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.

Watch this first

(if you are having trouble viewing the clip, you can try going to the YouTube clip directly)

Personally, I think this video is fantastic. I wholeheartedly endorse the principles discussed here.
The principles that Dave Ramsey teaches in it are fantastic. How does this system work? Easy. No interest is paid. Instead of paying interest, you save that money and put it into your next car. Piece of cake. This is why debt is not your friend. Your monthly payment on the car isn’t really telling you what you are giving up.

What I would like to point out is how this illustration is effective only for the exact terms used. It assumes that you invest a full $464 a month at a constant 12% interest rate. And that’s great. There’s nothing wrong with that assumption. But if you want to run the same system yourself, and only save $200 each month at 4%, you may be surprised to find that you can’t upgrade the quality of your car quite so quickly.

This is why it is important for everyone to understand the basic principles of finance. Every situation is different and will yield different results from any other situation. So, what should you do? You should run this system for sure. You will save hundreds of thousands of dollars in car payments over the course of your working life. But, to minimize the number of surprises you encounter while operating this plan, you should run the numbers for yourself, for your situation. By doing so, you will be sure that your plan will run smoothly.

A Helping Hand

It just so happens that I have created a spreadsheet that you can use to create your own free-car plan. Ready? Then download it now to get started!

Okay, I may be guilty of perpetuating a money myth. In my post you must use credit to get credit I am afraid I may have given the impression that the quality of your credit history and score is not an important consideration for lenders (see how easily these myths can spring up?). That was not the point of the post. The point of the post was to show how important it is to make sure your income exceeds your expenses by fair margin, and that by using credit heavily, you reduce your available income and thus hurt your credit worthiness in the eyes of lenders. However, your credit score is a very important factor in your life. It can affect your work, your insurance rates, and, of course, your credit worthiness.

Tricks of the Trade

Your credit score is a strange creature. The most bizarre things can hurt it, and even more bizarre things can improve it. Let’s take a look at some tricks of the credit scoring game.

1. Increase your credit limit. An important factor in your credit score is a ratio called the “debt utilization ratio”. This ratio is calculated by the following formula: 
   Debt Balance ÷ Available Debt
   For example, if you have two credit cards each with a credit limit of $2,000, then your available debt is $4,000.  If you have a balance of $300 on one card and $700 on the other, then your debt balance is $1,000.  This would give you a debt utilization ratio of $1,000 ÷ $4,000 = .25, or 25%.  Generally, the people who keep their debt utilization ratio around 10%-20% have the best credit scores. A low debt utilization ratio shows lenders that you use your credit wisely, not excessively.  Just make sure that you are making prompt payments!
2. Don’t wait for your bill to pay down your card. The credit card company reports the balance on your credit card to the credit reporting agencies at the time that they process your monthly bill. If you have a high balance at the time the bill is printed, then that is the balance that goes on your credit history, regardless of when you pay it off. So, if you have a high balance and pay it off after you get your bill, the high balance will still hurt you. Go check your card online and make payments on it, even when your bill has not been sent to you yet.
3. Keep a small balance on your card when your bill is processed. If you pay your credit card off comlpetely right before your credit card company sends you your bill, it will show a zero balance when they submit the bill to the credit reporting agencies. By keeping a balance on the card to show up on the bill, you how that you are using your credit, and by keeping that balance small you prove that you are using it wisely. After the bill has processed, immediately pay off the remaining balance so that you don’t have to pay any interest. A good strategy would be to make regular payments to your credit card and keeping the balance always below 20%, and making sure that you pay the full balance after your bill is printed. By doing this, you will improve your credit score quickly, and you won’t have to pay any interest.

Be Careful

What creditors are looking for in your credit score is evidence that you are in control of your own finances. If you cannot have a credit card and remain in control of yourself and your spending, then do not use credit cards. If you do, your lack of control over your finances will be evident and you will have a poor credit score. Be careful to not get carried away by credit, because it is very tempting to some. Don’t be fooled by the low payment the credit card requires. Always pay your card off in full each month, never ever pay interest on a credit card unless you absolutely must. Maintain control of yourself and your finances, keep a close watch on your credit history and your credit card balances, and watch your budget and expenses. If you do so, you will eventually find yourself living the lifestyle you have always wanted.

The Word on the Street:

Everyone wants to have possessions as fine and expensive as their neighbors do. Most people try to spend in such a way as to ensure that they appear no different than “everyone else”.
 

The Truth:

While it is totally possible to keep up with the Jones’, do not do so without an understanding of where it will lead.

The Destination

 
If you keep up with the Jones’, that means that you must be on the same track. Where the Jones’ track leads, you will go. So what exactly do the Jones’ get in the end? John Cummuta, in his Transforming Debt into Wealth system, cited the following fact:

95% of American’s FAIL to achieve a true definition of finanical independance, where they are independent of having to work or get charity or help from the government or help from family members…What does that mean? It means that most people, the Jones’ for example, are doing it wrong…The Jones’ are chasing a barely achievable, unsustainable model of success.

If the 5% who achieve financial independance are spread equally among people of all income levels, that implies that only 2.5% of people with above average income (about $60,000 in the U.S. for a family in 2006) actually become financially independant. Why not? Because they spend all their money before they have a chance to earn it trying to buy a lifestyle that they cannot yet afford. So, you can keep up with the Jones’ if you want, but beware: they may be leading you into bankruptcy.