Pay cash for your home vs opportunity cost

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“Cat: Where are you going?
Alice: Which way should I go?
Cat: That depends on where you are going.
Alice: I don’t know.
Cat: Then it doesn’t matter which way you go.”

― Lewis Carroll, Alice in Wonderland

Much to my surprise, my portfolio breakdown in my last post caused a few interesting comments on social media. Specifically, a few folks stated, dumping a huge chunk of money to pay cash for my home only means I would miss out on valuable gains that could have otherwise been invested in the stock market. I guess in theory, there may be a valid argument there.  And to be clear, the act of me missing out on stock market gains is a prime example of an investing term called, “opportunity cost”. But it’s not that simple. There is more to investing than just throwing money in the stock market and wishing for the best.  We all need a place to live. And the cyclical nature of our recessions ought to be considered.

For instance, way back in my early 20s, I started to make decent money flipping repossessed homes. Each year my income increased so naturally, I took on more debt as I aged. I assumed, my income would continue to increase. Boy was I wrong, as soon as the 2008 recession hit, my income literally was zero for months due to the mortgage crisis. Oh yeah, and from my perspective, none of the “experts” predicted said mortgage crisis until it was too late. But the moral of the story, I nearly lost my home and all my possessions because I struggled to keep up with the monthly payments.

It took me 70 months of saving $1500 per month to pay cash for my home. And during that time, I reflected on the risk involved with the global markets. I read many fact-based books on economics in an attempt to learn from the 2008 recession. Although I didn’t articulate it the same way, the book Big Debt Crisis by Ray Dalio literally invoked PTSD with some of the insight shared. And this made me come to the conclusion, putting the bulk of my net worth into a vehicle in which I have very little control leaves me vulnerable to the whims of a global economy. And when it comes to debt, the statements below made me feel like a typical consumer sheep.

Lending naturally creates self-reinforcing upward movements that eventually reverse to create self-reinforcing downward movements that must reverse in turn. During the upswings, lending supports spending and investment, which in turn supports incomes and asset prices; increased incomes and asset prices support further borrowing and spending on goods and financial assets. The borrowing essentially lifts spending and incomes above the consistent productivity growth of the economy. Near the peak of the upward cycle, lending is based on the expectation that the above-trend growth will continue indefinitely. But, of course, that can’t happen; eventually, income will fall below the cost of the loans.

One more paragraph from this great book…

In the short-term debt cycle, spending is constrained only by the willingness of lenders and borrowers to provide and receive credit. When credit is easily available, there’s an economic expansion. When credit isn’t easily available, there’s a recession. The availability of credit is controlled primarily by the central bank. The central bank is generally able to bring the economy out of a recession by easing rates to stimulate the cycle anew. But over time, each bottom and top of the cycle finishes with more economic activity than the previous cycle, and with more debt. Why? Because people push it—they have an inclination to borrow and spend more instead of paying back debt. It’s human nature. As a result, over long periods of time, debts rise faster than incomes. This creates the long-term debt cycle.

These statements from Ray’s book resonate with me because, as Ray states,  “human nature“. And that brings me back to the original point here.  To me, investing is not about making money in the stock market. It’s about controlling myself from inflicting unnecessary pain. I’ve said it before, poverty is hell. By owning a home, one tips the probability scale of good luck in their favor. Because even when your investment portfolio inevitably takes a hit from a recession, at least you know your housing is secure.

 

Volatile nature of traditional investment vehicles

You read that header correctly. That means you could lose your butt! Most investments (that pay above inflation) don’t guarantee the safety of your money. And I used to think bonds were safe until I learned about the fiscal crisis happening to the state of Illinois. This state’s budget blunders demonstrate, all it takes is one incompetent leader and your bond fund could be insolvent. That is not to say bonds or the stock market are bad vehicles for investing. We need them due to the benefits of diversity lowering risk. But how you dance with the devil is the thought I’d like to provoke with this post.

 

Devil’s advocate

So now, let’s take an opposing view. Let us make the claim, in 2008 millions of homes lost their value due to the recession. And if that were to happen today, there goes the bulk of my net worth! Wait just a minute… There is more to say on this story. Firstly, I’d like to make the claim, my home is not my tool for gaining wealth. Rather, the purpose of my primary residence is to provide a dwelling for safety. A home needs maintenance and upkeep which cost money. But unlike rental prices, which I don’t control, the fees that come with owning a home are traditionally lower than rent and how I repair a roof or windows can impact what I spend.  Keep in mind, a lower priced home typically means one pays less in property taxes and repair supplies. For instance, changing the windows on my 1500 square foot ranch style home was $6,000. But my older brother has a monster 3200 square foot home with double the amount of windows so he would pay $12,000. Insult to injury, the additional fees from owning a bigger home literally compound: double the HVAC needs, double the hot water heater needs, double the property taxes since larger homes normally have higher property values. You get the picture.

So now let’s talk about rent. I rented a duplex while I was saving to pay cash for my home. To be honest, I liked it. There was a real peace of mind knowing, should something go wrong, I just call the landlord. But there is an opportunity cost here too. That is, You don’t own anything. No value is reserved or gained. At least when one owns a home (meaning no mortgage), they can sell it and usually gain their money back. Depending on the local economy, usually, you can sell and get all the money back plus some interest from the accumulated value. But with a rental, 100% of the time, you get nothing back after living in the property for however long.

As a reference,  here is a chart that shows the values of homes in the US since the 1960s. Do you see a trend?

Screenshot 2018-09-28 at 6.25.37 AM source

The highs of the chart are interesting yes. But the lows are what I’d like to focus on because the average person only has two options, rent or buy a home. And you can see, over time, your home will most likely pay dividends.

Generally speaking, most smart people I talk to say, if you plan on living in a property for five years or less, you should probably rent. This is probably because moving fees, upgrading costs, downtime from work cost money and in a five years span (according to the chart) the gains are lower in that time span. Clearly, there are always exceptions to any rule. But it’s nice to have some guidelines.

 

Net Benefits of Risk

So, you have read the statistical argument. Now, please allow me to tickle your emotional nerve endings for a moment. There is a true feeling of freedom by not having a monthly mortgage or rent payment.

As my wife and I prep for the new baby, I feel that my family is secure because we own our property. If I lose my job, I could live off my savings for a while and help out around the house more, read more, etc. If I were to lose my job, I would not need to rush into the next opportunity because a healthy savings account and a debt-free lifestyle grants me options.

For instance, a few years ago I left a relatively secure job in corporate America so I could join a fast-paced growing startup tech company. The demands were incredible, nothing was routine, and as a result, the pay was 40% higher. However, the job security is almost nonexistent in this highly competitive tech market. Well, It’s been nearly two years now and I am still at this awesome startup. As a result, I have grown significantly (professionally and financially) because of this lateral move.

Looking back, I would have never taken this job if I had monthly payments. This is because the anxiety of failure and then losing my debt-owned possessions would have caused me to lose focus. This example just mentioned is a huge contributor to a larger strategy of mine. That is the attainment of Financial Independence. As you see, living a completely debt-free life pays dividends. And I feel the sky is the limit if I continue to take calculated risks chasing hard challenges.

Bonus: Kill your Mortgage tax deduction and become rich!

This post has been another entry in my investing series where I share lessons on growing money. How does investing work and how can we grow our funds responsibly? Perhaps we can create some rules of engagement. Perhaps we can avoid investing in schemes we don’t understand based on emotions. Lastly, perhaps we can contribute towards mitigating the pain of poverty by the opportunities created from Financial Independence.