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.

The Word on the Street:

Everyone seems to believe that the only way to get good credit to qualify for a necessary loan (usually a mortgage), they have to use credit cards, get auto loans, etc in order to get a good interest rate on future loans.

The Truth:

Your history of repaying debts is a relatively small portion of the considerations lenders make before offering to extend credit to a potential borrower. In short, a bad credit history can sink your hopes of getting a good loan, and a good credit history can certainly help, but a neutral (or non-existant) credit history will not preclude you from qualifying for a loan when it really matters because there are other, more important considerations.

Doubt me? Let’s take a look at the attributes and procedures used by lenders to determine a would-be borrower’s credit-worthiness.

The Three “C’s”

The only concern of the lender is your ability to repay the loan along with any related expenses. To assess this ability, lenders often look at the three C’s of credit:

Character

How you have handled yourself in previous financial dealings. This includes not only your credit history, but how reliably you have paid all of your financial obligations, including rent, utilities, alimony, etc. Your credit character helps the lender get an idea of whether or not you WILL repay the debt.

Capacity

Refers to your ability to repay debt out of your future income. Here, the lender looks not only at your income but also at future commitments that might restrict it. These commitments are almost always debts, although some commitments are non-debt related (such as alimony). Your credit capacity gives the lender an idea of whether or not you CAN repay the debt. This differs from the character portion of the analysis, where they simply want to see if you have been reliable in the past. In most cases, your credit capacity will be the most important factor that determines whether or not you qualify for a loan, for reasons that I hope will become obvious with an example.

Suppose you have the opportunity to loan money to one of two people. The first borrower, Jack, has a great credit history. He has carried lots of debt for a long time, and has never once failed to make his payments. The problem is, Jack spends most of his income on debt payments, and barely has enough extra income to make payments on your loan. The other borrower, Minnie, has only a small credit history. She has not debts whatsoever right now. A quick check show you that she has been very consistent in paying rent and utilities, indicating that she takes her financial obligations seriously despite having rarely incurred such obligations. She has plenty of money each month with which to repay you. Who would you give your money to? Personally, I would give it to Minnie because she actually has the ability to repay, and has not demonstrated a propensity for fiscal irresponsibility. Jack has managed his obligations well, but he has no wiggle room for your loan. The slightest mishap in his finances would cause him to lose the ability to repay you.

Capital

Refers to your financial strength, usually measured by net worth. Net worth is a financial term that simply means how much you own (assets) minus how much you owe (debts or liabilities). Essentially, this is a measure of how much money you would have left if you were to sell everything you own and repay all of your debts. This is an important consideration when looking at whether or not to lend money. If the borrower has extra funds or assets that he could potentially sell to repay the lender, then this reduces the risk that the lender will never get their money back in the event the borrower faces financial difficulty. Like the credit capacity rating, the credit capital rating measures whether or not you CAN repay the debt.

As you can see, only one of the three factors considered above pertain to your credit history and whether or not you WILL repay the loan. The lender is much more concerned about whether or not you CAN repay the loan, as measured by the capacity and capital components of credit-worthiness. Notice also that use of past debt is only a portion of the character component. In essence, it might be said that your use of credit in the past constitutes less than 33% of the considerations made when you apply for a loan.

This is not to downplay the importance of the character component. Certainly, if you took a test and missed 33% of the questions, you might be a bit disappointed in your score(well, I guess it depends a bit on which subject the test covered….66% might be a great score for some classes!). But it is important to realize that you do not have to go into debt in order to satisfy the charcter requirements. By simply showing that you have handled your finances responsibly, you can satisfy the character component.

How can you build your character score without going into debt? First is to take care of your obligations. Everyone has financial obligations, even if they have no debt. Pay your rent, make your utility payments, pay your taxes (and on time!). Next, take advantage of the fact that the three components are very interrelated. Your character score can be much improved by simply taking care of your capacity and capital scores. Think about it; if you see someone who has taken on a great deal of debt, and has maxed out credit cards, would it surprise you to learn that they had been evicted several times from various apartments? It wouldn’t surprise me. What if you saw someone who had a wad of cash in savings and whose income far outstripped their living expenses? Would you consider that person likely to take care of their financial obligations? I certainly would, and I would be much more inclined to lend that person money even if they had no past history of repaying debts. That person has improved their capacity and captial scores to the point where few would doubt their willingness to pay off their debts. And that’s what lender’s really want, isn’t it?

Risk and Return

The topic of investment risk and investment return could occupy an entire college semester (I have, in fact, attended just such a class). For the purpose of this post, I will just touch lightly on this topic to help you get an idea of how and why banks charge higher interest rates to some people, and not to others.

It is one of the most, if not the absolute most, fundamental principles of investing that higher returns cannot be gained without taking greater risk. In the stock market, higher risk is usually found in the volatility of a given stock; the chance it might go up by a large amount is offset by the fact that it might also go down by a huge amount. This principle becomes intuitive when we pull it out of the financial arena and bring it home in terms we see every day.

