Inflation Killers—Credit Card Rebates

NOTE: If after reading this, you would like to apply for one of the credit cards that the Fox family uses to max out credit card rebates, we can send you a link and that lines our pockets with a bit of money at no additional cost to you.  Let me know if you’d like to do that.

We’ve talked about how your cell phones are a great killer of inflation, along with other things store brand groceries and Craig’s List and the sharing economy.  But there’s another product that is totally killing inflation that makes those seem like small potatoes—your credit card and the rebates you can now get.

Back in the day credit cards allowed a convenient way to purchase products without having to carry around a lot of cash.  Eventually competition among credit card companies began to heat up, and by the late 1990s they started offering rebates to card holders on their purchases.

Let’s take a quick look at how credit card companies make money:

  1. They charge interest and fees to those who carry a balance. This is where there is a ton of money to be made.  For the purposes of this post, we’ll ignore this other than saying the Fox family never carries a credit card balance.
  2. They take a cut of all purchases. When you buy something for $10 at the store with your credit card, you end up paying $10.00 for it, but the store only gets about $9.41.  That’s because the credit card processing company charges 2.9% of the purchase plus $0.30 on each transaction.  Most people don’t think about this revenue stream, but it definitely adds up.

 

So obviously to maximize revenue from #2, credit card companies want as many people buying as much stuff as possible on their credit cards.  That leads to competition from the likes of Chase and Capital One and a ton of others, and that competition has taken the form of credit card rebates that over the last 20 years have gotten more and more generous.  Credit card companies are enticing you into using their products by giving you a cut of #2.

My first credit card was a Visa associated with Exxon.  It offered a rebate that could be redeemed for free gas.  It was something like 0.5% of my purchases, but it was better than nothing.  I was already buying gas so once a month I would get something like $12 off a fill-up.  Over the course of a year that added up to maybe $150, not a ton of money but free money nonetheless.  Given that I wasn’t getting that before, that was definitely “deflation” on my gas purchases—SCORE.  Compared to what is offered today, that was just a pittance.

 

Credit card arms race

Fast forward to 2018 and things have definitely become higher stakes.  We are bombarded with commercials where Discover gives you a rebate and then matches it at the end of the year, Capital One gives you a 1.5% rebate on all your purchases, and Chase gives 2 airline miles for every dollar you spend.

Credit cards are even offering one-time bonuses of hundreds of dollars if you sign up and spend a few thousand dollars in the first few months.

It’s easy to get overwhelmed by all the marketing and confused by all the intricacies of the rebate programs.  But there’s gold in them hills.

If you take a few minutes (and that’s really all it is) to understand the different programs and figure out which one is the best for you, it can be thousands of dollars each year in your pocket.  THOUSANDS OF DOLLARS.

 

The impact is huge

I’ve mentioned this a few times, but the Fox family plays the credit card roulette game and last year it amounted to about $4,000 in our pockets.  Given we spend about $120,000 a year on expenses, that’s almost 4% of our expenses each year.

You’re probably not surprised that I look at the impact with a spreadsheet, and when you do the numbers it has an enormous impact.  Let’s genericize it and look at my cousin Savvy Fox.  He’s a 22-year-old who graduated from college making $50,000 per year and spending about $40,000 per year of which 80% is stuff on his credit card.  His only major expense that he doesn’t put on his credit card is his rent (and eventually his mortgage); but for everything else he uses his credit card.  Of course, he pays his credit card off each month to avoid usurious interest expenses.

Over the course of his life his income and expenses will grow 3% each year until he’s spending $120,000 per year (like us) when it flattens out.

At age 22 Savvy spends a total of $40,000 of which $32,000 (80% of the total) he uses credit cards for.  Because he’s savvy with his credit cards, he gets about a 4% rebate on those purchases which is $1,280 for the year.  This is found money so Savvy invests it in and index fund and gets about 8% each year.  If he follows this plan for his entire working life (until age 65), when he retires this little exercise will give him a nice little treasure chest of about $660,000.

$660k for doing nothing more than maximizing his credit card rebates!!!  Go ahead and read that again.  In a world where the average net worth of a person is $80k, this little gambit by itself gives you 8x that.  BOOM!!!

To further illustrate the point, $660k is when Savvy is really savvy with credit cards and gets the 4% rebate.  If he wasn’t savvy and just got a 1% rebate, at age 65 he’d have $165k.  That’s really, really good; twice the net worth of the average American, but still HALF A MILLION less than what he could have.

That should show you the stakes.  Now let’s talk about how you get there.

 

Specifically what the Fox family does

It’s important to find a credit card with the highest rebate.  Right now the ranges from about 1.5% to 2.0%.  But the key is the sign-up bonus.  You can fairly easily get a credit card with a sign-up bonus of $200 and higher, and you get that if you spend something like $1,500 in the first few months.

Our family typically plays this game 2-3 times per year, for both Foxy and me.  So we sign up for a new credit card every few months.  Our normal spending easily gets us to that threshold for the bonus.  So take 3 new credit cards per year times 2 people, and you get a total of 6 new credit cards per year, each of which has a $200 rebate.  Just the rebate gets us at least $1,200.  Add to that 1.5% rebate on all our purchases that we can use a credit card for, let’s say $6,000 per month, and you have another $1,080.  That’s over $2,000 right there of found money.  That gets us to about 3.2%, but we do better.

As generous as personal credit card rebate programs are, business credit card rebate programs are better.  Since Foxy Lady and I hung up our own consulting shingles, we had to set up a business.  Because we have a business we can get business credit cards!!!

At Capital One a typical personal credit card has a rebate of $150 and a 1.5% cash back.  Not bad.  Their business credit card has a rebate of $500 and a 2% cash back.  Much better.  At Chase, they have a business credit card with a $700 rebate (after you account for the annual fee).  Now we’re talking.

You can easily imagine that if Foxy Lady gets two Capital One credit cards per year and two Chase cards, and I do the same, the rebate dollars add up.  I’ll do the math for you—it’s $4,800.  Add to that the cash back which is around 2%, and that’s another $1,440.  We’re getting about $6,200 EVERY YEAR for doing nothing more than using credit cards.  That’s a ton of money that is just sitting out there for the taking.

 

Bringing this full circle, there is a ton of money out there for people who put maybe two hours per year into getting it by playing the credit card game.  That money hasn’t always been there, so that by definition is DEFLATION.  Credit cards can be a huge inflation killer.

If you are interested in signing up for one of the cards we use, if we send you a link we get a bit of a bonus from Chase or Capital One.  If you want to do that, just shoot me an email.

Bitcoin—Top 5 WTF

A few of you have written in asking what I think of Bitcoin and its crazy ride.  Here are my Top 5 observations on Bitcoin.

