Afford Anything - Ask Paula: Can I Quit My Job Before I'm Financially Independent?

Episode Date: May 26, 2020

#258: “Burned Out in Boston” wants to reach financial independence. But she’s not sure she can stick it out in Boston much longer. She and her husband want to move to an area that doesn’t have many job prospects, and they want to make this leap soon, ideally before they reach FI. How do they know when it’s the right time to jump ship to their dream location? We tackle this topic, plus four other questions about stock market and real estate investing strategy, on today's Ask Paula episode. Enjoy! For more information, visit the show notes at https://affordanything.com/episode258 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything, but you can't afford everything. Every choice that you make is a trade-off against something else, and that applies not just to your money, but to how you spend your time, your focus, your energy, your attention, any limited resource in your life. And that leads to two questions. One, how do you want to direct these resources? What is most important to you? And two, how do you make sure that your daily decisions align with that? Answering these two questions is a lifetime practice, and that is what this podcast is here to be. explore. My name is Paula Pant. I'm the host of the Afford Anything podcast. Every other episode,

I answer questions that come from you, the community. And today, we're going to kick off with a question from someone who wants to reach financial independence, FI, but is not there yet. She and her husband would like to make big lifestyle changes, move out of the city into somewhere more bucolic. Given that they haven't reached FI yet, should they make this leap? Let's hear her question. Hi, Paula. I'm a big fan of your podcast. It's always the first one I listen to each week. I'm anonymous, but you can call me burned out in Boston. And my question is about evaluating the right time to make a big lifestyle change. My husband and I are in our early 40s living in a high-cost area. Our only debt is our mortgage and our net worth is about $1.1 million. About $300,000 of that is equity in our house. Of the remaining $800,000, most of it is in traditional pre-tax retirement accounts. Only about 80,000 of it is either in cash or taxable accounts, and we've made about 70,000 in Roth contributions in IRAs or our workplace accounts. That means we don't have a lot we can easily draw from if we retired early.

I feel like we're in pretty good financial shape, but we're not FI yet. I think our target number is about $1.2 million, not including equity in our home. The thing is, it's slowly killing us to live in the big city with the crowds and commuting and the 9 to 5 grind, our dream is to move to a quieter, slower-paced life closer to the outdoor spaces where we spend most of our free time. And we'd like to road trip a month or two each year. We don't even want to fully retire as much as take a mini retirement or semi-retire and keep working part-time to cover some expenses. But the area where we want to move doesn't have many job prospects for either of us. Our current expenses are about 45,000 per year and we're able to

save about 60 to 70,000 a year. We're committed to working here in Boston for two more years until I fully invest in my employer's retirement plan, but I'm not sure we can stick it out much longer than that. If we move to the area where we've been eyeing, we could use the equity we've built up in our current house to purchase our next house outright, which would lower our monthly expenses. So my question is, would it be irresponsible to pull the trigger and move away from the city before we're FI, when we could get there a lot quicker by staying here? And should we change our savings strategy in the next couple of years so we have more in taxable accounts or raw contributions that we can draw from before we reach the age of 59

and a half? I would love your advice. Thanks so much, Paula. What a fascinating question. When is the best time to make a big lifestyle change? Do you have to reach a certain target or a certain number for that lifestyle change to be okay? That's a great question. Thank you for asking it. And first and foremost, I'd like to say congratulations for everything that you've built. You're debt-free other than your mortgage. You have a $1.1 million net worth. You've made huge contributions to your retirement accounts.

So as you say, you're in great financial shape. You're doing an amazing job at living below your means. I mean, you're living on $45,000 a year and you're saving as much as $70,000 a year. So first and foremost, congratulations to you for living that lifestyle and making those choices that got you to where you are now. And so to your question, what next? What I can hear from your question is that you do sound burned out. You're burned out in Boston.

That burnout isn't healthy, and ultimately it will hold you back. So if what you want is to move to a smaller area, a quieter, more peaceful place, do it. But do it with a plan. Now, one thing that I loved about your question is that you mentioned that you're committed to staying in Boston for the next two years, so that you'll be fully vested in your employer's retirement plan. Two years will give you a lot of time to prepare for this transition. So I think you're ready to start making that two-year plan, start mapping out your last two years in Boston, your last two years at your company,

and start putting the runway in place so that after you transition to the new place where you'll live, you will have enough of a cushion, enough of a runway, that you can comfortably live on that while you're figuring out what's next. In other words, don't feel pressure to have enough money that you could fund retirement in perpetuity because that's not what you're trying to do. You're trying to have enough money that can get you through the transition. And you know that that transition might be long. It might take a while.