Suppose you were in Las Vegas with $100 in hand, and were considering which game upon which to place your bet. In one game, the dealer draws a card from the deck. If the suit of the card is a spade or club, then you win $200. If it is a heart or diamond, you win nothing. In the other game, a giant wheel with 100 slots in it is spun. If it lands on the number you picked, you win $200. Which game would you play? You would play the card game because it gives you the best chance (50% compared to 1%) of winning the same prize. Now let’s change the scenario a bit. Suppose instead of winning $200 on the wheel game, you had a chance of winning $1 million dollars. Now which game would you choose? It’s a harder choice, isn’t it? The card game is far less risky (because you have a 50/50 chance of winning), but the wheel game has a far greater reward. You would expect the games to be structured more like this because it doesn’t make sense for you to take more risk for the same reward, when you could take less risk and still get the same reward. This is the relationship between risk and reward(return), and it holds true in Vegas just as easily as it holds true in the stock market, the bond market, or even the mortgage market.

You are an Investment

You need to keep in mind that when you apply for a loan, the lender is not looking at YOU and deciding if YOU can have the money or not. They are looking at an investment, pure and simple. They want to invest their money in you. If you are a risky investment (i.e. with a low chance of repaying), then they will want a greater return in order to justify investing in you. They get that return by offering you a higher interest rate than they would to someone who was “less risky”. That is why it is important to make yourself appear as though you can repay them. If you look like you can repay them, then you most certainly can because lenders are very thorough and will find out if you cannot repay. So, when trying to qualify for a great interest rate on a loan, just think about what YOU would want to see in someone that you were considering loaning money to. Chances are, your lender will be looking for much the same thing.

The Word on the Street:

This is one of the big myths of our day. The myth holds that keeping a mortgage to its full term, rather then paying it down early, is wise because the homeowner can deduct the interest payments from his/her federal taxes.

The Truth:

Keeping a mortgage (or any other loan for that matter) for a longer period of time will always end up making the homeowner pay more in interest than can be saved in taxes.

Doubt me? Let’s run the numbers on three different size mortgages and see if I am right.

A Simple Truth

It always amazes me to think that there are professors and other people with PhD’s who cannot decide if this myth is true or not. I have crunched the numbers on dozens of different mortgages with a range of interest rates and tax brackets, and I have never found a mortgage for which this theory holds true.

In fact, when you look at it a different way, you can see that it is impossible for the tax savings on a mortgage to save you money while the mortgage is in force. It really boils down to a very simple truth about taxes.

Depending on your income, the government takes a percentage of your income as taxes. The higher your income, the higher the percentage they take in taxes. The idea behind the tax deduction is that you reduce how much of your income that the government taxes. So, if you pay 40% in taxes and you make $100,000 in a year, the government will take 40,000 in taxes. If, however, you have a mortgage and you deduct $10,000 worth of interest, then the government only takes 40% of $90,000, which is $36,000, a tax savings of $4,000.

But think with me now. In order to get the deduction you must pay interest. In the example above, the person paid $10,000 in interest, but only save $4,000 in taxes! This is the simple truth: in order to save $.40 on taxes, you must spend $1.00 in interest. The interest will always exceed the tax saving! To put it mathematically:

Tax Savings = Tax percentage * Interest Paid

And since the tax percentage is always less than 1, the tax savings is always less than the interest paid.

An Example

The following tables analyze a $200,000, a $300,000, and a $400,000 mortgage at 6% interest kept for the full 30 years, and for a shorter term if an additional $200 is paid towards the mortgage each month. The homeowner is in a 40% tax bracket.

You can see that the interest payment dwarfs the tax savings in every case.

Now let’s take the same graphs and combine the results. The yellow area in the graph below represents the positive cost difference between early repayment (ER) and paying to full term (FT).

As you can see, paying the mortgage down early will save you more money that you can save in taxes. This is the simple truth, no games or hidden tricks.

Another Perk

Another perk of early repayment of a mortgage is that you have saved time for investment. In the case of the $300,000 mortgage, a $200 extra monthly payment would chop about 7 years off the repayment time. That is 7 years that you get to enjoy your home payment free. That is also 7 years in which your income is freed up for investment. This is when you do your heavy hitting investing. With the mortgage gone, it is not unreasonable to invest the entire mortgage payment (a total of over $20,000/year). Investments like that add up fast!

It can’t be so simple, can it?

Well, when you boil it down to just the taxes and interest, it is that simple. However, many people endorse a philosophy of investing your extra money instead of paying down your mortgage. This philosophy has its merits, but is beyond the scope of this particular post. If you want to see reasons to keep your mortgage, then keep coming back, because this myth is next on our list!