 

5. Unprecedented wild ride

What has happened with Bitcoin in 2017 is really unprecedented.  Its price has risen about 17x which obviously is a lot.  To me, the more astounding point is that it has risen that high given it has a market cap of $300 billion (that is the total value if you added up all the bitcoins in the world).

If you think of bitcoin as a stock, that combination is pretty incredible.  A lot of stocks have had crazy good years where they increased 17x.  However, most of those are off a really low base: so maybe a $50 million company grew to a $1 billion company.  Obviously, that is much easier to do off a smaller base.

However, with Bitcoin, continuing with that analogy, it grew from a $15 billion company (that’s about in the top 2000 globally) so that isn’t exactly small.  Then it vaulted to $300 billion which would put it at about top 10.  Think about that for a minute.  Crazy.

 

4. I still don’t get it

I feel like some old man who doesn’t get the world around him.  Damn kids won’t get off my lawn.

I couldn’t tell you with any specificity what Bitcoin is (there are buzzwords like “blockchain” but I don’t know what that means either).  I certainly couldn’t tell you how I could “buy” them or “mine” them.  I don’t know a single vendor who would accept Bitcoins, and if they did I wouldn’t know how you do that transaction.

And I think I tend to be fairly knowledgeable about these things.  I can pay for stuff using my watch which proves I’m at the forefront of technology, but Bitcoin is just beyond me.  I think that applies to most people—the story of Bitcoin is exciting but the details are pretty fuzzy.

 

3. Not surprising run-up

Given the incredible run-up, I am not surprised of it’s continued push higher in the past couple weeks, thanks to it’s listing on the Chicago Mercantile Exchange earlier in the month.

Being listed (or having your futures listed) on a very legitimate financial exchange obviously lends some credibility to something that up to this point had very little of it in respected financial circles.  Also, it somewhat addresses #4.  You can buy Bitcoin futures on the CME and I think many more people know how to do that than knew how to buy Bitcoins on their own two weeks before.

I still think Bitcoin is built on quicksand and will eventually collapse (more on this in a second), but in the short term it’s not surprising that it’s value has gotten a huge bump as it has been listed.

 

2. Ticking timebomb

There are a lot of people extremely bearish on Bitcoins, and many can give you a ton of reasons why it’s just an eyelash away from collapse.  I predict that eventually a central bank will crush it like an elephant finally getting annoyed by a gnat.

What would provoke such action by the US Treasury?  A terrorist attack.  It seems likely that given Bitcoins anonymity features, it will be used to fund some type of terrorist attack that will kill innocent Americans.  When that happens you can easily imagine the headlines, and then easily imagine the government’s response.

Bear in mind the whole premise of Bitcoin is that governments aren’t responsible stewards of their fiat currencies, so society needed some type of currency that the government can’t screw up.  That’s a bit of a “Screw-you” to Washington, so I think if there’s any connection between Bitcoin and a terrorist attack, the government will come down HARD.

 

1. Go left when everyone else says “go right”

There’s a famous saying in investing that saying when everyone believes one thing, the opposite tends to happen.  Right now, EVERYONE is saying that Bitcoin is a bubble and its value will crater.  People have been saying that when it was at $1000 and then the chatter exploded when it crossed the $10,000 threshold.  Now it’s at about $18,000.

Seriously, can you think of one serious, respected analyst who is bullish on Bitcoin?  I can’t.  Can you think of highly-regarded financial people who said Bitcoin is a crazy bubble that will crash HARD.  I can think of about a thousand.

Given that, it makes me think that Bitcoin might still have some upside.

 

Who knows with all of this?  I know I certainly don’t.  Personally, we don’t invest our money in Bitcoin, mostly because of #4 and a bit because of #2.  That said, I am enjoying the crazy ride that makes for fun reading in The Wall Street Journal.

 

Lending Club—No Bueno

About two years ago we broadened our investment portfolio with this new-fangled things called peer-to-peer lending with Lending Club.  This has turned out to be a pretty major disappointment for us, and we are in the process of exiting the investment (which isn’t a quick process—more on this in a second).

Basically, the idea of peer-to-peer lending is like match.com for lenders and borrowers.  People who want to invest/lend money meet people who want to borrow money.  Borrows can get money they need at much lower rates and much less hassle than if they got a loan from a bank.  Lenders can earn interest at a much higher rate than they would get from a bank.  Banks are cut out of the process and everyone wins, right?

 

How it works

There are people looking to borrow money for debt consolidation/payoff credit cards (that’s about 80% of the loans), help their small business, pay for home renovations, etc.  Let’s say a given loan is for $10,000.  A bunch of lenders like us each kick in $50 or so, so you’ll be in this loan with hundreds of other people.  The person gets the money and then pays off the loan over 3-5 years.

Lending Club vets each loan and each applicant, and assigns a credit score.  That credit score determines the interest rate which can range from 5-20%.

As a lender you can go through all the thousands of loan application and pick which ones you want to lend to.  That’s fun at first, but quickly becomes a hassle, so you can just put it on auto-pilot and Lending Club will pick the loans for you.  That’s what we did.

 

What happened to us

In mid-2015 we opened our account, starting with $3000.  Of course, I watched the process like a hawk, from the loans I picked to when they started paying back.  At first it went great (isn’t that line in pretty much every movie, before everything goes to hell?).  We were getting paid back by all our loans, and our return was over 12%, which of course is amazing.  That’s free money.

We put more money in over the next couple months, and then when we sold our California house we put a big chunk ($60,000) in.  By that time, our account was worth about $100,000.  Through mid-2016 things were going well.  Our returns had inched down to about 10% (still spectacular), and I was congratulating myself on being a financial genius.

Towards the end of 2016 I started to see some of my loans default.  Of course, this is to be expected.  Some of the loans will go bad but those should be offset by the higher interest rate, and everything works out.  Still, it was a disturbing trend.

After a few months, the bad loans kept coming and my return steadily dropped, until it settled at 2.5% which is where it’s at today.  That’s crazy!!!  Obviously, there’s a huge difference between a 10% investment and a 2.5% one.

In early 2017 I decided to pull the plug, and stopped reinvesting my money.  Now, as the small loans (we have about 3000 out there) pay off, we take that money and put it back in our Vanguard account.  Unfortunately, this isn’t a fast process so it will take us about 5 years to unwind everything.  Oh well.

 

Why it works (or doesn’t)

On paper it sounds like one of those awesome ideas where the power of the internet changes an old business model for the better, and I think there’s a lot of truth in that.  It brings borrowers and lenders together and cuts out the middlemen, and lowers the borrowing costs substantially.

The problem lies in their ability to ensure payments are made.  Fundamentally, what is stopping borrowers from getting the money and then just going away and not paying?  It may not happen a lot, but it doesn’t take a lot of these to really kill your return.

I have a bit of insight here because I was a large enough account that I would get a call about once per quarter from them “seeing how I was doing”.  You can imagine the tone of these calls changed as my return dropped.

