What scary form of investment do Americans throw millions of dollars a month at. It is a common investment that all too often is not considered as an investment option, but as a necessity to “invest” in. This particular investment vehicle is rarely considered in the same form many other investment vehicles are considered. In order to demonstrate this concept, let’s look at some features of an investment that over 200,000,000 million Americans throw money at every month, their home equity.
Imagine for a moment that you were sitting across the table from your trusted investment advisor, and he or she has invited you over for a meeting to learn about a revolutionary new investment opportunity that hundreds of millions of Americans will make sacrifices every month to invest in. Then imagine that he or she began to share with you the features and benefits of this particular investment before telling you what the investment vehicle actually is. Read the following features and benefits of investing in home equity, as if you were evaluating any other investment before putting money towards it:
1. You, the investor, are required to make an initial contribution to the investment in order to even open the account. The initial contribution required is typically between two to nine percent of the total, long-term investment amount, in other words the set up fee will be between two and nine percent of every dollar you intend to invest in this vehicle over the next 30 years.
2. You, the investor, have a very limited number of contribution options, but you ultimately retain the ability to choose the amount you would like to contribute on a monthly basis; however, once you have elected your monthly contribution amount you are locked in for the life of the investment.
3. You, the investor, have the freedom to contribute more than the elected monthly minimum investment, but you are never allowed to contribute less than the monthly minimum you elected upon set-up, even in the case of job loss, medical issues, or other hardship.
4. If you, the investor, elect to pay less than the minimum contribution amount in any given month, you risk losing the entire contribution amount to date regardless of how long you have been contributing to this investment.
5. In most cases, approximately $0.95 of every dollar contributed during the first five years, funds the investment company directly, leaving only $0.05 of every dollar to benefit you. Over a 30-year period, you will own less than 50% of the total investment contributions you make over than entire time frame.
6. You have no liquidity. The money is tied up and unavailable, with the exception of certain loan provisions that allow access to a small portion of the investment. The investor must meet rigorous standards for the investment company to even consider allowing the investor access to the liquid portion of the investment.
7. The money sitting in the investment is completely at the mercy of the market, and those dollars are not guaranteed or insured. In other words, they could go “poof” at any given second.
8. Every time you invest, you put the principle at greater risk. Yet, at the same time, as your principle becomes less secure, it further secures the investment company’s position with your money.
9. The money in the account, or the principle, will earn somewhere between a 0 and ‐3.8 percent rate of return over the lifetime of the investment. There is a 75 year track record of these investments earning negative 3.8%, so the “0” is being generous and optimistic.
10. Once you have fully funded the investment, you are no longer allowed to contribute any additional dollars to the investment.
11. The fully funded investment pays no dividend or income of any kind at any point unless you sell off your entire interest in the investment.
12. You will be required to pay taxes on the fully funded investment as long as you hold onto it, even though the investment provides no income or dividend at any point.
So, who wants in? Does this sound like an exciting investment opportunity? Any takers? If your trusted investment advisor shared these twelve features of a “revolutionary” new investment with you, and then asked you to invest a half a million in to it over the next 30 years, you would likely call him or her insane and march out of the office. Your skin should be crawling with the absurdity that over 200,000,000 Americans invest in this thing every month.
Your Primary Residence Isn’t An Investment
Millions of Americans are willing to mortgage their lives away for a sense of security, believing that the equity building in their homes will somehow provide the level of retirement and security they seek after their entire lives. People work a lifetime to own a home “free and clear,” only to realize they cannot retire once they reach retirement age. Our “free and clear” home no longer feels like an asset at retirement; it feels more like a consolation prize. To bring this point home, let’s look at the same twelve investment features described above and discuss them in terms of the mortgage on your primary residence:
1. The investor is required to make an initial contribution to the investment in the amount of two to nine percent of the total, long-term investment amount.
Your initial down payment of 3-1/2 percent to 20 percent of the total purchase price of the home will, at the end of a 30-year note, equate to approximately two to nine percent of the total purchase price over the lifetime of the loan.
2. The investor has a very limited number of investment options, but ultimately retains the ability to choose the monthly investment amount. Once you have elected your contribution amount you are locked in for the life of the investment.
