When should you take a loan instead of saving?

debt v savingsHere’s a commonly asked question:

In which cases should you take credit or a loan instead of saving up?

Len correctly answers:

When the price of whatever you are looking to buy is rising faster than the interest on the loan.

But, the answer that I want to focus on is that by popular financial blogger, Pinyo who says:

Buying a house at today’s interest rates is a good example of where taking a loan could be more beneficial than saving up.¬† You’re amortizing over 30 years and inflation would counter the interest expenses you paid over the life of the loan. In the mean time, you get to enjoy the house much sooner.

Whilst what Pinyo suggests is correct: real-estate is a great hedge against inflation; and, borrowing to purchase your home is probably the only way that most people will ever get to buy one …

… his comment actually fails to mention that it’s also a pretty good investment. Even your own home.

Let’s take a look at a simplified case of somebody purchasing their own first home (house or condo) for $100k, including closing costs. They put in a 20% deposit and take out a 30 year fixed loan, locking in at 3% interest.

Let’s also take Pinyo’s line that the interest rate just happens to offset 30 years of inflation (i.e. inflation also averages 3%), which is almost spot-on, based on the past 30 years’ average inflation rate.

Whereas Pinyo suggests that you are (a) offsetting inflation, and (b) enjoying your house …

… I think you are also making a great investment.

Here’s why:

– Over the 30 years, at just 3% inflation, your $100,000 home would have grown in value to $237,000

– Of course, in that same 30 year period, you would have also paid your bank $52,000 interest on that $80k loan

– Don’t forget that you put in a $20k deposit, which could have been earning interest elsewhere; let’s say that you would have averaged a 5% return on this investment, so your $20k could have grown to $86k.

The bottom line is that you will make an additional $17k profit, if you buy the house instead of just ‘saving’ the $20,000.

To me, this is a clear and tangible case where borrowing (to buy your first home) is better than merely saving …

What about the repairs and maintenance cost, you ask? And, the insurance, and the land tax?

My feeling is that these would be a lot less than the rent that you no longer need to pay …

… after all, you did just buy your own first home didn’t you? ūüėČ

 

Why I don’t manage my rental properties …

Managing your own rental properties sounds like a good idea; you get to save some money – and, you hand choose / hand manage your tenants.

The World Of Wealth (blog) puts it nicely:

Manage your properties yourself!

Reason Number One – It’s Valuable Experience
Managing my rentals has taught me numerous life skills from how to negotiate with a contractor to the best way to (attempt to) collect rent from a deadbeat tenant.

Reason Number Two – You WILL Do A Better Job Yourself

First of all, your property manager may not actually be very experienced. Secondly, your problem may be worse if the manager IS highly experienced and recommended. In that case, you will probably find yourself be at the very bottom of their priority list.

Reason Number Three – You’ll Save LOTS of Money

Property managers and leasing companies don’t come cheap. You’ll pay 6% – 10% of gross rental income directly to the manager. A rental property with 6-10% of cash flow is rare and precious indeed, so hiring a property manager is all but ensuring your cash flow will be negative.

Reason Number Four –¬†You Won’t Save Yourself Any Stress
One of the main reasons I hired a leasing company this summer was because I didn’t think I could effectively handle 3 vacancies while I was traveling in and out of town.¬†But I was more stressed out than ever before! I still worried about when I’d get a new tenant in each unit, how I was going to make the cash flow work in the meantime and how much the repairs were costing.

I can’t comment on how much less or more stressful it would be to manage my own rentals …

… because I have used a property manager since the get-go.

But, my case might be different to yours: my properties were investments, not my source of business income. So, for me, time was more precious than money.

Even so, Dave Lindahl – well-known property ‘guru’ – makes the case for NOT managing your own properties, at least not after the first 3 or 4 that you own: burnout.

Handling all of those “Reason 4” issues that The World of Wealth blog mentions (dealing with tenants,¬†vacancies, defaults, etc.) will stress you out more than you can imagine, then burn you out pretty quickly.