It may take a while to find jobs. It may take a while to get your bearings. And during that period of transition, there will be an issue. interruption to your income. And so your goal right now is not FI in the long-term passive income in perpetuity sense. Rather, your goal, your immediate goal, is to have a big enough bucket of money that you can transition without stress. You can transition with the benefit of time on your side. Perhaps kick it off with a one-month road trip. And then once you're settled in your new home, enjoyed the luxury of having time to find new jobs that are a good fit without panicking about

how you're going to cover your monthly bills during the interim period. So I think you can guess what I'm going to say next, which is that for the next two years, I'd like you to prioritize saving cash. You've done an amazing job of putting money into your retirement accounts. The thing that I would like to see you have as you move into this next phase is a pile of cash, literally cash in a savings account. Don't invest it because two years is a short time horizon. And if it helps, you can mentally bucket your cash into two different categories. You'll have that bucket that's the emergency fund, and then you'll have a separate bucket that's the cash that you're going to use to get you through the transition. Now, in terms of your emergency fund, it sounds as though you may be

on top of it because you mentioned that you have $80,000 in a combination of cash and taxable brokerage accounts. Now, I don't know what that split looks like, but assuming that that 80,000 is split 50-50 with 40 grand in cash and 40 grand in a taxable brokerage account, well, that means that you have an emergency fund of $40,000 and your annual living expenses are $45,000. So you have almost a year's worth of expenses already saved. And when you transition to this smaller town, if you buy a home outright in cash, then your monthly expenses will drop, which means you'll need even less than $45,000 a year to cover your basic living costs. So once you move to this smaller town, the size of your emergency fund, again, assuming a 50-50 split of that 80,000 figure that you mentioned,

the size of your emergency fund will be a year's worth of expenses or more. So it sounds as though you're doing great there. You've got that nailed down. And now it's time to start bucket number two. Make it a separate account so that you can't mentally commingle these funds. and bucket number two is purely for this transition. You don't need to reach FI. You just need to have a good runway.

Thank you for asking that question, and I'm excited for you. I'm excited for all of your plans, the road trips, the quieter community that you've always dreamed of living in, the fact that you'll be completely debt-free. Once you sell your current home in Boston and you move into this new place in two years, you'll buy it outright.

You don't have any other debts besides your mortgage, so you'll be kicking this off debt-free. And that means you'll be starting this next chapter in your life from a position of strength. So I'm very excited for everything that lays ahead. And congratulations. Please call back, leave another voicemail, and give this whole community updates on your progress along the way

because I suspect that your feeling of burnout will dissipate and give rise to much bigger, bolder, better things. Thanks for the question. Our next question comes from Chelsea. Hi, Paula. My name is Chelsea. I am 28 years old and I live in Birmingham, Alabama. My question is about what to do if you've accidentally bought a money pit.

My wife and I have been living in this house for about a year and a half. We told our real estate agent that we were interested in a house that was move-in ready since we didn't have any extra time to invest in home repairs because we're both working full-time and we're both in school. We also chose to live in Birmingham. over Atlanta because you can get a fully renovated house in Birmingham for the price of a burnt-out shack in Atlanta. We believe that we had done our due diligence. We had our inspection and we visited the house several times and we drove through the neighborhood. We did, you know, all that jazz.

I've gone back to our inspection documents and I feel like some of our problems came out of the blue. When I came home today, the ceiling in my bathroom had fallen in from water damage. This, while we're in the midst of dealing with the ceiling in our little bit of the ceiling in our little, living room falling in from water damage. And this happened after we depleted our emergency fund, trying to fix our HVAC. And that happened after we fixed the water damage in our master bedroom, where the wall was so soaking wet that the paint was blistering. It's feeling like one thing after another. All the advice online seems to be about how to avoid buying a money pit, where there's next to no advice about what to do once you've done it.

I feel so overwhelmed. Looking at the fallen ceiling in my bathroom is really discouraging. So what do you do when you accidentally bought a money pit and how do you stay motivated when the sky is literally falling? I really love your show. Thank you so much for everything you do. Chelsea, congratulations on buying the house, and I'm sorry to hear that it is not what you thought it would be.

damage can be incredibly expensive and time-consuming and frustrating to deal with. So I'm sorry to hear that you've had to deal with far more damage than you thought that you would. And let's talk about what you can do. Now, we're going to talk about both the seller and the inspector with regard to their roles and their responsibilities to you during the home buying process. Let's start with the seller. The seller is required to fill out a seller disclosure form. You should have received one of these during the home buying process. Within this seller disclosure form, the seller is required to disclose to you any material defects or adverse facts about the property that they know about.