These loans are unsecured, so the only thing that makes borrows pay back is morality (I never want to count on that when it comes to money), the threat of negative marks on their credit rating, and the general badgering from Lending Club as it tries to collect.  With traditional bank loans that are collateralized, the threat of repossessing something seems a lot stronger.

Not difficult to predict, there was a large portion of the borrowers who would take the money and then not pay it back.  Some might be thieves who borrowed the money in a scam and never intended on paying back.  Others certainly intended on doing it but things didn’t work out.  Given the economy has been super strong the past couple years, this is especially troubling because it should be as good as it gets right now.

When someone stops paying Lending Club goes after them with phone calls, but those don’t seem really effective.  Seriously, what are they going to do?  Some delinquent borrows do starting paying back but most either never answer the phone, or they do and say/demand that Lending Club quit bothering them (there are actually notes lenders can see on all this activity).

I personally think that in our litigious environment today, lenders don’t have that much leverage.  Also, to avoid claims of bias or discrimination, it’s probably not easy to turn down borrower applications.  That leads to a perfect storm of crap that I think I got caught up in.

 

What is the lesson?

Investing is an interesting psychological experiment.  The simple approach of buy-and-hold broad index mutual funds is almost certainly the best, yet it’s the most boring.  When you’re doing that and things are going well, there’s that itch to see “what else you can do” and “what you can do better”.

That’s what happened to me, and most of the time that’s death.  That’s what happened with us and our commodities investment, which has been a major loser.  That was also the case with Lending Club, and we’ve had disappointing results (especially since stocks are up about 15% annually in the time we’ve invested in it).

So the lesson here is that it’s probably always better to stick with the boring but tried-and-true approach.  History is on your side here.  We have over 100 years of data on how stocks behave, in good times and bad.  Peer-to-peer lending is fairly new so you don’t really know how it will play out.  Maybe you’ll miss out on something that’s new but amazing (see: Bitcoin), but that leads to an interesting second point.

Many leaders—NFL head coaches, CEOs, politicians—say that success finding all the great things, but more avoiding the bad things.  Stocks are similar.  It’s a game rigged in your favor, but there are pitfalls along the way that are so tempting.  That’s where I think I tripped up.  Lending Club and commodities were sexy investments at the time, and it scratched that itch for me to be “doing something.”  And it hurt me.

Of course, that doesn’t mean we never innovate.  Peer-to-peer lending may turn into something big; digital currencies might turn into something big.  They might be important parts of a financial portfolio, but I think now is way too early a time to be putting my money down on that bet.  I know I’ll miss some big wins, but hopefully I’ll also avoid big losses and come out ahead.

Should you use an investment adviser?

I started writing this blog because I wanted to share my own experiences with investing, including how to navigate the complex world of investing on your own.  I am a firm believer in DIY financial management.  That is what worked for me, and I believe all people can get really great results doing it on their own.  That said, many readers ask about using a broker or investment adviser or financial planner.  Here’s my take.

Quick disclosure: I am an investment adviser.  I passed my Series 65 and work with a small number of friends, helping them with their finances.

 

Are financial professionals worth it?

As with any purchase you make, you need to evaluate a investment adviser on the basis of how much she costs, and how much value you get in return.  On the surface I would say “no, it probably isn’t worth it,” however there are definitely some factors which may reverse that decision.

First, let’s look at how much investment advisers cost.  The rates range widely.  Plus there isn’t a lot of transparency in the marketplace so it’s not always easy to know what the going rate is.  My experience says that 1-2% is typical.  This can come in many forms—typically brokers get paid fees from the mutual funds they suggest for you or from the transaction costs for trades.  Advisers tend to charge a percentage of your portfolio.  We know that 1% coupons are really valuable, so those fees are a lot.  Over an investing career they can add up to hundreds of thousands of dollars.  That’s a pretty big deal.

Of course, if you’re getting a lot of value from your investment adviser, maybe it’s worth it.  One of the main missions of this blog is to show you how you can invest successfully on your own, and I think most people can do that without having to hire a professional.  Sure you have to make decisions on asset allocation, which accounts to use, what investments to make; but those aren’t really all that complex.  Also, thanks to the efficient market lessons from A Random Walk Down Wall Street we know that you’re as good a stock picker as anyone.

So my general feeling is that investment professionals aren’t worth the money; a motivated investor can do just as well on their own and pocket the fees.  Wait, what???  You said “motivated”.  As it turns out, a lot of people, despite their best intentions, aren’t able to put their financial plan in motion.  If you’re one of those people, and if an investment adviser can help motivate you to do the right things, then I do think they are more than worth it.

In this way, investment advisers are a lot like personal trainers.  Most of us know that exercise is good for us, and most of us know how to run on the treadmill and lift weights properly (or you can find out by watching a 3-minute video on Youtube).  But if a trainer can motivate you to actually hit the treadmill and the weights, they’re definitely worth the money, right?  How much is your physical health worth to you?  Same thing with finances.  If you know what you should be doing, but for one of a million reasons you never end up actually doing it, maybe you should get an investment adviser to help you out.

Nearly every post I’ve done shows that there is a ton of value out there if you invest properly, taking into account things like time horizon, taxes, etc.  But if you don’t do anything, you’re losing ALL that value.  In fact, loyal reader Jessamyn noted that studies show that investment advisors do increase returns about 3%.  That’s a ton, especially because we know how much a 1% coupon is worth.  Are they magic?  Can they predict the future?  No.  The data shows that investment advisors help people do what they are supposed to–keep track with their plan, invest regularly, don’t panic when the market goes crazy, etc.

If an investment adviser helps you in ways you won’t or can’t, then you’ll probably end up ahead of the game, even after you take his fees into account.

 

How would you pick a financial professional?

So let’s say you’ve decided that an investment adviser makes sense for you.  How do you pick a good one?  This is one of the biggest challenges, and in my opinion one of the reasons a lot of people don’t get investment advisers: They don’t know a good one they can trust.  The problem is there are a ton of them and the quality varies greatly.  Sadly, there are a lot of unskilled people in the industry who don’t know what they’re doing.  Even worse, there are some real shysters who might take your money, either overtly steal it or use other schemes to siphon away your money and put it in their pockets.  It’s a legitimate concern.

First, you need to find someone you can trust.  Ideally, this would come from a personal reference.  Today you also have things like yelp.com or Angie’s List that gives ratings.  Additionally, there are government agencies like FINRA.org that track these people so you can look them up to see how long they have been around and any complaints that have been files against them, etc.  These are okay, but for my money, nothing beats a personal reference from someone you trust.  Of course, it’s not always easy to have those conversations with friends: “So Mary, who is helping you with your money, and can I talk to them?”