Also, the argument that properties return 6% and property management costs 6%, therefore all your profits go to the property manager, don’t hold water … because, commercial properties (for example) return 6% after the costs of property management are factored in (or, so they should) …

… and, even residential property may return the same – if you purchase cheap and add value (e.g. paint, add a bedroom, etc.) before you rent expensive.

By all means, manage your own rentals, if that’s the way you want to roll.

But, have the expectation (and, build the cost into your calculations from the start) that you will employ a property manager sooner rather than later, because managing your own rental properties simply isn’t any fun ūüėČ

Avoid wiggly-line investments!

UPDATE: We have a winner in my $700 in 7 Days Giveaway … yep, ‘barbaramontgom’ (with 6 points) was chosen by random drawing (see below) and wins the entire $700 Cash!!!!!! Barbara just needs to send me an e-mail ajc [at] 7million7years [dot] com to claim her $700 cash prize (less any PayPal fees)!

Bet you wished that you had entered ūüėČ

Special thanks to Steve and Trisha who tied at the top of the leader board … if you send me an e-mail with your name/mailing address I will send each of you a $60 Apple Gift Card! Thanks to all of the others who entered and promoted the contest like crazy!

LAST CHANCE¬†to enter my free contest: CONTEST OVER: in just ONE more¬†today, I am giving away $700 cash to one lucky reader (drawn at random) as part of my $700 in 7 Days No Strings Attached promotion. It’s free to enter simply by clicking here.

________________

CNNMoney fields a question from a reader who’s scared that her money will run out before she does:

Question: I recently had to take early retirement at age 57 because of back problems. I’m now looking for a safe place to invest my retirement money where I’ll have no risk losing it. Any suggestions? — Donald H., Morris, Alabama

Yes, I have a suggestion: don’t post your questions to a financial ‘expert’ who still works for a living!

If you do, you’ll get answers like:

Answer: If the threat of losing principal were the only financial risk you had to protect yourself against in retirement, then finding a safe haven for your money would be pretty simple. You could plow your entire nest egg into Treasury bills or spread it among FDIC-insured savings accounts and CDs (taking care to stay within the FDIC coverage limits).

But while doing this would insure that you would never lose a cent of your money, it would also insure that your retirement stash earned a pretty measly return.

Good, so far … so, no cash. Got it!

What should she do instead (?):

If you want to have a decent shot at your retirement savings lasting as long as you do, you also want to invest in a way that has at least some potential for long-term growth.

[Keep some in cash and the] rest of your savings you want to keep in a diversified portfolio of stock and bond funds. Again, there’s no single correct mix. Typically, though, someone just entering retirement might have 50% or so of his or her portfolio in stocks and the rest in bonds.

Zowie!

Question: If you are aiming to retire, why do you want long-term growth?!

Answer: Because, you expect to lose some significant proportion of your capital to:

– Spending too much,

– Inflation,

– Market downturns.

In other words, the expert recommends to invest in a ‘wiggly line’ investment, hoping that the upswings outweigh all the downswings + spending after inflation is taken into account.

How well has that been working out for the past, oh, 20 years?

So, can you think of an investment that tends to grow with inflation, and provides income that also tends to grow with inflation?

Well those treasury-protected bonds certainly have principal that keeps up with inflation, but the returns are so low that income will become a real problem.

But, what about real-estate?

It’s where ‘the rich’ have kept the bulk of their retirement savings since time immemorial … I wonder why? ūüėČ

A great retirement plan executed badly …

I have a good friend who had a successful business; while not exactly a retirement plan (as he still had the business), it would work as one:

He would buy a commercial property (e.g. office or warehouse) in a good near-downtown area, refurbish as necessary and put in place good tenants.

The next year he would buy another.

And, for the next three years after that he would buy another … until he had 5 such quality properties (purchase price around $1 million each).

Then he would do something pretty neat: he would sell the first (i.e. 5 year old property), taking about $1 million out to buy another property worth $1 million, and use the excess capital appreciation to fund his lifestyle.

Nice … except it didn’t make sense.

Because he was simply trading down one property (bought for $1 million 5 years ago so, hopefully, worth a little more now) for another (worth $1 million today), incurring all sorts of changeover costs and possibly even capital gains (unless he could qualify for a tax-free exchange).