So go back to your purchase and sale documents, the documents you received during the home buying process, and dig out that seller disclosure form, take a close look at it, because it may be the case that the seller failed to disclose to you important information. material defects and adverse facts, and if that is the case, then you may be able to go after the cellar. However, if you do go after the seller, it is on you to demonstrate that the seller knew about it. For example, you mentioned that the ceilings in the bathroom in the living room have fallen in from water damage. Let's assume, hypothetically, that the seller was aware that there was some serious leaking going on and had called in contractors, roofers, to assess the damage and give an estimate. Or perhaps the seller even hired those contractors to perform some cursory repairs,

ones that wouldn't solve the underlying issue but would paper over it for a while. And the contractors, in the process of doing so, pulled permits on that work. If, hypothetically, this was the case, and if also none of that damage was disclosed on the seller disclosure form, then you may be able to demonstrate that the seller knew this information. They were aware of these material defects with the property, and they failed to disclose it. In most cases, that's a fairly hard thing to demonstrate. In the hypothetical example that I just gave, we talked about a permit being pulled for insufficient work. So there's documentation, and yet there's still insufficient work.

And in an example like that, perhaps the roofer, in the estimate that they handed to the seller, the roofer could have said, hey, this is what's wrong and you need X, Y, and Z in order to fix it. And the seller might have just said, you know what, let's only do X, let's not do Y and Z. And then the seller did not disclose Y and Z to you. In a situation like that where there is that level of documentation, then there's evidence that the seller knew about the problem and didn't disclose it to you. But if that's not the case, if it's possible that the seller may not have known, well, then it's possible that the seller may not have known. So to the question that you asked, which is what can you do, one step is to gather as much information as you can about what the seller disclosed to you, which will be on that form, and what the seller knew. Now, a different option is to go after the inspector.

If the inspector absolutely botched the job, you could go after the inspector for either negligence or breach of contract. But again, this is going to be difficult because the challenge here is that you. you need to demonstrate that the water damage that you referenced in the voicemail, you need to demonstrate that that was there before you bought the property. Because of course, if the water damage took place after you purchased the property, well, then it's yours. You own the property, you own the water damage. But if this is old undisclosed damage that existed before you purchased the property and that the inspector did not report to you in the inspection report, then you may have a claim. Again, the challenge is demonstrating when the water damage took place.

You mentioned that you bought this property one and a half years ago, and in the world of real estate, one and a half years is a very long time. My question back to you is, what problems started arising within the first 30 days of living there or within the first 60 days of living there? Because if you can show receipts, credit card statements, photos, any documentation that shows problems that started as close to the date of your closing as possible, that will help. Now, there's no hard cutoff. There's no official cutoff at 120 days or 180 days. There's no official line in the sand. But generally speaking, the closer that the problem started to the date in which you closed on the property, the stronger of an argument you have if you want to argue that these problems existed prior to the purchase of the property. Again, with that purchase happening one and a half years ago, that's a very long time.

But, I mean, I don't know how long you've been dealing with this, you've been working on it. If you moved in and within that first week you had already spotted the water damage and started getting repair estimates, that proximity to date of closing will help bolster your argument that the problems were there prior to closing. Now, I don't know the details of everything that you've dealt with. You mentioned that your HVAC went out. Was that because it was old and it just was so old that it was eventually time to replace it, similar to a car or a computer, items like air conditioning units wear out and need to be replaced periodically?

So was that the issue or was there damage? And if there was damage, then when did that damage take place? Now, stepping back from this conversation around dates and documentation and data gathering, the other side of that question of what can you do is, unfortunately, overestimate how much you'll be spending in repairs, maintenance, major capital expenditures, and create a bucket of savings specifically for that, create a bucket of savings specifically for home maintenance and repairs and CAPEX. Because as time goes on and as more and more things around the home get fixed,

