If you fail this test, you don’t understand money.

[Matt]

That’s fine though, failure is needed on the path to success. If you feel strongly about this I advise you to:

• Argue.
• Listen.
• Change.

I promise to do the same.

You should not accept anything that is written as the truth, you should seek to challenge it. In the end you will either confirm your hypothesis or refine it. Either way is a win.

Here goes…. do you agree with this flowchart?

Equity Flowchart

This flowchart is something everyone seems to agree with. But it shows a massive disconnect of financial intelligence. The problem: Most people who are invested in stocks have debt. It might be in the form of overt debt, such as a loan (Mortgage, Student Loan etc) or covert, such as an obligation to assist a child through college or a parent through retirement.

The chart here says it is clearly ‘silly’ to take out home equity to invest in stocks. But that is really saying you should not invest in stocks while you have debt. Too tantric for you? Let’s look at home equity as a concept first.

• A home is not an investment. It is a vehicle for storing equity and debt. Fringe benefits of ownership is shelter need. Frequently, home owners in start out with an equity:debt ratio of around 25:75. That means on a $400,000 home you put $100,000 down and borrow the remainder as mortgage.
  • If the home appreciates in value by $100,000 the equity is now $200,000, the loan remains $300,000 and the equity:debt ratio has become 40:60.
  • If the home depreciates in value by $100,000 the equity is now zero and the loan remains $300,000. The equity:debt ratio is 0:100. Should the price depreciate any further the loan is considered ‘under water’ because the loan is more than the resale value of the property.

Example 1 (the person the chart is aimed at)


The home appreciates to $600,000. Equity is now $300,000, loan is $300,000. 50:50 ratio. Advice is ‘don’t take out equity to buy stocks’. Everyone agrees.

Example 2 (why this chart is illogical)


A person who cannot afford a home purchase has no home equity, therefore can invest in stocks.

Example 3 (another example – using me)


My equity ratio is 100:0. If I pull out a a chunk of money, my home equity ratio will still be better than a person starting out. I’ll have a mortgage, and a let’s say $200K in cash.

What advice would you give?


If you saw a person with a reasonable equity:debt ratio, and say $200K in cash, would your advice be ‘you should NOT invest in stocks, you MUST pay down your mortgage!’ or would you instead compare opportunities for the money?

Let’s take this further… lets compare two hypothetical people:

• Person A buys a house with 33% downpayment ($100K) and has $200K in stocks
• Person B buys a house with 100% cash ($300K) and has no stocks.

Which person is smarter?


This flowchart states that if Person B was to become Person A he would be an idiot… in that case, we can surmise that according to this chart you should not be invested in stocks until your mortgage is paid off in full.

Now, I’m not saying whether I agree with that or not, but you should ask yourself, if you think that flowchart is so awesome, what are you really saying…

Conclusion


This is a massive financial concept. It ties into my talk at TravelCon about being able to view financial decisions holistically, and not in isolation. If you look holistically at Person A and B in the final example their net worth is identical. As such, if one cashed out equity from their home they would still appear to be in a strong financial position.

The holistic view in this example should compare opportunity cost between low cost borrowing and high risk investing. The correct path will be subjective, but not as silly as that flowchart makes it appear. For that reason, this flowchart is silly. It looks only at your home as an investment vehicle and doesn’t consider overall wealth. Once we understand these concepts we can decide when investing in stocks is a good idea.


The post If you fail this test, you don’t understand money. appeared first on Saverocity Finance.

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[Sesq]

When you are a hammer all of the world is a nail.

I am paying off my debt faster than I really should based on prevailing interest rates but I would hate to have passed up years worth of chances to fund tax sheltered accounts, receive matches, etc just to erase a liability.

 

[Annie H.]

Let’s take this further… lets compare two hypothetical people:

• Person A buys a house with 33% downpayment ($100K) and has $200K in stocks
• Person B buys a house with 100% cash ($300K) and has no stocks.

Which person is smarter?


.

Last Friday, person B was smarter. Today person A is smarter. You propose an interesting concept and it makes sense but there are lots of other factors and especially time horizons.

Reminds me of the: Would you drive an hour to buy a car that cost $30K in your hometown but only
$29, 700 in a town an hour away? versus-- would you drive an hour for a free $300?

not exactly the same but aren't we getting into ‎Dan Ariely and behavioral economics?

 

[Free-quent Flyer]

I wanted to bump this thread after reading the Kitces article @Matt recently posted on Twitter (article itself is from 2012): https://www.kitces.com/blog/why-keeping-a-mortgage-and-a-portfolio-may-not-be-worth-the-risk/

Here's the nut graf:

"Which means in practical terms, the mortgage borrower shouldn't avoid pre-paying the mortgage and investing in stocks simply because equities are expected to earn a higher return. If the borrower is going to be compensated for the risk of the investment, the borrower shouldn't direct money towards stocks unless expected to earn the mortgage interest rate plus a 5% risk premium."

What I want to draw attention to is not the expected return on riskier investments like stocks (the article is obviously directed at people who think they know how much stocks will return on a risk-weighted basis and I have not even the vaguest clue how much stocks will return on a risk-weighted basis), but rather how this logic breaks down when you have access to FDIC-insured high-interest savings accounts. If you are borrowing at less than 5% APR and saving in FDIC-insured accounts at more than 5% APY, then you absolutely should consider paying down your mortgage as slowly as possible once you've reached the point where the balances in the accounts are the same. If you have access to $60k in FDIC-insured savings, that means even if you paid down your mortgage aggressively until it reached a $60k balance, you should then proceed to make only the minimum payments, and direct the additional funds into other savings vehicles (or H&B, obviously). If you have access to $120k in FDIC-insured savings, the same applies once you've paid your mortgage down to $120k (if you're married, for example).

