage payment on the house (40% more).
3. You plan to be in the home at least 5 years.

You should probably rent if:

1. The mortgage payment is barely affordable.
2. You have the opportunity to save your money at a decent interest rate.
3. Local real estate prices have historically risen slowly.

If your situation falls somewhere in between these two categories, then a more thorough analysis is needed to give an accurate decision. If you can do this yourself, then great. If you can’t, you could find someone trained in finance to help, or you could just eyeball it. Just remember to include all of the relevant benefits and costs and you should come out fairly close. Remember that 5 years is a typical time frame for buying to be profitable. If you don’t know anyone who can run the numbers, just let me know and I would be glad to help.

Lastly, remember a financial loss is sometimes worth the satisfaction of home ownership!

A Shocking Discovery

I was recently watching a financial self-help video from a very popular finance guru, and I was shocked to hear this person say that buying a home was a great investment because it would yield a very high return in the first year that it was owned, and that it would continue to give high investment returns throughout the life of the home. This is surprising, because any one well grounded in finance would be able to tell you that a home is a very very bad investment for the first 3-5 years. It is not until after that time range that the home’s appreciation will begin to actually give a positive investment return.

How Could They Miss?

If the point of the high cost of a mortgage and the need for longevity in a mortgage are such a fundamental principles, then how could the guru have possibly missed it? The answer lies in the cash flows the guru used for the analysis. See, from a certain perspective, the guru was right. But it’s not the whole story. It’s kind of like in Star Wars, when Luke accuses Obi-wan of lying about his father’s death. Obi-wan tells Luke that what Obi-wan’s statement that Luke’s father had died was true, from a certain point of view. And it was. But did Luke realize that he was not hearing what he thought he was hearing? No. He thought that his father was physically dead, while Obi-wan meant that he was dead in a less literal sense. So, while what Obi-wan had said was true from a certain perspective, it certainly succeeded in deceiving Luke. Such is often the case in finance. What you hear may be true from a certain perspective, but it is still deceptive and does not tell the whole story of what is happening to your wealth.

So What Is Happening?

Before I can answer the question of what is really happening and what return you are getting from your investment in your home that first year, I first need to explain a financial tool called a cash-flow diagram. The diagram is fairly simple: it consists of a horizontal line with vertical hash marks all along it. Each hash mark corresponds to a specific time period (ie a month, a year, etc). The diagram must be consistent in that each hash mark must represent the exact same amount of time that each other hash mark represents. On each hash mark, the relative cash flows for that period of time are listed. A cash-flow diagram helps us visualize where the money is flowing, when it is flowing, and which way it is flowing (in to your pocketbook or out of your pocketbook).

With that brief introduction, let’s take a look at the two cash-flow diagrams below. Here’s the scenario: you make a $10,000 down payment on a $160,000 house, meaning that you must borrow the remaining $150,000. Closing costs (typically ranging from 3-5 percent of the balance of the loan) come out to $6,000, a conservative 3% of the loan amount. The home appreciates 4% the first year that it is owned. The top diagram shows the full, actual reality of what the calculation of mortgage returns would look like; the bottom one illustrates a diagram like the one the guru was using for their analysis.

The areas highlighted in yellow are cash-flows which the guru neglected to account for. Notice that in the top analysis, we have taken into consideration EVERY expense and EVERY income associated with the mortgage. In both cases, the final amount of equity in the home that you get when you sell the home is the same, but the amount of the expense is different. The difference in the “investment return” is 138%!

Okay, time to break out the ol’ thinking cap. A negative investment return means that you are losing money at that particular rate. In order to get an idea of the implications of this loan, think of the cash-flows above as a savings account. If you put $16,000 (the $10,000 down payment plus the closing costs) in a savings account today, and deposited $997.95 into that account every month and you only had $17,923.71 in that bank account at the end of the year, what would you think? You deposited almost $38,000 between the initial deposit and the monthly deposits. And at the end of a year, you have less than half of what you deposited in the first place. Wouldn’t that make you mad? I know I would be calling the bank and giving them an earful if my savings account exhibited such behavior!

This is why it is so very very important to consider all cash-flows associated with a purchase/investment. I am not trying to say that buying a home is a bad thing to do. I am only trying to show the importance of understanding and applying the effects of all relevant cash-flows when considering an investment. Suppose you had gone in to the bank and your mortgage officer had told you that you could earn a 79% return on your home in one year. Before you read this post, you would probably have believed him, wouldn’t you? But that fact remains that, while the equity growth from $10,000 to $18,000 is indeed 79%, it does not really tell the whole truth. What about the expense of closing costs? What about the interest expense? Shouldn’t that be considered? Isn’t that important? Doesn’t that strongly affect the investment returns your home is providing? Absolutely. So before you jump into a financial decision, stop and ask yourself the following questions: (1) What will it cost me, both now and in the future? and (2) What will I get (income) from it, both now and in the future? If you do that, you will find yourself making much better financial decisions. And if you can’t figure it out, or what a specific calculation in regards to your decision, then ask a (unbiased!) financial professional for help.