then you will have a very firm, very clear idea of the remaining lifespan of the major components of the home. I mean, you already certainly have a fairly clear idea of the remaining lifespan of the roof, the windows, the HVAC, but how old is your electrical panel? How far into the future might it need to be replaced? By looking at the major components of your home and anticipating the major CAPEX needs of the property, that is an exercise that puts you in a position of being able to estimate those costs more accurately, moving forward, to be able to budget for those costs, moving forward, to have a clear idea of what repairs, maintenance, and CAPEX needs that property is going to have in the next five to ten years. One thing that I frequently recommend that my students do, the students in my rental property investing course, I always tell them to have, to have, two walkthroughs of the property

before you purchase the property while you're in the due diligence period once you're under contract, I tell them to send in an inspector and also to send in a licensed general contractor whom you will pay on an hourly basis to do a walkthrough of the property

and to be a second set of eyes on the property. Now, this is redundant. The inspector and the general contractor would be doing exactly the same thing, not at the same time you don't want their visits to overlap, but by sending in two redundant people, one person may catch something or spot something that the other person didn't. So there are other real estate investors who will say, like, that's overkill, you don't need two people.

But I think that having that second opinion, having that second set of eyes is a good idea. And it doesn't cost very much. You know, if you have to pay that contractor $50 an hour to spend three hours doing a very thorough walkthrough of the property, that's money well spent. So I know that that doesn't help you right now in your situation, but I'm saying that for the sake of everybody who's listening who might be wondering, right, how can I protect myself, or how can I verify that what I learned from the inspection report and what I learned from the seller disclosure form jives with my understanding of this property. Thank you for asking that question, Chelsea. I'm sorry to hear that you're dealing with this. Stay focused. Take it one step at a time. And you'll get through. this, and you'll have an amazing property that you have restored back to health. Thanks, Chelsea. Up next, we're going to hear from Pat, who lives in Los Angeles and is thinking about converting

her garage into a rental unit. But before we get to that, here's a quick break for a word from our sponsors. Fifth Third Bank's commercial payments are fast and efficient, but they're not just fast and efficient. They're also powered by the latest in payments technology built to evolve with your business. Fifth Third Bank has the big bank muscle to handle payments for businesses of any size. But they also have the fintech hustle that got them named one of America's most innovative companies by Fortune magazine. That's what being a fifth third better is all about. It's about not being just one thing, but many things for our customers. Big bank muscle, fintech hustle. That's your commercial payments a fifth-third better.

The holidays are right around the corner, and if you're hosting, you're going to need to get prepared. Maybe you need bedding, sheets, linens. Maybe you need serveware and cookware. And of course, holiday decor, all the stuff to make your home a great place to host during the holidays, you can get up to 70% off during Wayfair's Black Friday sale. Wayfair has Can't Miss Black Friday deals all month long. I use Wayfair to get lots of storage type of items from

my home, so I got tons of shelving that's in the entryway, in the bathroom, very space-saving. I have a daybed from them that's multi-purpose. You can use it as a couch, but you can sleep on it as a bed. It's got shelving. It's got drawers underneath for storage. But you can get whatever it is you want, no matter your style, no matter your budget. Wayfair has something for everyone. Plus, they have a loyalty program, 5% back on every item across Wayfair's family of brands.

Free shipping, members-only sales, and more. Terms apply. Don't miss out on early Black Friday. deals, head to Wayfair.com now to shop Wayfair's Black Friday deals for up to 70% off. That's W-A-Y-F-A-I-R.com. Sale ends December 7th. Welcome back. Our next question comes from Pat. Hi, Paula. I'm looking into converting my garage into an ADU or accessory dwelling unit in the city of Los Angeles. I have estimates of about $100,000 to do the conversion, and I could rent it out for a minimum of $1,500 per month. I'd like to find out if it would be better to pay for this through a

HELOC or to refinance my mortgage, which is currently at 4.25%. It would definitely increase the value of my house, although I'm not looking to sell the house for at least five or more years. In addition, my lot is not that large, and I already have tenants living in another cottage on the property, so I'm just not sure if I want another stranger living so close to me. I live in a very high-cost area, but I could potentially use that refinance money to buy another property elsewhere, although since I'm currently working full-time, I don't have a lot of time to manage properties at a distance. I'd love to hear your thoughts on this plan. Thank you, Paula. Pat, first congratulations for already having a rental. You mentioned that you currently have one cottage on your property

that you use as a rental. So congratulations on having that first one and on thinking creatively about how you can get this second one. So let's talk about your idea. So you're thinking about converting your garage into an ADU. The numbers that you gave right off the bat are excellent at a conversion cost of $100,000 and then rent for $1,500 a month. Wow, I mean, just on its face, your potential gross rent, which means the gross top line rent that you could collect at 100% full occupancy would be $18,000 a year on a $100,000 investment. And for a potential gross rent to have that top line gross of 18% of the investment value, I mean, whoa, that's very good. Now, of course, that's not what your net returns are going to be. First of all, nobody ever has 100% occupancy.