Second, you need to find someone who is good.  Of course, knowing this isn’t always easy.  Using that same personal trainer analogy, you probably wouldn’t hire an obese trainer.  You’d want someone who is ripped, someone who has shown they have been successful at physical fitness themselves (like my totally buff friends Christel and Tobias).

Tobias
If you have a personal trainer, he should be ripped like Tobias here. Similarly, if you have an investment adviser, that person should be somewhat wealthy.

 

Similarly, you want a rich investment adviser.  You want someone who has been successful creating wealth for themselves.  But this is where the challenge comes in: if the investment adviser is wealthy then why is he working with you?  Seriously.  You have a lot of young kids who are doing this (let’s say less than 30).  I’m sure there are some good ones, but I’m not trusting my family’s financial wellbeing to someone without a lot of experience.  You also have a lot of people who just aren’t that good.  If someone has been an investment adviser for 10 or 20 years and they aren’t a multi-millionaire, how good can they really be?  I’m not trying to be mean, but shouldn’t that be more than enough time to accumulate some serious wealth?

 

Questions to ask:

If you do decide to go with a investment adviser, make sure you ask a lot, A LOT, of questions.  Beyond your doctor or minister/rabbi, this person will probably have the biggest impact on your wellbeing.  Take the time to make sure you find a good one.

How long have you been doing this?  This is an area where experience definitely matters.  In particular, you want her to have lived through a few bear markets.  At a minimum she should have been doing advising people since 2008 and even better if she’s been doing it since 2001.

What did you do during 2001 and 2008?  Investing is a lot easier when things are going well.  You prove your mettle during the tough times.  Figure out how he handled himself when everyone thought the world was coming to an end.

What are you paid?  This should be answered in excruciating detail.  Does he get paid by you (how is the amount determined, when is it paid), by others like mutual fund companies (how much, how do you make sure you serve my interests ahead of theirs)?

What is your personal financial situation?  No point sugar-coating it.  Find what his financial situation is like.  As mentioned above, if he isn’t pretty well off, how good is he really?  Also, the relationship you have with him needs to be based on trust because you’re going to be sharing everything with him.  If he isn’t willing to reciprocate in some way, that might tell you something.

How will you ensure you serve my best interests?  This is a biggie.  Ideally you want her to have a fiduciary relationship which is a legal standard where she serves your interests ahead of anyone else’s, including her own.  No matter how this turns out, you’re going to need to trust this person, but you should get a sense of how she will ensure that you are #1.

What is your investing strategy?  Obviously, there are a lot of nuisances to this, especially as he customizes it to your specific situation.  But he should definitely have an approach and a philosophy that he can articulate clearly and understandably.

What type of power will you have over my money?  Will she be able to make trades and move money between accounts with your express permission, on her own, or not at all?  This is a tricky one because maybe you want to offload these activities completely, so her having a ton of control may be okay.  No matter, you should definitely understand this completely.

How will you take into account other assets that you won’t manage?  Most situations will have him managing an account like your IRA or brokerage account but not others like your 401k, mortgage, pension, etc.  Most times, he’s only paid on the accounts he manages, but to do his job well he’ll need to take into consideration those other accounts as well.

 

Those are what I came up with off the top of my head.  At the end of the day, if you do go with an investment adviser make sure you find someone who has demonstrated they have the skills to build your wealth.  Just as importantly, make sure you find someone who you can trust completely.

My, oh my, how money has changed

We just got back from a trip to Disney with Lil’ Fox and Mini Fox.  As an aside, Disney World is a pretty amazing place and I highly recommend it to anyone.

While we were on the trip, I was thinking about similar trips my dad took with me and trips his parents took with him.  Because I always think about finance and money, it got me thinking how people paid for those trips—not necessarily how they saved for the trips (which is, of course, an important thing), but how they actually paid money at the point of sale.

Money seems like a real constant in our lives for decades and centuries and millennia.  However, it’s hard to think of something so central to our lives that has changed so drastically over such a short period of time.  In the past 100 years it has changed more than food or clothes or shelter.

 

Things used to be really risky and inconvenient

Back in the day, let’s say when my dad was a cub in the 1950s, everything was paid in for in cash.  There were innovations like Traveler’s Checks that substituted for cash, and I imagine many people thought of those the way today many people think of Bitcoin—kind of confusing and you aren’t really sure you “get it”.  It was just easier to use cash, something they understood and were used to.

Pretty much all of life revolved around having a ton of cash on hand to conduct your life- -groceries, gas, vacations, washing machines, everything.  That was hugely inconvenient and also incredibly risky.  I remember my grandfather taking about his money belt and false wallet, both tools meant to counteract enterprising pickpockets.

A couple decades later, let’s say the 1970s, charge cards hit the scene, first for department stores and gas stations.  Those could only be used at a specific store (your Sears card could only be used at Sears), so that wasn’t super convenient, but it was a major improvement.

In the 1980s, credit cards as we know them today became widespread.  Credit cards cousin, debit cards, which act in pretty much the same way but deduct straight from your checking account, were being used broadly by the 1990s.  Even though that’s where we are today, even credit cards have evolved in a major way.

 

The modern art of buying

Today the vast majority of retail transactions are done with credit cards, but the credit card you’re using is very different from the one my dad used in 1983.  Probably the biggest difference is that nearly every credit card offers a pretty substantial bonus of some sort.  It can be airline miles or hotel points or cash.  This can be a pretty big deal.

The Fox family plays credit card roulette (we get a new credit card every few months to take advantage of their initial purchase bonuses) and that nets us about $2,500 each year.  That just paid for our vacation.

All that said, we are very far from the cutting edge when it comes to this stuff.  In the mid-2000s this crazy thing called “Paypal” hit the scene.  When I was in grad school the cooler kids were using Paypal and paying each other for stuff.  I didn’t fully get it, and I admit that I don’t use it today.  Nonetheless peer-to-peer pay networks were here.

Fast-forward a few years and you got digital currencies like Bitcoin.  As much as I don’t fully understand Paypal, I understand Bitcoin even less.  What I do know is that Paypal was based on US dollars but offered a different and more convenient way to pay.  Now it seems Bitcoin is based on its own currency and then also offers a different and more convenient way to pay.

Add on to that, if you like a bit more risk in your investing portfolio, Bitcoins themselves, beyond just the ability to pay for stuff, can go up or down in value so it that way it looks like an investment (or gamble).  One Bitcoin was worth $1000 at the start of the year and now is worth about $7000.  Crazy.

 

What it all means?

For finance and history nerds like me, I think this is a really fascinating study.  I have always said that inflation is way overstated and I think we can find one of the reasons here.  Think about how much easier and faster things are for businesses now with credit cards and other electronic financing compared to the cash economy of my grandfather’s time.  That impacts nearly everything so the stakes are high.  That savings gets passed on to the consumer, and we get lower inflation.  Score.

