The difference between a debt and equity strategies is simple. Debt strategy aims to get-ahead by managing a slew of monthly payments in the hope that paper profits will make up for all the interest expense, presuming they cash out in time. Equity strategy aims to build real equity ownership at the lowest cost, and rely on money in the bank. Appreciation is but icing on the cake.
The debt strategy worked well in the Old Normal when steady pay raises made debt look gradually cheaper. Guaranteed pensions removed much of the risk. So long as a rising tide lifted all boats, it was a good way for ordinary people doing ordinary jobs to build soft equity.
The fundamentals have changed, however. The tide isn’t lifting all boats, secure jobs and steady pay raises are the exception, reserved for those in science, medicine, and technology. Guaranteed pensions are a thing of the past.
Managing debt, supporting a slew of monthly payments, is no longer a sure way of getting-ahead. Appreciation, i.e. paper profits can disappear, taking all the money spent on interest expense. In other words, it’s increasingly difficult to borrow yourself “rich.” The chance of ending up with an empty bag is much greater.
It’s time to reverse direction: Instead of monthly payments, it’s time to make monthly deposits into saving and investment accounts. Instead of paying compound interest, it’s time to earn compound income. In other words, it’s time to get the time-value of money on your side. This is the “equity strategy.”
Money in the bank may be the old fashioned way of getting rich, but it’s the proven path to enjoy financial peace of mind, protecting you through thick and thin. After all, everyone needs a safety-net of their own.
The equity strategy is the winning formula in the New Normal.
Equity Strategy vs “Cheap Mortgage”
Yeah, but … isn’t a cheap mortgage, i.e. low interest rate and small monthly payment, just as good? Actually, it’s not the rate that controls the cost, but the length of the repayment period – the longer the period the more expensive, irrespective of the interest rate.
For example, it seems a 5% interest rate means the cost to repay $1 of debt is 5 cents on the dollar. Wrong! The interest rate is only the annual cost to keep the loan afloat, not the true cost of repaying the principal itself. True cost is based on the total amount of cash to repay $1 of principal, regardless of how long it takes.
For example, for every $1 of principal repaid during the first five years of a 5%, 30-year mortgage, the homeowner pays about $10 of interest, a true cost of 1,000% (10 to 1), That’s because so little of the payment goes to principal repayment that homeowners pay interest time and again on virtually the same balance, year after year.
This proves that it’s not the rate that adds the greatest cost to a mortgage, but time! The longer the repayment period, the more expensive the mortgage. Hence, a 15-year term with a high interest rate is cheaper than a 30-year mortgage with a low rate.
The reality is most people have no choice but to take the longest mortgage in order to qualify for the loan. Happily, they don’t have to live with it as their circumstances improve: They can give back some of the money and thus eliminate the front of the mortgage, where most of the interest is located. In other words, they can buy back time.
For example, $1 of principal acclerated during first five years of that mortgage example eliminates $10 of scheduled interest expense. In effect, a 1,000 percent return, the best investment you could possibly make. Another avenue it to refinance and get a shorter term, in lieu of a smaller payment. Once in the back of the mortgage, your monthly payment has real buying power.
All of which would be undone if you get a new 30-year mortgage every time you move. Your career will be over before you know it! Which would make it the most expensive mortgage ever!
Safety Net
The equity strategy applies to all purchases and investments that require monthly payments, when they’re too expensive to be paid all at once.
The same principles apply – it’s time that adds the greatest cost to the purchase, not the interest rate or monthly payment. The longer the payments the more expensive the purchase. Conversley, the more money the lender makes. Which is precisely why they offer low low monthly payments (“only pennies a day”), which is the seductive trap. (It would take 34 years to pay off a credit card with minimum payments.)
Therefore, instead, of shooting for the lowest monthly payment, consumers should aim for the shortest term. Aside from a home or an automobile, it’s best if other time-payments were a year, or less. Before long, money that went to these payments could go to savings, even before 15 years of career are liberated for a retirement nest egg.
Savings and investments of your own, supplemented by a cash nest egg for retirement, are a genuine safety net. Money you can lean on. So much the better if inflation and appreciation increases the paper value of assets, but you’re not betting on it, gambling.
One thing the Pandemic has proven is everyone needs a rainy-day fund. With so much access to credit before the pandemic, many didn’t think they needed a safety net of their own. One of the first steps in the New Normal is to reduce time payments to a year or less. Money that went to those payments could then go to saving and investment accounts.
Eventually, after you pay off the mortgage, 25 percent of income could go to those accounts. Not coincidentially, this is the size of the mortgage payment, if not more. Once again, this prove that Millennials cannot spend their entire careers on mortgage payments.
Their financial security comes from leaving time and money to invest in themselves.
A Last Word…
People are tempted to gamble when they wish things were otherwise. A “gamble” is when they don’t know all the factors, nor have control over them. It’s a calculated “risk” when they know the factors and have reason to believe he or she can influence them in their favor.
Why people would gamble, rather than take a calculated risk, is due to Human Nature. For example, many will gamble the good ole’ days will be back, rather than plan on liberating the last 15 years of their careers for saving and investment accounts.
Indeed, 90 percent of people would rather wait and see than break from their friends and relatives and be a forerunner in adopting the Equity and Nest Egg Strategies. Which means only 10 percent of Millennials will make the switch and build a cash nest egg of their own. Even so, that would amount to 7.5 million Millennials, enough to shift the entire paradigm on how people finance their biggest investment, and leave time to invest in themselves.
© Copyright, Cunningham Advisors LLC., 2020
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