And then, of course, there's repairs, there's maintenance, there's management, there's increased insurance and property taxes. All of those will take a bite out of it. But what's cool about your situation is that the bite isn't going to be as big on an ADU as compared to what it will. would be if you were to buy a single family home that had those exact same numbers. So hypothetically, if you were to have said, hey, Paula, I found this great single family home that costs $100,000 and I can rent it out for $1,500 a month, I would still go, wow, those are awesome numbers. But in that case, I would say, hey, and all of your operating expenses are going to take about a 50% bite out of your top line gross. So that 18% top line gross then is going

to shrink down to around 9%, which is still an amazing number because that's a 9% unleveraged dividend stream. If you conservatively assume equity growth at just keeping up with the rate of inflation and nothing more, which historically has been 3% per year, then that leads to a total return, unleveraged total return of 12%. So that's what I would say if you had shown me those numbers on a single family home. But what's cool about your situation is that with those numbers applying to an ADU that's on your property, you're going to have the same benefit that a lot of multifamily home investors have, which is that because it's on your same property, you will consolidate some of the overhead. For example, water, sewer, trash collection.

landscaping and yard work, when you have three autonomous units that are all on that same piece of property, the ADU, the cottage, and the home in which you live, all three of those autonomous units on that shared piece of property are going to be sharing in those costs. As another example, your insurance, yes, is going to rise, but it will not rise to be as high as it would cost if you were to take out a completely new separate insurance policy on a separate property. And so for all of those reasons, your operating overhead will be most likely less than 50%. And you'd have to run a spreadsheet to know exactly how much less. But I mean, let's say that it's 40% instead of 50. So in this hypothetical scenario, of the 18,000 that you collect each year in potential gross rent, 40% gets consumed by vacancies and operating expenses, leaving you with the remaining 60% of 18,000, that's cash flow of almost $11,000 a year, 10,800. So the number sound great.

You're getting huge rent relative to the cost of the investment. And on top of that, the ongoing operating costs are likely going to be lower if it's an ADU that's on your property. Now, I want to address a few things that you said within your voicemail. So first, you asked if you should pay for this with a home equity line of credit, a he lock, or if you should refinance your mortgage, which is currently at 4.25%. Now, a helock is not meant to be a long-term loan. A heloc is a revolving line of credit, kind of like a credit card. So you can borrow the money that you need against the line of credit that you've been authorized to receive, and you make payments only on the amount that you actually borrow, not on the full amount available. So again, compare it to a credit card

where a credit card might authorize you up to spend up to a particular credit limit, but they don't charge you for the fact that you have a certain limit on your credit card. What they charge you for is the amount that you actually borrow against if you carry a balance month over month. So a HELOC works in a similar way. It's a revolving line of credit. You can tap it when you need it, but it's not designed to be a long-term line. loan. Many helocks also have variable interest rates. Now, you could take a home equity loan, which is for a fixed amount of money with equal monthly payments over a fixed term.

Think of two types of debt. There's revolving debt, like a credit card or a helock, where you just have authorization to borrow up to a certain amount and you, you know, tap it a little bit here and there when you need it. But that open line of credit model, that's called revolving debt. The other model of debt is installment debt, where you have those equal monthly payments over a fixed term. And that type of debt, installment debt, is much better for any type of long-term loan that you are looking to get into. So a home equity loan has installment payments, and a cash-out refinance also has installment payments. So those are two common types of loans that are both designed to be long-term, which is what you're looking for.

And between those two, the cash-out refinance is going to. offer the lower interest rate. And the reason for that is because with a cash out refinance, you are paying off your existing mortgage, you're closing out that existing mortgage, and replacing it with a new one. So you only have one mortgage. When you do a cash out refinance, you close the mortgage that you have and then you open up a brand new one. If you take out a home equity loan, then you're taking out a second separate loan. So you have your current mortgage and then you also have this second payment on top of it from a second and separate loan, which is the home equity loan. And because home equity loans are second loans,

rather than first loans, they have higher interest rates. So due to those factors, the cash out refinance will fit what you need. It's a long-term loan with installment payments and it'll carry a lower interest rate relative to taking out a second loan. So go for the cash out refi. Now, there are a couple other things that you said in your voicemail that I want to address. First, you said that you already have a cottage on your property that you use as a rental. You don't know if you want to have another second rental on your property. You know, you don't know if you want that. And that's a really good thing to know about yourself. And only you can answer the question of whether or not you want it.