Second, today, there’s a huge upside to using money innovations like credit card rewards.  It can pay for our Disney vacation every real.  That just became real.

If credit card rewards can do that for me today, and I admit I’m a late adopter when it comes to this stuff, what is the upside still out there.  Are there similar dollars provided by the Paypals and Bitcoins of the world that I just don’t understand enough yet to pick up off the ground?  Probably.

Are there going to be further money innovations in the future that will provide even more dollars?  Certainly.  I don’t know what they are in a similar way my dad in 1983 could never have imagined Paypal or Bitcoin, but they’ll certainly be there.  If today I’m basically getting a vacation for free, who knows what money innovations will bring me over the next few years.

Maybe that should motivate me to figure out this crazy, newfangled Paypal and Bitcoin things.

 

DIY oil changes and investing

The Top 5 ways changing your own oil is like doing your own investments

Just the other day, I changed the oil in our 4Runner and our Honda.  It was the first time in my life I ever did that by myself instead of taking it to a dealership or one of those quick lube places.  First, I want to thank my new BFF Jesse Bearcat for helping me.

Second, as I was doing that and since, I have started to think how changing your own oil is a lot like doing your own investing.  In fact, a lot of the benefits of doing an oil change yourself are exactly the same as doing your investing yourself.

 

Here are my Top 5:

 

More conscientious:  No one cares more about you and your wellbeing than you.  Twice in my life I have had horror stories of the guy at the shop doing a crappy job and it leading to bad, bad results.  They were sloppy and forgot to connect a hose which led to my car breaking down and needing a tow.  Once I was driving on the road into the LINCOLN FREAKIN’ TUNNEL.

When I do the work on my own car, the car that hauls around my family, you can be sure that I check and double-check every screw and tube and everything.  Investing is the same.  Is someone else going to check the next day to make sure your fund transfer happened or that the change in your 401k allocation took?

 

Better materials/parts:  I buy name-brand oil and filters.  I don’t know if they are better than the discount stuff those quick-lube places use (normally I am a big fan of generics, but motor oil seems a little different).  It’s an open question.  At a quick lube place I never used synthetic oil because it was an extra $30 or so, and I’m too cheap for that.  When I do it myself, 5-quarts of oil costs about $3 more when you buy synthetic, so that’s a no-brainer.

Similarly with investing, when you do it yourself you can pick the best mutual funds at the lowest price.  I have spent a ton of time on why I think index funds with a low management fee are the best.  When you do it yourself, you can pick anything you want.  When someone else does it for you, your choices tend to be more limited.

 

Better use of your time:  This is a bit counter-intuitive, but it’s absolutely true.  When you change your own oil or do your own investing, you actually save a lot of time.  To change your own oil, you take 5 minutes to set everything up, 1 minute to unscrew the oil plug, and 1 minute to unscrew the oil filter.  Then you let the car drain for 10 minutes or so while you’re doing something else.  You can come back, screw the new oil filter on (30 seconds), screw the drain plug in (30 seconds), fill the oil and check the levels (5 minutes).

If you go to a place it might take you 10 minutes to drive there, 10 minutes waiting time, 20 minutes for them to do it while you’re stuck in the car.  Doing it yourself saves a lot of time.

Investing is the same way.  If you have your investment advisor do it all, you still need to meet him, drive to his office or schedule a call, etc.  You can do it on your own at night in your pajamas after the kids have gone to bed while the World Series is on in the back ground.  I know which one I would choose.

 

Look at other things:  As I have started doing my own oil changes, I am becoming more knowledgeable and look at other things about my car as well.  When I went to a place to get my oil changed, they always say I need extra stuff down, and I totally shut them down because I think they’re just trying to fleece me (good analogy to personal finance there).  However, there are other maintenance things you need to do to your car.

Changing the air filter is one of those.  The oil change place says I always need to do it, and I actually do it every once in a while.  Now that I change my own oil, I have the confidence to check that and it’s surprisingly easy.  I can do it in 2 minutes (plus get a good price on the filter from amazon.com which is maybe 80% less than what they charge me).

Investing is the same.  It’s easy for an “expert” to come at you and tell you all the things you need to do.  It’s natural to resist that a little, knowing a lot of it you don’t need to do, but some of it you probably should do.  As you get more knowledgeable, you’ll know what does make sense (probably an IRA) and what doesn’t (probably an annuity).  That can pay HUGE dividends (figuratively and literally).

 

Lower cost:  It costs $40-60 to change our oil at one of those quick lube places, plus a lot more if they did my air filter and other stuff.  It’s much higher at a dealership.  My all-in cost for an oil filter and 5-quarts of synthetic oil are probably about $20.

Those are decent numbers for a car, but you know how that translates to your personal finances.  If you do investing yourself, you can save a boatload in costs and fees that would line the pockets of investment advisors, mutual fund companies, and everyone in between.

 

You only need three investing ingredients

“Less is more” –Robert Browning

o-TABASCO-SAUCE-HISTORY-facebook

The fine people at McIlhenny make Tabasco sauce, one of the most popular condiments in America.  Can you guess how many ingredients go into their sauce (you might have an idea from the title of this post)?  You guessed it, three: peppers, vinegar, and salt.  That’s it.  Nothing else.  Only those three.  In investing you can take a similar approach.  In a world where there are thousands of stocks to pick from, thousands of bonds, tens of thousands of mutual funds, how do you pick which ones to go with?

Let’s break this down one step at a time.  First we know from Asset Allocation that our portfolio needs some stocks and some bonds.  That’s at least two different investments—one for stocks and one for bonds.

Second, we know from Diversification that we should be . . . well, diversified.  There are a ton of mutual funds out there that can give us plenty of diversification with the stock market.  I personally like either the Total Stock Market Index from Vanguard (VTSMX) or the Spartan Total Market Index from Fidelity (FSTMX).  But wait, those are all (or very nearly all) US stocks.  To be really diversified don’t we need international stocks as well?  The answer is an unequivocal “YES”.  So let’s add a highly diversified international stock mutual fund like Vanguard’s Total International Stock Index (VGTSX) or Fidelity’s Spartan International Index Fund (FSIIX).

With a broad US stock mutual fund and an international mutual fund, you pretty much own a small sliver of every stock in the world.  Add to those two mutual funds a bond mutual fund like VTSMX or FBIDX, and you have your three ingredients, just like Tabasco sauce.

Can it really be that easy?  I say “yes” but let’s look at some of the objections you might have:

 

What about an international bond fund?

Fair point.  We have an international stock fund to give us diversification for our US stocks.  Shouldn’t we have an international bond fund for a similar purpose?  Maybe.

I don’t because bonds are such a small portion of my portfolio right now (less than 5%), mostly due to the stage of our lives that Foxy Lady and I are at.  So I don’t think it’s really worth the hassle.  When we get older and Asset Allocation dictates that a larger portion of our portfolio should be bonds, then having two bond funds might make a lot of sense from a diversification perspective.