He did this until I pointed out the obvious; I said: “Instead of selling one to buy another, why don’t you simply refinance the oldest property each year to release the capital appreciation, tax free?”

Oh!

And, that’s what he did from then on …

People often come up with great, innovative ways to do things … but, it doesn’t mean that they’re the right way.

For example, in our former family finance company, my Dad used to give our clients a check for the full face value of their loan, and ask for a check back to cover our up-front commission.

His reasoning was that we would have the commission money in our hand and earn extra interest on it. Neat, until I pointed out that it was exactly the same as giving the client the net amount (i.e. face value of loan MINUS our commission): One check. Sensible.

Needless to say, that’s exactly what we did from then on.

Always evaluate what you are doing and how you are doing it, even if you are successful … you may be leaving (a lot) of money on the table.

BTW: I’m wondering if you picked it? There seems to be another flaw in the retirement plan executed by my friend and promoted my many a financial spruiker that I have listened to …

These real-estate investment ‘gurus’ say: “Buy lots of real-estate and when you retire you will have a LOT of equity available to fund your own retirement … simply take out a loan against this property every time that you need more money. Because it’s a loan and not income, you pay NO INCOME TAX on it, so it’s worth more to you than taking the money as rent; and, the excess rents will cover the mortgage payments. Of course, because it’s an investment loan, it’s tax deductible.”

Now, there’s so¬† many things wrong with this strategy that I wouldn’t even know where to start (how about vacancies, as one example?), yet I have been to at least half a dozen seminars where this exact strategy and tax-effectiveness argument was put forth.

However, I take issue with the last statement:

Just because a loan is taken out on an investment property, does NOT necessarily make it tax deductible.

In many countries, the real test is “what’s the PURPOSE of the money that you are borrowing?”

If it’s to refurbish the property to increase rents (hence, so that you can pay the IRS more tax … you win, they win!), more power to you!

But, in this case, it’s not to derive more investment income … it’s so that you can go out and have a good time!

Q: Why would a government want to subsidize your personal spending habits?

A: They probably wouldn’t!

Find a good tax advisor before implementing this strategy … oh, and take what you hear from financial spruikers with a kilo-grain of salt ūüėČ

How much home should I buy?

A reader who works with RE, Whittier Homes, says:

I’m in the camp that you don’t leave too much equity tied up in the walls of a house. That being said there is a risk factor or a comfort zone that every investor has to know. The bottom line is you don’t want to get over leverage and get caught on the short end of a declining market.

Home equity is simply what your home is valued at (today) less what you still owe on it (today).

This leads me to think that I’ve never said … and, nobody’s ever asked: How much equity should I have in my own home?

Well, there’s a reason:

I have NOTHING to say about how much equity ‚Äď as a % of your house value ‚Äď and, EVERYTHING to say about how much equity ‚Äď as a % of your Net Worth ‚Äď you should have tied up in your own home.

In other words, your equity is a function of:

– How much your house costs to buy

– How much it increases in value over time

– How much deposit you have available now

– How much you choose to put in / take out of the value of your house over time

I have no advice as to how much you should spend on your house in the first place, that’s your business not mine ūüôā

But, I do have some guidelines that pretty much help to answer the “how much home should I buy?” question (other than for your first home), albeit obliquely:

1. The 20% Rule ensures that you are always investing at least 75% of your entire Net Worth (after allowing for another 5% to be spent on ‘stuff’),

2. The 25% Income Rule ensures that if you do decide to borrow money to buy a home, that you do not overcommit your cashflow,

3. The Cash Cascade makes sure that if you do have a mortgage, that you don’t pay it off too quickly if better investing opportunities abound.

Put these ‘rules’ into practice and you won’t go too¬†far wrong, when it comes to your own home …

Punch Buggy Blue!