But I would invite you to think very carefully about that before making this six-figure investment. I think it's quite wise of you to have the self-awareness to question whether or not you want the day-to-day experience of having somebody live in this additional unit on your property. Now, you also said, adding the ADU is going to increase the value of your house. When it comes to analyzing rentals, I don't care about the increased value. I care about the dividend, like the income stream from the ADU conversion. And then finally, you floated the idea of buying a property in a different area and mentioned that you don't have the bandwidth to manage a property from a distance. That's not going to affect your numbers.

When you run the analysis, you want to run the numbers as though you're hiring a property manager in either scenario. Even if you plan on self-managing, run the analysis as though you are hiring out a property manager. calculate your returns based on that assumption. That way you have the ability to do so at any time. Thank you for asking that question, Pat, and congratulations on this amazing opportunity. We'll return to the show in just a moment. Our next question comes from Julia. Hi, Paula. I wanted to call in to ask about how you think about index funds for specific sectors. So up until this point, I had invested in total stock market or total bond market funds. So VT Sachs on domestic, VTIX on international, BNDX for international bonds, and BBTLX for domestic bonds.

Now I'm looking into having some of my future funds invested into specific sectors, in particular. I have worked in the utilities sector before, and I think compared to the rest of the market, it is more stable, and so I have started to invest in it in this time through VPU, the utilities ETS. Right now, I have about $2,500 of a $43,000 portfolio in VPU, and I put another $900 into consumer staples with the thought that these might be sector. that'll be more stable if there's a long period of social distancing. To give more context about this fund, I've been maxing out my 401k, and since we have a solid six-month emergency fund, and my husband, who makes less than me, contributes to his Roth IRA. I contribute on pre-tax side, and we file separately, given student loan reasons. I've been investing in this brokerage account, any extra funds with stated purpose of retirement, but the added flexibility of it being a taxable brokerage.

Curious to get your thoughts on if I'm investing in individual sectors, if I should think of these as bets, that should be less than 5% of my portfolio, or if these could be a larger percent given that they aren't individual stocks, but rather sectors that I think, may be undervalued compared to the rest of the market, given that I don't think VT Sacks is valued correctly right now. Thanks for everything you do. Julia, that's a fantastic question. How do you think about sector-specific funds and what is the ideal asset allocation for it? Because you're totally correct. Sector-specific funds are not as volatile as individual stocks. An individual stock can go all the way

down to zero, whereas a sector-specific fund is a fund. It's a basket of stocks. So the winners will offset the losers, and that means the volatility won't be as high. So you're totally correct in that in terms of confining these sector-specific bets, these do not need to be as limited as a self-imposed limitation on individual stock exposure. But at the same time, of course, you don't want it overtaking an excessive amount of your portfolio. So what is a smart allocation. How do you slice the pie? To answer this, let's talk about a style of investing, an approach to investing, that is known as the core and satellite portfolio. Here's how it works. Sit back, think big picture about your entire portfolio, and divide it into two buckets,

core, which is the bulk of your portfolio, it's the main course, and satellite, which is the smaller portion of your portfolio. It's the side dishes. Now, in a core and satellite portfolio construct, the core component would be very similar to Julia what you described having. Total stock market, total bond market. And that's it. There's no further diversification inside of that core. It's total stock market, total bond market, done. The satellite portion of the portfolio is where you have that further diversification.

And this would include things like sector-specific funds, reits, emerging markets funds, high dividend yield funds, the satellite portion is where you really get to have some fun. And so the beauty of mentally compartmentalizing this into two different buckets is that the core portion of the portfolio does not get traded, does not get tinkered with, and you can continually add to it regularly through a workplace retirement plan, through making automatic monthly contributions. So you can keep adding to and growing that core portion and you're not touching it. It's boring, it's hands off. You may need to rebalance between stocks and bonds once a year. Other than that, you're not touching it. The satellite portion of the portfolio, that's where you can tinker with those specific sectors,