 

Why not use a total world fund?

Vanguard does have a total world stock index fund (VTWSX) that combines both US and international equities.  You could imagine just having this one mutual fund for stocks instead of two (a US fund and an international fund).  That’s reasonable and knocks your ingredient list down to two.

Yet I choose not to do this because I am cheap.  The total world index fund as a management fee of 0.27%.  That’s low but the management fee is 0.17% for Vanguard’s US fund and 0.22% for their international fund.  Shame on you Vanguard!!!  Why are you charging more when you combine them.  It’s not a ton, but we know that even increasing your returns a small amount like 0.05% can still be thousands of dollars over the years.

 

Why not use a target date fund?

You could do a total one-stop shop using a target fund like Vanguard Target Retirement 2050 (VFIFX) or whichever year makes sense.  You get your US and international stocks and your US and international bonds all in a single mutual fund.  As I mentioned before, I’m not a huge fan of these because I think figuring out your asset allocation is a little more nuanced than just picking a year, but I’m a little OCD when it comes to this.  That might be the best choice for someone who is willing to trade a small amount of mutual fund performance for a lot of simplicity.

 

What about all the other investments out there?

Ahhhhh.  That’s the question we’ve been waiting for.  I am a firm advocate of efficient markets so I really don’t think I can successfully pick individual stocks or even stock sectors.  I’d rather just pick a really broad index mutual fund knowing that the winners and losers will balance each other out and over the long run I will do okay.

That said, beyond those basic three ingredients, the Foxes have invested in two other investments.  We have a commodity ETF (DJP) which has turned out to be the worst investment that we’ve ever made (which I chronicled here).  Also, we invested in a REIT index fund (VGSLX) when I thought that real estate would be a good investment.  From 2010 to 2014 this turned out to be the case and we did quite well with this, but since 2017 it has been mediocre to bad.  That just goes to show that trying to beat the market is a futile effort.

 

Does Stocky Fox eat his own cooking?

For the sake of full disclosure, I’ll tell you where our investments are.

Investment Ticker symbol % of portfolio
US stock fund VTSAX 51%
International stock fund VTIAX 36%
Bond fund VBMFX 1%
REIT fund VGSLX 7%
Commodities DJP 3%
Others 2%

 

I already mentioned the REIT and commodities investments.  The “Other” is composed mostly of Lady Fox’s 401k accounts, our money in Lending Club (which has been a total disaster which I’ll chronicle in a future post), and a couple other odds and ends.

 

So there you go.  With all the crazy things going on in the world, and all the things that need your attention, I think which investments to pick is an easy one.  With three fundamental building blocks—a US stock mutual fund, an international stock mutual fund, and a bond mutual fund—you can build a rock solid portfolio.

So which investments do you pick?

Invest in 401k before you payoff student debt

“The longest journey begins with a single step” –Laozi (580 BCE)

Investing is a long-term game.  As that really smart Chinese philosopher said, that long-term game needs to start with your first move.  For most people, investing will start when they get their first “adult” job after college (you already know how I feel about college).

Some people start with a clean financial slate when they leave college, but many have student debt from all the loans they took for that degree.  That sets up an interesting question as they get their first paychecks: what to do with the money?  You can even make the question more precise and ask: should I use my savings to payoff my student loans or start investing?  Let’s dive right in

My niece Starty Fox just graduated with her engineering degree from State U.  She has $20,000 in student loans that has an interest rate of 4.45% (I think that’s the current rate for government backed student loans).  Because she listened to her wise uncle, she got an engineering degree which presents many job opportunities.  She took a good job paying $54,000 per year (luckily her salary is divisible by 12 so this post is a little easier to write).  Plus, they offer a 401k which matches her contributions up to 6% of her salary.

After she accounts for rent (her parents made it clear she could visit, but not live with them), her car payment, food, and other living expenses  she is able to save 10% of her income each month.  She makes $4,500 per month and has $450 left over at the end of each month (let’s ignore taxes for a second, but just a second).

So what should she do, payoff that nagging student debt as fast as she can or start investing in her company’s 401k?

 

A match lights the world on fire

Let’s say Starty has a neurosis about her debt.  She was raised never to have any debt (although maybe that’s not always the best idea—here and here), so she wants to pay it off as quickly as she can.

If she applied all $450 each month to her student loans, she would pay off that whole $20,000 in a little over 5 years.  There would be a couple things she wouldn’t like.  First, that $450 would be taxed (just like the rest of her income).  Let’s say her marginal tax rate is 20%, so that means the $450 she has set aside is really only $360 after she pays Uncle Sam.  Taxes are unavoidable, so while that’s a bummer for Starty, she accepts it as a fact of life (although maybe she shouldn’t—more on that in a second).

When it is all said and done, she will have paid everything off by the time she turns 27, which isn’t bad.  Through it all she would have paid about $2,300 in interest.  That interest is tax deductible, so it would only feel like about $1,840.  After everything is paid off, she can start investing in her 401k with a clear conscious.

Let’s take the other extreme, and assume that Starty watched Wall Street a lot with her adoring uncle when she was little.  She’s not too concerned about debt, especially when there are other good investment opportunities out there.  She pays her minimum payment on her loan ($150 per month before taxes, $120 after taxes) and then invests the rest in her 401k.

Obviously, the downside of this is it takes her a lot longer to pay off her loan; instead of being done by age 27, she’ll have the debt until she’s 40.  That sucks.  But she more than makes up for that with her 401k.  Every year she contributes $3,600 to her 401k.  When she does this she has three really big spoonfuls of awesomeness working for her:

  1. Tax free—her 401k contributions are pre-tax so just off the top she is saving $30 per month that would go to taxes if she used that money to pay off her loan. That’s enough to buy a new Lululemon outfit and splurge on extra spin classes each year (Foxy Lady just took over my computer for a second).  Sure, eventually she’ll have to pay that in taxes, but there are a lot of things she can do to minimize that when the time comes.
  2. Match—the big one is that Starty gets to take advantage of her company’s match. They match dollar-for-dollar up to 6% of her salary.  Since she’s contributing more than that, she takes complete advantage of the match, and that comes to $270 each month.
  3. Investment returns—obviously this is why we do invest money. On average Starty is going to earn a 6-8% return on her 401k.

If you put that all into the pot and mix it, you’d have a 27-year-old Starty who is debt-free but with nothing in her 401k, or you could have a 27-year-old with $41,000 in her 401k and still with $16,000 in student loans.  Obviously, the 401k option is much better. She has a net worth of $25,000 on her 27th birthday (versus $0 if she paid off her student loans first).