Let’s say that you do agree that real-estate is one of the best MM301 (wealth preservation) strategies … although, many of my readers would disagree …

[AJC: I’m happy to meet all the dissenters in, say, 50 years – at a very cheap restaurant, as they won’t be able to afford much more –¬†to discuss how they went with their TIPS, bonds, cash and stocks-based retirement strategies. Then I’ll meet Scott, Ryan and all¬†the other RE and business-based retirees¬†on their private golf-course in Palm Beach for a second debrief ūüėČ ]

… but, what type of RE would fit the bill?

After all, many of my readers, Evan included, have had mixed experiences with RE:

I have watched my dad deal with C R A P for years. He owns 2 properties:
1) CASH COW ‚Äď 2 family residential unit income exceeds mortgage payments. They always pay on time and there mostly are no problems

2) 2 family unit with a bar attached. I have listened to him say for YEARS, that if the bar paid its rent things would be different. I feel like the stress associated with this property is going to kill him eventually, and that is the commercial part.

In NY it takes 9 to 18 months to get someone out, so even if you try to evict you are looking at legal and time costs that could literally eat 6 months profit.

As I said to Evan:

That‚Äôs why we keep TWO YEARS‚Äô buffer ūüėČ

But, we all have a Reticular Activating System (RAS) that attracts us to whatever it is that has caught our attention … for example, have you ever played the Punch Buggy / Slug Bug game with your friends and / or kids?

If not, it’s a bundle of fun – and, pain. Actually, mainly pain ūüôĀ

It works like this: who ever sees a VW ‘bug’ first calls out “Punch Buggy [insert color of choice: yellow, green, red, etc.] !!” and gets to whack the other person on the arm … as hard as they like¬†[AJC: usually me. ouch!] …

It’s amazing how many VW Beetles there are on the roads, these days!

We used to play a similar game – many, many years ago – when I was on the school bus: we used to look for Chrysler Chargers, and whomever saw one first would yell out “Hey, Charger!” and hold up their hand¬†with a Richard Nixonesque V-For-Victory sign.

The winner for the day was the one who scored the most ‘victories’ …

It’s amazing how many Chrysler Chargers there¬†were on the roads, in those days ūüôā

Of course, what’s happening is that our RAS is simply filtering IN Chargers (or VW Beeltes) and filtering OUT other types of vehicles, making it SEEM as though Chargers / Beetles are everywhere … of course, there are no more / less than there were before we started looking out for them.

Similarly, with RE – or other – investments:

Our view tends towards our first direct – or, even indirect – experiences; which helps to explain why my generation is more conservative (we went through some down cycles in the late 80’s and early 90’s) and younger folk were more bullish, having had 15 to 20 good years … until resetting their RAS’ in the current cycle.

Similarly, Evan’s views may be colored by his Dad’s experiences albeit mixed.

But, Evan’s Dad could have avoided many of his RE problems by buying well … now, for MM301, buying well is NOT the same as buying well for MM201:

While we are still building towards our Number, we need to buy RE that will appreciate strongly, with rents just covering cashflow (of course, we wouldn’t say “no” to more!) …

… but, when we have reached our Number, we need to generate INCOME, so buying well really means that we need to:

Buy to protect our future income / rental stream

As I have shown you, it’s easy to get a positive cashflow from RE; just pay cash!

And, live happily from 75% of the rents (less taxes), knowing that the other 25% will cover all of your ‘normal’ costs (management fees, vacancies, repairs and maintenance, etc.), and will keep up with inflation.

It’s the last part that is key: since we are never selling these properties [AJC: lucky kids!], we don’t really care how much/little the RE itself appreciates, we just care how much the rents appreciate, and our benchmark for this is:

The rents must appreciate at least as much as inflation

That is through both UP and DOWN markets …

… so, I would keep away from bars and other retail EXCEPT for counter-cycle retailers such as dollar stores, groceries / food stores (food staples only), and – of course – Walmart and Walgreens¬†[AJC: if I could get my hands on the freehold!].

Remember, we’re not looking for extraordinary capital growth (any more), but protection in down-cycles.

[AJC: oh, and if you were going to buy stocks (again, for retirement capital protection and dividends); these types of retailers and food businesses would be great ‘protection stocks’ to own, as well]

And, moving away from retail, I would also happily buy small offices, say, housing a number of separate professionals (e.g. doctors, attorneys, etc.), as these professions are required in all markets and my risks are well spread.

