“…if your house is your largest investment, you’re in trouble.” — Robert Kiyosaki
My household has finite income.
It turns out this is a common problem. When you have a limited amount of money coming in each paycheck, it can be very easy to have conflicting financial goals.
My wife and I find ourselves in this situation. Here are our top two long-term financial goals:
- Achieve financial independence through property investment.
- Pay off our personal home.
These two goals create tension, competing for every extra dollar that we can make available. It’s easy to have an “I want it all” attitude, but life has a way of forcing you to prioritize. Which of these goals should get the focus of our attention and money?
I’ve had this discussion numerous times with friends and colleagues. Across the board, the priority for most people is to pay off their home. Other than some retirement account contributions, most people plan to begin investing only after they are mortgage-free.
Is this the best way to approach this problem?
Risk and Reward
I understand the logic. If my home is paid off, then I’ll have more money available to invest. There’s also the risk factor: On the one hand, if I lose my job and my home is not paid off, then I could lose my home. On the other hand, if I lose my job and my home is paid off, then it’s just my investments that will suffer.
In a recent article, I explained how my wife and I followed the BRRRR strategy to purchase three rental properties and put all of our investment money back into our bank account. The purpose of the article was to explain how the BRRRR strategy works, regardless of how you obtain the money for your deposit and rehab costs.
However, I received a number of questions asking me about the way we actually obtained our initial deposit.
In our case, we got the money to invest in rental properties by refinancing our personal home. This is often referred to as a Home Equity Line Of Credit or HELOC. By doing this, we actually chose to get further away from the goal of paying off our home in order to purchase rental properties — the exact opposite decision that most people make. As was pointed out to me, this also means that we were paying interest on the money that we used for our deposit, as well as the money that we borrowed from the bank for the mortgage on the rental property. This is true.
But is it a good idea?
The fact that the BRRRR strategy eventually returns your money to you means that you’re only paying interest for a period of time. But even if this wasn’t the case, I would still do it. Why?
The Hidden “Mortgage Tax”
First, let me ask a question: If you have a mortgage on your personal home, is there anything that you can do with the money from your paycheck that doesn’t come with an interest payment attached?
If I have a mortgage on my home and I choose to spend $5 on a coffee, that is $5 that I could have paid toward my home mortgage, right? So really, I am borrowing the money for the coffee and paying interest. That sucks! In fact, this “mortgage tax” applies to everything you spend money on, including food and clothing, piano lessons for your kids, and popcorn at the movies.
It may not seem like much on a $5 coffee. But in reality, all of your paycheck that isn’t going toward paying down your mortgage is being charged interest. This really adds up.
This line of thinking supports the theory that paying off your home mortgage should be your top priority. I think that this is what drives the majority of people to make this their top priority.
What Are You Planting?
But let me ask another question: If your plan is to grow a forest, would you plant a single tree and wait for it to reach maturity before planting a second tree? Of course not. Plant as many trees as you can effectively water. Right?
It turns out that there is an exception to the “mortgage tax” rule: Money that earns a higher return than you are being charged on your mortgage is effectively exempt to this hidden tax.
Investments require time to grow. Whether you’re buying properties or investing in the stock market, it takes time to build real wealth. Most people who want to pay off their home before investing seriously simply can’t visualize the financial forest that they haven’t yet planted; they can’t see the forest for the trees.
Meet Adrianna and Dolores
Here’s a little thought experiment that presents one way of thinking about it:
Adrianna’s goal is to achieve financial independence. She sells her home and moves her family into a rental. Taking the equity from the sale of her home, she invests it in assets for the next 10 years. She implements a plan similar to the BRRRR strategy; after 10 years, she has established an annual passive income from her assets equal to the income from her job. Adrianna is now financially independent.
Financial independence means that Adrianna has options. She can buy a house if she chooses and pay the mortgage using passive income. It doesn’t really matter how long it takes to pay it off since she doesn’t have to worry about losing her job — she doesn’t rely on her job for income. She can also choose to continue working, pursue other interests, such as starting her own business, or just put her feet up and relax. Adrianna gained nothing financially from paying rent for 10 years, but she’s now financially free.
Dolores thinks financial independence would be nice, but can’t imagine where she’d find the money to invest. She takes those same 10 years to pay off her home. After 10 years, she is mortgage-free and decides that it would be good to start investing. She then starts investing in assets. After another 10 years, she has established an annual passive income from her assets equal to the income from her job. Dolores is now financially free.
It took Adrianna 10 years to achieve financial independence, while it took Dolores 20 years to achieve the same goal — everything else being equal.
Pick a Strategy
The exercise shows two ends of the spectrum, given the same two goals: home ownership and financial independence. Obviously, there’s a lot of room to flex in between the two extremes. The correct answer for you might be somewhere in between. But at the end of the day, each dollar you earn can only be applied to one or the other. You must decide what you want to achieve.
In reality, if it is going to take you 20 or more years to pay off your home before you even begin to start investing, it might be worthwhile to reconsider your strategy.
The argument isn’t about math. It is qualitative rather than quantitative in nature. It’s about opportunity cost.
The way I see it, there are four ways to approach the problem:
- Don’t own a home at all. Rent a home and invest until you are financially independent.
- Buy a home that costs you less than you would pay in rent. You need a place to live, but if you’re paying less than what it would cost you in rent, then you effectively get to own the house for free.
- Pay off your home first. Whatever size home you have, pay it off before you invest. This might be effective if you start very young and pay it off very quickly, leaving you many mortgage-free years to invest.
- Buy a home for your family. But use this information as a guideline — purchasing more investments is always the higher priority.
Our family is actually using approach #4. We have looked into a number of options, including house hacking (a variant of approach #2). However, we have chosen to have a home in which to raise our family. We do this knowing the risks involved with having a mortgage on our home. And we also do it with an eye always to building our investment portfolio as the higher priority. This is why we have chosen previously to use home equity to invest in property — and why we would do it again to continue to grow our portfolio.
Protect Your Strategy
I’m not telling you which approach is best for you. In my opinion, getting a HELOC to spend the money on just about anything other than a solid investment is a bad idea. If you do decide that a HELOC is the way to kickstart your investment portfolio, remember this: All of the normal rules of budgeting apply. You need to be able to afford to make the additional payments on your home mortgage. And you still need to have 10 percent or more of your net income left over for future investing.
The key to accepting the risk involved with not having your home paid off is to mitigate it. A multi-factor approach can be effective:
- Establish an emergency fund. Most financial advisers recommend having an amount of money set aside equal to 3-8 months of expenses. Having such a fund buys you time. In the event that your lose your job, you have several months to pursue any number of solutions. You might sell your home, find a new job, sell an investment property to pay down your home mortgage, etc.
- Having various forms of insurance also helps. This may include life insurance if you have a partner or dependents, income protection insurance in case you become unable to work, or medical insurance to ensure that you don’t get financially sunk by illness or injury.
- Understand how to get your investment money back. You can reapply it to your home mortgage until you’re ready to invest again.
Whatever strategy you choose, make sure you understand both the risks and the rewards. Take steps to compensate for those risks. Then start planting a forest of wealth for your future.
What’s more important to you? Which strategy are you using?
Let’s discuss in the comments below!