 

The cause of it all

Those numbers tell a pretty powerful story that from a mathematical point of view, paying off your student loan at the lowest level is best so long as you put that money into your 401k (and not spend it on stupid crap).  However, there are some fairly big assumptions there.

Match—obviously the match is a big part of it all.  Without the match the numbers don’t look nearly as good, but the 401k option still comes out ahead.  On her 27th birthday, she would have a net worth of $5,500, without the match.  Many people may complain that this example isn’t realistic because Starty’s 401k match is so generous, but without the match she still comes out to the good.  And we know a 401k without a match is basically like a traditional IRA which is available to everyone.

Liquidity—when Starty chooses to go all in on her 401k she’s losing a lot of financial flexibility.  At 27 she’ll still have $15,000 of debt that she’ll have to pay off plus she’ll have a lot of her money tied up in her 401k which is very hard to access.  If something happened at ages 22-27 she’d be in pretty much the same boat either way, but after age 27 she’d have a little more flexibility if she had killed the college debt.  This becomes a question very similar to the one we raised with the post on the emergency fund.  Personally, I would be willing to roll the dice for that extra $5-25k over five years, but risk aversion is different for all of us.

That’s all good, but fundamentally this boils down to Starty being able to borrow money at 4.45% (3.6% after taxes) and being able to invest it at a higher rate, 7% for argument’s sake.  Over a 20 year time horizon (about how long it takes her to pay off her student loan), stocks have historically done much better than that 4% hurdle.  For all these reasons, it does make a lot of sense—in Starty’s case thousands of dollars each year—to slowly pay off her college debt and put that money into her 401k.

Emergency fund

As you might imagine, I talk to a lot of people about what they’re doing with their investments.  One of the things I hear a lot is, “I’d like to start investing, but before I do that, I need to build up my emergency fund.”  That sounds pretty prudent.  You don’t want to get caught in the lurch when life throws a curve ball at you.  Yet, I actually think this is a really bad move.  I freely admit that the Fox family does not have an emergency fund.  We have investments, and if the unforeseen happens that’s what we’ll use.

 

How likely is an emergency?

What are the types of things that you’d use an emergency fund for?  Almost by definition, an emergency is something that is unpredictable and somewhat rare.  If your 12-year-old Honda Civic is starting to die and you know in the next couple years you need to get a new one, that isn’t really an emergency as much as something you need to budget for (that was the exact circumstance of the Fox family a few years back).  If you’re having an “emergency” every year, either you’re the unluckiest of people, or probably  more likely you just have a lifestyle that needs to be budgeted a little differently.

When I think of things that you’d spend an emergency fund on it’s stuff like: your hot water heater gives out, you’re 7-year car gets totaled and insurance only gives you $6000 to get a new one, your son goes into the NICU for four days because of croup and your portion of the bill is $4000 (as happened with Lil’ Fox last year), or you are fired from your job.

As I was writing this post, I asked Foxy Lady if she could remember any emergencies that we have faced since we were married 7 years ago.  The hospital thing with Lil’ Fox was the only one we came up with.  There were smaller things like when we had to replace the dishwasher ($500) or fix the clothes dryer ($400), or fly back to Michigan for a funeral ($400), but the hospital thing was the only major one (I’m defining “major” as more than $1000).  So that means we have averaged one emergency every several years.  Once every several years—I don’t know if we’re more or less prone to emergencies than the general population, but that seems about right.

So be a little more cautious and use once every five years as an average—you have about a 20% chance in any given year of needing to tap into your emergency fund.  We’ll use that in a second.

 

How likely is it you’ll make money in the stock market?

Obviously we put a huge caveat on this, but we can look at historical performance to get a sense for how likely it is that you’ll make money or lose money if you invest your emergency fund in stocks.  Actually, we kind of did this in a post a while back.

Remember that historically, if you have a one-year investment time horizon, you make money with stocks about 70% of the time.  That is actually pretty good odds that investing your emergency fund in stocks would have you come out ahead, just looking at it for one year.  In fact, we can do the math, and the chances of you having an emergency in a given year and losing money in the market are about 6% (20% chance you’ll have an emergency x 30% chance you’ll lose money in the market that year).

But remember, emergencies don’t happen every year—they tend to be much less frequent than that.  For the Fox family, they happen on average once every five years.  Just for the fun of it I put a table together that estimated the chances of having an emergency if you assume in any given years there’s a 20% chance of having one.  Also, I looked at the historic data to see the probability that you would have lost money in the market over different time horizons.

Time horizon Chance of an emergency Chance of losing money in stock market* Chance of emergency and losing money
1 year 20% 28% 6%
2 years 36% 24% 9%
3 years 49% 18% 9%
5 years 67% 13% 9%
10 years 89% 3% 3%

 

As we mentioned above, there’s a 6% chance that in any given year you would need to tap your emergency fund when the market was down.  Looking at other time frames you get similar results.  Pretty much any time frame has a less than 10% chance of you needing that emergency money at a time that you would have lost money in the market*.  You need to decide if you’re willing to take that risk, but to me that seems like a no-brainer.  If I have a 90%+ chance of coming out ahead on something, I’m doing it.

You can see where I’m going with this.  First, emergencies don’t happen all that often (if they do, you probably need to come up with another name for them other than “emergency”).  Second, if you give yourself a few years in the stock market, the probability of losing money goes down a lot (of course, it never goes to zero).  That seems like a perfect combination for investing your emergency fund the same way you invest any of your other money.  $10,000 invested in stocks with an average return of 6% would give you about $13,300 after five years; keeping that same amount if your savings account at today’s interest rates would give you about $10,050.  Seriously, that’s ridiculous.

I get that many people look at that and say, “the whole point of an emergency fund is you never know when you’ll need it, so don’t put the money somewhere where you might lose it.”  That’s a very understandable concern, but it’s also where a lot of people are leaving a ton of money on the table.  Over the past 150 years, investing in stocks has a really good track record, and the more time you give it, the better that track record becomes.  You’ll never eliminate all the risk from investing, whether it’s your 401k or US bonds or the cash in your checking account, there will always be some type of risk.

It’s the successful investors who understand that risk and understand how to decrease the risk (expanding that time horizon to five years cuts in half the likelihood of losing money), that are able to get the most bang for their buck.  This is definitely one of those areas where you can get a 1% coupon.

 

The Fox family eats on our cooking on this one.  We don’t have an emergency fund.  When emergencies do happen like with Lil’ Fox, we pay for it out of our investments, absolutely believing that over our lifetimes there may be one or two instances where we lose money but there will be many, many more where we come out ahead.

 

Let me know what you think.  Do you have an emergency fund?  Do you think I’m crazy not to have one?

*I used the same methodology for this table that I did for my post “Will you lose money with stocks?”