regions, or styles. And so, Julia, your question was about sector-specific funds, but within the core satellite model, sector-specific funds get lumped in with small-cap funds, mid-cap funds, mid-cap, funds, Latin America funds, all of those together have a combined aggregate allocation, which is considered the satellite. And so the natural and obvious question is, all right, what percentage should be in core and what percentage should be in satellite? And as you might expect, there is no agreement among people who do this for a living. I have seen some people say that you should allocate 80% towards the core and the other 20% towards satellite. I've seen other people at the opposite end of the spectrum, go so far as to say that you can allocate 50% or less to the core,

which personally, I think, is not a very good idea. I mean, by definition, the whole implication of core and satellite is that the satellite would be smaller. So to the people who say, like, yeah, core satellite can be 50-50, well, that perspective contradicts the entire visual model of what this approach was named for. So anyway, if you go out and research this, you're going to see a huge, variety of different core satellite allocations that people recommend, and you will see people making those more aggressive recommendations. So I'm throwing that out there because you should

know that if you start talking to people about core satellite investing, then you are going to encounter a huge array of ideas around what that split should be. Myself, personally, I think something like an 80-20 split, 80-core-20 satellite, is a good, moderate starting point. if you want to be more aggressive, I think a 70-30 split, I would have no objection to. But I wouldn't push it too far past there. And I should give a disclaimer that I'm specifically talking right now about people who are following specifically the core satellite approach. I'm not recommending that people, that everybody who's listening go out and do this. This is just one of many different investing strategies, investing approaches.

So I am in no way stating that people should have core satellite portfolios. I'm simply, Julia, to answer your question, I'm simply trying to give context to the question that you asked, which is how do I think about sector-specific funds as it relates to my overall portfolio. And in order to be able to set up a framework to address that question, introducing the core satellite approach as one of many options that some investors choose to follow, can wrap some context around this question of sector-specific funds. But a few more diversification notes specifically about sector-specific funds, don't let any one sector-specific fund represent more than a total of 5% of your portfolio at the maximum. You see, the challenge when talking about asset allocation as it relates to the satellite portion

is that there's so much variation in the way that people set up their satellites. So if your satellite consists of high-risk, higher volatility investments, such as sector-specific funds or country-specific ETFs, if you're holding those types of high-volatility investments in your satellite portion of your portfolio, then that overall satellite portion should be a lot smaller. If that's the case, I would say 20% for satellite is the absolute maximum. I would, if you're holding high volatility holdings in the satellite, I would dial it down to between 10 to 15 percent. Again, if the satellite portion of your portfolio consists predominantly of those riskier bets. And that's the same reason why I say don't let any one specific sector represent more than 5 percent of your overall portfolio. Again, because sector-specific funds are significantly more volatile than broad market funds. and so you don't want to be overrepresented in any one given sector.

Now, again, if you construct your portfolio in a way in which those high volatility, the sector-specific or country-specific ETFs, that high-volatility slice consists of 10 to 15 percent, and then you round out the satellite with maybe a mid-cap fund or a dividend fund, something that's more broad market, it's in those instances when you can up the total satellite holding because of the fact that the high volatility portion of the satellite is confined. So, Julia, I hope this gives some context around how to think about sector-specific funds. And more broadly, what your question really addresses at a macro level is, how do we think about deviation from total market index funds?

If we want to deviate away from purely total stock market, total bond market, total international market, how do we think about that? What framework do we use when we think about adding a small cap slice or adding a dividend growth slice? Or in your case, adding a sector-specific slice. One final thing that I will say, beware of overlap. There are many funds that contain overlapping underlying investments, which means that you may be more represented or have more exposure to a certain type of industry or type of market segment than you realize. And so Morningstar has this thing that's called the instant X-ray tool. And this allows you to x-ray all of the funds that you're holding and see where that overlap is so that you don't accidentally over-expose yourself to a particular sector without intending to do so. we will link to that in our show notes.

The show notes are available at Afford Anything.com slash episode 258. That's Affordanything.com slash episode 258. Thank you, Julia, for asking that question. And congratulations on everything that you've set up. You max out your 401K. You and your husband have a six-month emergency fund. Both of you are contributing to IRAs. And you're also investing money in a taxable brokerage account.

So you've got a lot of accounts. You've got great investments. you've got a healthy emergency fund. I absolutely love everything that you've set up. You're in a place of strength. You have that financial security, that strong footing. And you're asking very wise questions. You know, essentially you're saying, hey, I'm afraid that the market may be overvalued at the moment.