But, I would avoid large offices – or industrial showrooms and warehouses – housing SME’s, as these are prime candidates for simply shutting shop in a down cycle, and I may only have one tenant per property (even though¬†buying 6 or 7 of these would certainly help to insulate the ‘shock’)

And, you might be surprised to find that I am not all that excited about residential (even multi-family) for MM301, simply because the rental returns are usually not that great (but, they can make a fantastic MM201 strategy).

Remember, RE isn’t the only MM301 Wealth Protection strategy that you can base your retirement (or, life after work) around,¬†it’s just that¬†I am struggling to find another one that has both income and capital that can keep up with inflation, fairly consistently,¬†through at least the 30 to 50 years that I still plan to be around¬†…

… can you?

One of the best tips for small business owners …

One of the very best wealth-building secrets for business owners has nothing to do with improving your business … and, everything to do with turning that spare cashflow into appreciating assets:

Just like buying your first home is a 7million7years key wealth building strategy, so is owning your own property for small business owners, just as the guy in this video recommends … I can’t vouch for his financing strategies as I don’t know enough (but perhaps some of our readers do?) …

… but, simply buying my own office generated in excess of $1 million extra net worth for me in just 5 years.

I bought an office block for $1.27 million; I then completely rehabbed it (including new offices, workstations, phone system, and computer equipment) for another $500k, which I leased over 5 years (with a $1 balloon/final payment).

The mortgage interest and the lease payments were 100% tax deductible from my business income (actually, I charged myself a high commercial rent as the property was in a different company name).

I sold the building for nearly $2.5 million just 5 years later!

The Ideal Perpetual Money Machine …

So,¬† it seems that creating a mix of bonds and stocks and then picking some magic withdrawal rate (e.g. 4%) is not the ideal way to plan our retirement (a.k.a. life after work) after all …

… instead, it seems that we need to create our own Perpetual Money Machine: a renewable resource of cash ūüėČ

The¬†ideal Perpetual Money Machine¬†– at least, according to my liking –¬†is Real-Estate (more wealthy people build their own Perpetual Money Machines using real-estate that any other investment, even more so than cash, CD’s, bonds, mutual funds, or stocks):

1. Real-Estate (particularly commercial real-estate, when purchased well) protects your capital and keeps pace with inflation; it will last as long as you do, and then some!

2. Real-Estate (when managed well -and, this is something that you CAN confidently outsource) protects your income (i.e. net rents; they will grow with inflation).

3. The bumps in your real-estate road can be managed with insurance and provisions: you can insure against most catastrophic losses (and, you can spead your RE investments to minimize even those risks), and you can keep a % of your rents (and, starting capital) aside to help smooth your income stream (against vacancies, repairs and maintenance, etc.).

For example, with $7 million (aiming for a $350k per year gross income Рindexed for inflation Рwhich should net $200k Р$250k after tax), you could:

1. Keep $500,000 as a two years of living expenses cash buffer (one year to allow for the rents to start coming in, another year “just in case”),

2. Invest $6.5 million CASH into 5 x $1.0 million to $1.25 million dollar properties (allowing for closing costs, etc.),

3. Which should provide 5 x 7.5% x $1.0 million to $1.25 million = $400,000 gross rental income

4. Of which you would pay tax of 30% (say) and divert another 25% of the remainder¬†to your ’emergency /¬†provision fund’ leaving $215k (PLUS, tax benefits such as depreciation, tax deductions of cars, certain travel and other business expenses etc.).

After every few ‘good years’, you can trim your provision fund back to two years of living expenses, allowing you to buy some more real-estate (therefore, providing the basis for another future pay rise!).

If you don’t like real-estate, then you can always lower your spending expectations and dust off your bond-laddering books ūüôā

Fitting a square peg into a round hole …

The real problem with any of the so-called ‘safe withrawal rates’ that we explored¬†yesterday – with 4% currently¬†being perhaps the most popular amount advocated –¬†is that they all assume a fixed annual spending amount, but are actually generated by a totally volatile (some would say random) portfolio.