Your house–the leveraged buyout

Last week I did a post looking at if your house was a good investment or not.  A classmate named Karthee from ChicagoBooth made a really smart comment:

“Isnt the house purchase a Leveraged Buy out? You didn’t actually put in all the $785K, but took all the profits (1.15M – 785K) – so shouldn’t the return math be based on your down payment rather than the cost of the house (unless you paid for the house in full – which most people don’t)”

Before we dive into the issues, a quick thought: Karthee and I got our MBA together 10+ years ago.  He was a tremendously smart guy and has been very successful since we were at U of Chicago.  When I did my post looking at the value of college, I left out the value of personal relationships that you can develop with your classmates and the network you can build.  I did that deliberately because so many college grads are struggling to pay student debt and make ends meet.  A strong personal network that doesn’t translate into professional opportunities seems like a bit of a luxury.

That said, the people I met at ChicagoBooth are absolutely the smartest and most talented people I ever spent so much time with.  I don’t know if that alone was worth the cost of attendance, but as I get older and my professional career takes on a new look and feel, being connected to so many really amazing and scary smart people becomes the more dominant value I enjoy from my MBA experience.  You know, other than meeting my wife and the mother of my children there.

 

On to Karthee’s comment

I think he’s mostly right, but a little bit wrong.  Let’s talk about how he’s wrong first and then we’ll get to how he’s right.

His comment has less to do with the performance of the asset (did the house increase in price?) and more to do with how the purchase was financed.  Definitely in that he was right that we bought the house with a mortgage, paying a 25% down payment.  The house cost $785,000 and we had to “invest” $196,250 as the down payment.  Then every month we made a mortgage payment of $2,811, of which about $1,000 went to paying off our mortgage (the rest was interest).

He’s absolutely right that if you look at our investment as $196,250 and our gain as $365,000 that changes the numbers substantially.  But should you?  Maybe.  More on this when we talk about how he’s right.

If you just look at the assets’ performance—the house compared to the stock market—the house didn’t do as well.  In our particular case, our house increased about 46% over the five years we owned it; the stock market increased about 76% over the same time period (about 90% if you include dividends which you should).  The broader data shows that houses on average return about 0.4% annually while stocks have historically returned 8-10%.

 

How Karthee’s right

Should we consider how you finance an asset purchase when you make an investment choice?  Certainly, money is money.  Again, if we were doing apples to apples, you could put 25% down to get a house and compare that to if you bought stock on margin and leveraged it 3:1 (put $1 of your own and borrowed $3 to invest).  In that scenario you would have the same results that the stock market does better.

However, that’s a bit of a theoretical construct and Karthee’s point is much closer to reality.  Not many ordinary investors buy stock on margin; I certainly don’t.  About half to two-thirds of people borrow money when they buy a personal residence (I was shocked that it wasn’t higher).  So in that way, the default for home tends to be “leveraged” while that’s not the case for stocks.

Furthermore, interest rates when you borrow for a mortgage are much, much more favorable than if you bought stocks on margin.  Our mortgage is 2.2%; if I bought stocks on margin the rate would be about 6-9%.  Also, our mortgage is tax deductible which brings it down to an effective rate of about 1.5%.  I’m no tax expert so I don’t know if interest on margin purchases are tax deductible.  If not, that further supports Karthee’s point.

Certainly in a practical example of making the choice between buying a house and renting and then investing the money, reality is closer to Karthee’s point.  That said, most of the return comes from the decision on how you financed your house, not that you bought a house that increased in value.

We can put a little table together that figures this out.  The last row includes an adjusted CAGR which accounts for all the costs—realty fees, home improvements, plus the “value” we got from the house acting as a shelter.  We’ll also include the returns if we invested the money in the stock market and invested on margin (maxing out at 1:1 margin ratio at an 8% interest rate).

 

House paid with cash

House paid with mortgage

 

Buy stocks

Buy stocks on margin

Cost to house (2010)

$785,000

$785,000

$785,000

$500,000

Money “invested”

$785,000

$250,000

$785,000

$250,000

Sale price of house (2015)

$1,150,000

$1,150,000

$1,511,450

$595,375

Profit

$365,000

$365,000

$726,450

$345,375

Gross return

46%

146%

93%

138%

CAGR

8%

20%

14%

19%

Adjusted CAGR

9%

21%

 

This leads to some pretty insightful results.  To Karthee’s very correct point, when you look at your house as a leveraged-buyout, the profits are greatly magnified.  In our case, instead a 9% return assuming no mortgage, when you factor in our mortgage we would have a 21% return.  That’s enormous, and that’s really Karthee’s whole point.

You can compare that, as I did before to investing in the stock market.  The stock market had about a 14% return, so a house with a mortgage would have done much better.  However, if you leverage your investment in a similar way to how you did with your house, they end up about equal—the house is at 21% and stocks bought on margin have a return of about 19%.

19% and 21% are close, but the house is slightly ahead.  That speaks to some inherent advantages you get when borrowing money with a house.  For the stocks on margin, I assumed the most you could do is borrow at a 1:1 ratio (you could only borrow as much money as you were investing).  Keep in mind for a mortgage, we got a 3:1 ratio; we borrowed $3 for every $1 of cash we brought to the table.  Also, I assumed that when you borrow on margin you pay an 8% rate; that is much higher than the 2.2% rate we have on our mortgage.  Those two factors—ability to leverage at a 3:1 ratio and to borrow at such a low rate—give the house a great advantage.

So with all of this KARTHEE IS RIGHT.  If you consider a house as a leveraged investment, our housing experience did outperform the stock market.

 

What if we weren’t so lucky?

Our house appreciated at a particularly high rate, but most houses only increase at about 0.4% when you strip out all the home improvement and other stuff we talked about last week.  But to Karthee’s point, your house is a leveraged investment and we know that should increase the returns you experience as a home owner.

If we assume a very vanilla situation, if you put 20% down on your mortgage and the house appreciated 0.4% annually, the math would tell you that you would realize a 2% return per year due to the leverage you have on your house.  Obviously 2% is significantly lower than you could get in the stock market, on average.

Plus, that 2% number is a bit of a best case.  Over time, you’ll be paying off your mortgage so your investment will creep up over 20%, decreasing the impact of the leverage.  Also, as we mentioned last time, when you sell your house you’re likely going to have realty fees which basically act as a massive transaction fee which can really zap your profits.

 

We’re at 1500 words.  Karthee had a really great point that we should look at our house as a “leveraged” investment and that definitely enhances the positive returns if you house does increase in value (we didn’t touch the nightmare scenario of an underwater mortgage ☹).  In our case, the leverage put us ahead of what we could have done in the stock market, so that did make our house a good investment, I suppose.

However, the data shows that even with leverage houses tend to underperform the stock market pretty drastically.  As I said last time, that doesn’t mean you shouldn’t own a home.  We do.  There are a lot of great reasons beyond the investment angle to do so.  Let’s just be weary of thinking they are these great investments.