To Be Continued…

The Word on the Street:

People often buy homes or other properties because they feel that rent is wasted money. They want to build equity in their homes as soon as possible, and that by paying rent they are “falling behind” in equity.

The Truth:

While it cannot be denied that money paid out in rent is in fact lost and will not yield any future benefit (besides providing shelter), there are reasons to pay rent. In fact, depending on how long you stay in a home, it can actually be MORE wasteful to buy a home.

Doubt me? Let’s take a look at some factors that weigh in on this subject and see what we find.

What is Equity?

One of my biggest grievances against the “rent is waste” argument is that the people who generally espouse and propagate this myth are real estate agents and mortgage brokers. One of their prime arguments is that buying a home builds equity and renting does not.  While this is true, it doesn’t tell the whole story.  There ways to build equity other than buying property. In order to how to build equity, let’s consider what equity is.

Equity:

1. The monetary value of a property or business beyond any amounts owed on it in mortgages, claims, liens, etc.
2. The interest of the owner of common stock in a corporation.
3. The excess of the market value of the securities over any indebtedness.

Websters.com

Simply put, equity is the positive cash value that belongs to you, whether it be contained within the inherent value of a property or whether it be in the stock market, savings account, etc. So you can build positive value and increase your net worth in other ways than in accruing equity in a property.

Disadvantages of home equity

Property equity is an asset much like a fine painting, a vintage automobile, or a rare Mickey Mantle baseball card; IT ONLY HAS MONETARY VALUE IF SOMEONE IS WILLING TO PAY FOR IT!! The only way to access your home equity is to sell the house or take out a home equity loan (which has its own dangers in addition to costing you interest). And when you sell the home, how much equity will you get? You don’t know. An appraiser can estimate the amount of equity that your home has, but until the deal closes and you get a check in your hand, you don’t know how much equity your home truly will give you.

Another problem with home equity is that it is much like any other equity asset; its value can go up or down. While most profitable equity vehicles also have this feature, sometimes it is forgotten that property values can go down. With the 2007 housing slump, this is a point that many Americans have learned the hard way. If the housing market turns sour (or the city build a dump next to your house!), there is not much you can do about your home equity unless you leave your home before the market hits its bottom. Other accounts can be moved or adjusted to try to protect your cash value.

Don’t get me wrong, I think buying a home is a great way to accumulate equity, and it does have some advantages over other equity vehicles. For starters, while it can go down, property value usually increases much more consistently than other accounts. There are always exceptions, of course.

Mortgages Cost

Have you ever looked carefully at a mortgage bill or an amortization table? No? Well, I have an amortization table right here. Let’s take a look and see what we find:

This is for a $200,000 30 year fixed-rate mortgage at a 6% interest rate, analyzed over the first year of the loan. Notice how much is paid in interest. The cumulative interest for the year is almost $12,000!! That’s about $1,000 a month that is lost as surely as rent is lost when it is paid. You only have about $2400 worth of equity in the home, plus any appreciation that the property experienced that year. If you pay a higher interest rate than 6%, then you pay even more in interest and have a higher monthly payment as well.

Compare the mortgage above with the following situation. You rent an apartment for $600/month. You could afford to pay the mortgage payment, but are not sure whether it is a good time to move into a home. Instead, you invest the difference between your $600 rent and the $1200 mortgage payment.

So, after 5 years, where would you stand on the rent vs. buy scenario above? Let’s see.

Mortgage:

• Interest Paid: $58,000
• Equity (no appreciation applied): $14,000
• Total Change in Net Worth: -$44,000 + appreciation on the property

Renting:

• Rent paid: $36,000
• Savings Account Balance (no interest applied): $36,000
• Total Change in Net Worth: $0 + interest on the account

As you can see, the net benefit of renting exceeds the benefit of homeowner ship, at least from a purely mathematical perspective. With renting, you would have received interest on your invested dollars, and with the mortgage, you would have received appreciation on the property.

Many first-time home buyers neglect to account for some of the other costs of homeownership. Things like state property tax and higher utility bills make homeownership just that much more costly without providing any equitable benefit.  Think also about the cost of maintaining the property (not to mention the annoyance of having to fix everything that breaks!).  These costs can be quite substantial, just ask anyone who has owned a home for a significant period of time. When you own your own home, there is no landlord to come fix the broken water lines, or to replace the furnace, etc. Paying to maintain the house does not generally increase the value of the home, unless improvements are made while repairs are going on.

The last word

I know it may sound like I am opposed to mortgages and homeownership. The fact is, homeownership can be one of the best ways to increase your wealth, not to mention the perks of having your own private home. But when considering whether or not to continue renting, don’t just discount renting as an option because it provides no property equity. Take a look at your situation. Crunch some numbers (or find someone who knows how to do it for you), think things through, try to find the hidden costs, and make an informed decision. Homeownership will benefit you greatly in the long run, but in the short term can leave much to be desired.