We’re trying to fit a square peg (fixed annual spending) into a round hole ( a ‘random walk down Wall Street’) ūüėČ

But¬†7m7y readers have an even more fundamental problem with planning our ‘retirement’ based on this type of common industry wisdom: we are planning on¬†retiring early, hopefully, with a very large Number and a soon Date!

Most retirement models assume a 30 to 35 year retirement lifespan …

…¬†I don’t know about you, but I retired at 49 and intend to live AT LEAST another 40 years ūüôā

Many of my readers will be aiming to reach their Numbers even sooner .. and, may expect to live even longer!

The bottom-line: traditional retirement planning models don’t work, because we need money that will last as long as we do … we need a Perpetual Money Machine, because we don’t know how long we will live once we stop working.

A Perpetual Money Machine is anything that:

a) Protects your capital over the long-run, even allowing for the ravages of market changes and inflation, and

b) Produces a reasonably reliable stream of income, that also (at least) keeps pace with inflation.

Neither stocks nor bonds – the traditional tools of retirement investing – fit the bill for us:

1. Stocks are too volatile, and the income tends to be artificial (e.g. so-called dividend stocks attempt to fix the level of dividend provided even as the company’s profits fluctuate).

[AJC: Raiding marketing, R&D, and other seemingly non-essential budgets in lean years in order to protect the dividend stream is Рto my mind Рthe mark of a poorly run company]

2. Bonds provide a very safe return, but the % returned each year is too low, meaning Рat least, to me Рan unnecessarily reduced lifestyle, especially after allowing for reinvestment to try and keep up with inflation.

That’s why my Rule of 20 is exactly that: a planning rule, NOT a 5% spending rule!

[AJC: Otherwise, I would have called it the 5% Rule, d’oh!].

In other words, my advice for PLANNING your Number, is to decide what initial income you want and multiply that by 20 in order to find your Number

… but, my advice for LIVING your Number is to turn on your Perpetual Money Machine and live off whatever it happens to produce, after allowing for¬†taxes and¬†provisions against inflation and contingencies.

Is your first home a good investment?

This is a loaded question, obviously, because I just revisited the subject of buying your first home (of which I am now an avid fan) a week or so ago; Rick suggested:

Since equities also have a good long term investment record, why not scale back on the primary residence somewhat and invest in both real estate and equities?

At the time, I responded by saying: “The effect of the 20% Equity Rule and 25% Income Rule is to ensure that you are always investing AT LEAST 75% of your networth elsewhere (could be business, RE, equities, etc., etc.).”

Of course, that doesn’t address the question, as I have also said that these rules are up for grabs – meaning, you can just ignore them – when considering buying your first home.

Now, I am clearly¬†a fan of buying your first home – you just need to go back to one of my very first posts to see that – but, it wasn’t always that way …

… I started by believing that there were other investments out there that performed better than your first home.

And, that still holds true; after all, as my Grandfather once told my Grannie when they had the same decision to make soon after immigrating to Australia:

You can’t always buy a business from your home … but, you can always buy a home from [the profits produced by] your business.

This still holds true … as does the 20% Equity Rule. In other words, if you are absolutely committed to using the funds to start a business, or are ABSOLUTELY committed to ALWAYS investing at least 75% of your Net Worth, then by all means keep renting.

It’s just that 99% of people will – sooner or later – fall off the investing wagon. It’s human nature.

Then they’ll end up with no investments, little net worth, and no home. Buying your first home, and using that as a springboard into other investments, is a great way to go; just remember what I said, way back in the beginning of 2008:

 If you are ready, willing and able to buy your first house, or you are thinking of trading up (or, down) …. here’s my advice:

Put aside the emotional decisions and just consider the financial impact, and that is: your house is the ONLY way that most people will ever get off the launching pad to financial success …

Why? Because, you are building up equity over time (even a flat or falling real estate market eventually climbs back up again) …

‚Ķ but ‚Äď and here is the¬†key –¬†ONLY if you are prepared to put the equity in your house to work for you ‚Ķ that means, borrowing against¬†the equity in your house to INVEST.