You have the ability to shop around for the best interest rate on your mortgage, as well as the type of loan you want to accept.
3. The investor has the freedom to contribute more than the elected monthly minimum investment, but the investor is never allowed to contribute less than the monthly minimum, even in the case of job loss, medical issues, or other hardship.
You are always welcome to pay more than your monthly payment, but if you ever pay less, or don’t pay at all, you may be considered in default and the foreclosure process will begin ultimately resulting in your credit rating declining and in the potential loss of your home. The second you fail to make a full payment in any given month, even if your payment is $1200 and you pay $1199.99, the bank, if it so chooses, can consider you in default.
4. If the investor elects to pay less than the minimum contribution amount in any given month, the investor risks losing the entire contribution amount to date.
If your home slips into foreclosure, you will lose all of your principle payments, as well as all of the interest you’ve paid up to that point. There is no contractual provision in place to allow you to receive any of that money back if the bank forecloses.
5. In most cases, approximately $0.95 of every dollar contributed during the first five years of the investment funds the investment company directly, leaving only $0.05 of every dollar to benefit the investor. Over a 30-year period, you will own less than 50% of the total investment contributions you make over than entire time frame.
When researching a typical 30-year amortization schedule, you find that, on average, only 5 percent of your monthly payment pays down your principle balance, while the rest is devoted to interest. As your amortization schedule matures, you will begin to contribute more to principle and less to interest. However, on a $225,000 loan amount, with a 6 percent interest rate, your fully amortized payment would be around $1,350.00, not including taxes and insurance. If you make that payment for 360 months, or 30 years, the total amount you will have paid over the life of the loan is $486,000. Hence, only 46 percent of the total amount of the investment went towards paying down principle.
6. The investor has no liquidity. The money is tied up and unavailable, with the exception of certain investment provisions that allow access to a small portion of the investment. The investor must meet rigorous standards for the investment company to even consider allowing the investor access to the liquid portion of the investment.
Home equity, or the difference between the value of the home and the remaining principle balance, is tied up and not accessible. You have zero liquidity. The loan provisions referred to equate to either a refinance or Home Equity Line of Credit (HELOC), but those require you to pass multiple rigorous qualifications before the bank will give you that money. The lending industry is an ever-changing monster that has caused multiple casualties over the years. An unforeseen change in the lending industry may in fact mean that the mortgage you once qualified for when you purchased the home may be the only home loan you ever qualify for. If lending guidelines shift, you may not even be able to qualify for a refinance on your primary residence leaving those dollars eternally unavailable, unless you sell your home.
7. The money sitting in the investment is completely at the mercy of the market, and the investment principle is not guaranteed or insured.
Equity is ultimately a calculation of what someone else may be willing to pay for your home if you sold it, and that calculation comes from what some other people have paid for homes like yours, in your neighborhood, in the last six months. It certainly is not an exact science, and the only time you can ever really find out how much someone would be willing to pay for your home is when you actually sell your home. Homeowners have unlimited downside potential in their investment. This means that you could owe significantly more on your home than what it is actually worth if other people in your neighborhood are unable to meet their obligations, and they slip into foreclosure—a problem that helped drive the U.S. housing industry, and U.S. economy in general, into the ground.
8. Every contribution made puts the principle at greater risk; yet it further secures the investment company’s position.
As you pay your mortgage loan down, the loan-to-value on the home decreases, which means that the bank’s investment in you is even more secure than it was. Mortgages with a low loan-to-value amount are the easiest and quickest to foreclose on if you ever miss a payment. This of course puts your principle at greater risk. Think about this: you are a bank and you have ten homes you can potentially foreclose on. In deciding which homes to foreclose on first, you notice that one home is worth $225,000 but has a loan balance of $50,000, versus the other nine that are worth less than what is owed. Which home are you likely to foreclose on first, in hopes of minimizing the negative impact that asset will have on your books? It is a simple financial calculation; you will foreclose on the home with the lower loan to value. For you as an investor and home owner, this means that the longer you meet your obligations, and pay as required, you will be putting every dime of principle paid down and increasingly greater risk in the event you are ever not able to make a payment.