This is a very small amount like buying a house and then renting it out to cover the mortgage payments, but in that case you still need to earn a return that's adjusted for the riskiness of your tenant. In the case I'm describing, you're simply allowing the banks, prepaid cards, and credit unions that offer high-interest accounts to pay your mortgage for you, since the accounts are insured by the government, which is to say you shouldn't need to be offered any risk premium at all.

 

[janol]

turn this around and ask question, should you use your investment porfolio to buy real estate, in 2002 I did just that, I borrowed 100k from my brokerage acct to buy a 400k home, held it for 6 months and sold it for 480k, a 55K net profit on a 100k investment in 6 months.

 

[Matt]

turn this around and ask question, should you use your investment porfolio to buy real estate, in 2002 I did just that, I borrowed 100k from my brokerage acct to buy a 400k home, held it for 6 months and sold it for 480k, a 55K net profit on a 100k investment in 6 months.

Let me turn that around again.. why is your (successful) example 13 years old?

 

[Matt]

I wanted to bump this thread after reading the Kitces article @Matt recently posted on Twitter (article itself is from 2012): https://www.kitces.com/blog/why-keeping-a-mortgage-and-a-portfolio-may-not-be-worth-the-risk/

Here's the nut graf:

"Which means in practical terms, the mortgage borrower shouldn't avoid pre-paying the mortgage and investing in stocks simply because equities are expected to earn a higher return. If the borrower is going to be compensated for the risk of the investment, the borrower shouldn't direct money towards stocks unless expected to earn the mortgage interest rate plus a 5% risk premium."

What I want to draw attention to is not the expected return on riskier investments like stocks (the article is obviously directed at people who think they know how much stocks will return on a risk-weighted basis and I have not even the vaguest clue how much stocks will return on a risk-weighted basis), but rather how this logic breaks down when you have access to FDIC-insured high-interest savings accounts. If you are borrowing at less than 5% APR and saving in FDIC-insured accounts at more than 5% APY, then you absolutely should consider paying down your mortgage as slowly as possible once you've reached the point where the balances in the accounts are the same. If you have access to $60k in FDIC-insured savings, that means even if you paid down your mortgage aggressively until it reached a $60k balance, you should then proceed to make only the minimum payments, and direct the additional funds into other savings vehicles (or H&B, obviously). If you have access to $120k in FDIC-insured savings, the same applies once you've paid your mortgage down to $120k (if you're married, for example).

This is a very small amount like buying a house and then renting it out to cover the mortgage payments, but in that case you still need to earn a return that's adjusted for the riskiness of your tenant. In the case I'm describing, you're simply allowing the banks, prepaid cards, and credit unions that offer high-interest accounts to pay your mortgage for you, since the accounts are insured by the government, which is to say you shouldn't need to be offered any risk premium at all.

My feeling is that this is too small time. If you've got 60/120K in savings why are you jumping through hoops to make a tiny profit (the spread between the debt and the APR earned is minor)? And don't tell me that it is easy... because I've had 3 phone calls already just to netspend, who asked me for 3 forms of ID to be faxed (or luckily emailed) in, and neither my Citi or Ally account will recognize the netspend metabank account for funding...

That's time and effort, and it has a cost. On top of that, you need to micro manage, making sure you are transacting on each of 12-24 accts at the prescribed times in order to remain fee free, such as the netspend debit swipe.

At the end of the day, you're never going to really 'level up' when you fret about that IMO...

Additionally, it isn't a long term gig. Rates will rise, and chasing 5% will be worthless. As such forward forecasting is difficult. It is possible that these companies can offer a 5% premium always, EG my shittybank acount offers 5%, they offer 10%.. but by nature, that is downward sloping in terms of advantage.

The big issue I have is trying to squeeze too much out of too little. Better IMO to focus on income a lot more than optimization until such time as the nest egg is considerably larger.

 

[janol]

Let me turn that around again.. why is your (successful) example 13 years old?

because that was when I was into flipping real estate, now I prefer to hold, I do not believe having a more than 30/70 ratio in a single property is very smart unless that is your goal, but to say real estate is not an investment is wrong, it is one of the best investment in life. My goal is to own 10 houses by the time I'm 62, then start moving into each house for two years and taking the up to $500,000 tax free gain on a pricipal resisdency allowed every two years per couple

 

[Matt]

because that was when I was into flipping real estate, now I prefer to hold, I do not believe having a more than 30/70 ratio in a single property is very smart unless that is your goal, but to say real estate is not an investment is wrong, it is one of the best investment in life. My goal is to own 10 houses by the time I'm 62, then start moving into each house for two years and taking the up to $500,000 tax free gain on a pricipal resisdency allowed every two years per couple

I've not gotten into investment property yet, though I would like to. Your story sounds a bit odd though, it seems like you want to flip still, but (naturally) don't like the cap gains from that, hence the idea to live in the property.

However, I'd have thought it might be more desirable to have cashflow in retirement than worry about reinvesting the proceeds? I'm just wondering about the effort there.. you'd be constantly in upheaval, unless perhaps you kept two residences, and used one as a secondary base?

One thing I've been thinking about regarding the same desire to not pay the flip gains is to flip inside a Roth.

 

[janol]

No flipping, just selling a home every two years and living off the gains

 

[Matt]

No flipping, just selling a home every two years and living off the gains

That's a flip rather than buying for cashflow (to me)

 

[janol]

it is if you are only looking for monthly cashflow today, but I look at my current occupation as cash flow, the rest should be used to maximize gains for retirement