9. The money in the account, or the principle, will earn somewhere between a 0 and ‐3.8 percent rate of return over the lifetime of the investment.
Equity in your home earns you nothing. That money never produces more money for you. Equity is fully theoretical until you access it with a HELOC (home equity line of credit), refinance, or sale and the equity converts to real, physical dollars in your personal bank account. Not accessing the equity in your home is like having tens of thousands of dollars sitting in a bank account doing absolutely nothing. Putting money in a similarly structured non-interest-bearing savings or checking account would be like stashing money in a locked safe that you can’t open. Money sitting like that is subject to inflation, and the 75-year average on inflation, according to the United States Government, is 3.816 percent. Your home may increase in value, but the real estate market is not growing your money for you. The theoretical value of the home is growing, but that growth wholly dependent on market conditions you cannot control.
10. Once the investment is fully funded, the investor is no longer allowed to contribute to the investment.
When your home is paid off, you are no longer allowed to put any more money into your mortgage. Most long-term investments however, don’t cap the amount you are allowed to contribute. Most of us would never choose an investment that capped principle contribution; we would see it as too restrictive, yet most of us view our home as an investment and yet get excited that we don’t have to put any more than necessary in it.
11. The fully funded investment pays no dividend or income of any kind at any point unless the investor sells off their interest in the investment.
Once your home is paid off, it creates no residual income or dividend. The best way to put it is this: a free and clear home will never deposit a check in your bank account. Plain and simple if you put dollars in to any vehicle that does not cut you checks back every month, you are not properly investing. Even if you were to take the number of dollars you paid every month towards your mortgage and began allocating it to another investment account, once you have your home paid off, it would take you years before that money would begin providing any level of retirement income for you.
12. The investor will be required to pay taxes on the investment as long as they hold on to it, even though the investment provides no income or dividend.
Once you own your home “free and clear,” you are only clear of the mortgage payment. The home does not become yours and in no way is “free.” You are required to continue paying property taxes on the home as long as you own that property. In most states, you may not know what your tax bill will be year to year.
Do not misunderstand. Just because having a big chunk of idol home equity is part of a broken paradigm and an accumulation mindset, you should not use your home as an ATM machine, or use the equity in your home for debt consolidation. Practices like those add to debt proliferation and has ultimately resulted in bankruptcy for many Americans.
In fact, paying off your home is a noble and wise thing to do, but only if you have organized your financial house adequately enough to allow you to save for retirement, or at lease have a passive income that allows you to retire. If you spend your entire adult life chasing that financial unicorn called retirement, please reflect long and hard on the actual, practical, and very real side of what many Americans think is our best investment. Millions of Americans need a drastic financial paradigm shift.
Paying off your home FIRST is not the key to successful retirement. I do, however, suggest implementing “conservative” financial principles that may include using your home equity, and applying it to conservative and time tested real estate investments. Dumping money into a 401(k) or IRA account for decades, or paying off a home for decades do not work as a way to retire for the vast majority of Americans.
Ask yourself this question, “has practicing the traditional methods of saving, 401(k) and IRA contribution, and paying off my home first put me on course for the exact retirement I need, or want, to have, or am I currently behind schedule, and worried about the future?” Very simply, if what you have been doing is working you’re in good shape, or are you like the vast majority of Americans, and is what you are doing not working? Are you going to be able to retire if you maintain the current pace in this economy, or will you not be able to retire at your current pace? USA Today reported a now well known fact, and Dave Ramsey quoted it in his book The Complete Money Makeover, that “according to a USA Today study on people 65 years old, 97% can’t write a check for $600, 54% are still working, and just 3% are financially secure.
Paying off your home certainly feels good, and is indeed a wise thing to consider, but the question must be: is it the single best way to invest your hard-earned money? Is it putting me on track for the exact residual income I need come retirement? Is investing thousands of dollars over decades in to a broken, fee ridden, and market dependent vehicle like a 401(k) or IRA going to get me retired, or will it ultimately leave me short of my retirement goals.
Decision time: do you want to continue to purchase failure month by month, or is it time to control your own financial destiny, break the financial paradigms of your fathers, and begin creating real retirement by doing something different?