And so I would like to add in some additional diversification, but how do I do it? That is a great question to be asking. So you are absolutely on the right track. Thank you so much, Julia. Best of luck with whatever you decide. Our final question today comes from Ingrid. Hi, Paula. This is Ingrid. I'm a huge fan of yours. I don't ever miss an episode, and I've called in a couple of times. So I'm really excited to hear yet another great answer from you.

Here is my situation. My husband and I currently own two rental properties. One, we owe 350,000 on, and there's a 4.5 interest rate. And the other, we owe 150,000 on. And that one has a 4% interest rate. We also have a mortgage on our home with a 4% interest rate. We don't have any other debt besides those three properties. My goal is in 10 years to have all rental properties paid off so that we have about $100,000 in income coming from rental properties. So we need a couple more. We need about two or three more rental properties to make that happen because we're only making about $50,000 in income from the two that we have currently. So I'd like to make 100,000. $1,000 in income in 10 years and have all of the rental properties paid off. We save about $100,000 per year

that we put towards investments. So my question is, do I pay off the high interest, high loan balance rental property aggressively and have it paid off in about three to five years? Or do we purchase the other rental properties that we need to meet that $100,000 a year goal? Do we purchase those first and then start paying everything off aggressively. I'm just kind of wondering if there's a better way to do it. Pay the properties off first and then use that income from them to buy more rental properties, but then we're closer to that 10-year or buy them now, have the renters start paying them and then pay them all off.

Just wanted to see your insight. Thanks so much. Ingrid, first of all, thank you so much. I'm honored. I'm flattered. Super happy you're enjoying this podcast. glad that you don't miss an episode. That's amazing. So thank you so much for being a part of this community. And congratulations on what you've built. You're debt-free other than your mortgages. You have two rental properties bringing in 50K a year. And you have a super clear goal. $100,000 in rental income within 10 years with all properties held free and clear. Love that. Love it, love it, love it. Now, to your question of, should you pay off the homes first, and then buy more, or should you buy more now and then pay them all down,

let's talk through the pros and cons of both of those options, but let's also introduce a third option, which is to split the difference. As you said, you'll need to acquire two to three more properties. Let's just, for the sake of walking through this hypothetical, let's say that you need two more. So here's the situation that unfolds if you try to get two more properties right now. you will encounter what's known as the four property rule.

Until 2009, Fannie Mae had a mortgage rule that prevented real estate investors from financing more than four properties at once. Now, that rule lasted until 2009, at which point Fannie Mae changed the rules and started allowing a maximum of 10 properties. So while the official rule right now from the government is that you can finance up to 10, properties simultaneously, those are the official terms, but most banks are pretty reluctant to do that. So banks, essentially, when they're looking at what they're going to loan you, they group properties number one through four into one bucket, and then they group properties five through 10 in a different bucket.

Now, in order to provide financing for properties five through 10, the banks have to participate in what's referred to as a very well-named program, rolled out by Fannie Mae, called the five to ten properties financed program. But the thing is, the majority of banks don't participate in the five to ten properties financed program, largely because the underwriting is a huge buttload of work. So while it is technically possible to finance between five to ten properties simultaneously, most people aren't going to have much luck if they're going through an institutional lender like a bank or a credit union. Now, there are real estate investors whose workaround is to go to private lenders. They seek more creative sources of financing. That's a whole different can of

worms for a different day. But in terms of your institutional lending options, I mean, you're at three properties already because they count your primary residence with this grouping of properties in terms of the total number of properties that you have financed. So currently, you've already got three properties financed, including your primary residence. That means that most financial institutions will qualify you for one more. And that is the split-the-difference model. You're saving $100,000 a year, so I'm assuming that you have some cash saved up, that you could use for a healthy down payment on the next property.

You could, using that down payment, take out one more loan for your next. property, then you'll have a total of four, and then it's time to start paying at least one of them off. In terms of your paydown strategy, similar to the Dave Ramsey Snowball method, make the minimum payments on three of your mortgages and then concentrate all of your additional payments on the one property that you're trying to pay off first, since that will get you the fastest progress towards paying that property off. A few final notes. Now, I started this by saying that we'd walk through some of the pros and cons of the pay them all off now option, as well as the purchase them all right now option. I think we've kind of covered the cons of the purchase them all

right now option. One of them is fine, but purchasing more than one right now is going to get really tricky and is going to be much more expensive in terms of the, if you have to go to a private lender or go for creative financing, those are much higher interest deals. So I think there's some pretty significant cons to trying to buy more than one property right now. And conversely, there are some pretty significant pros to buying one more. So we've talked about that option, but let's go to the other option, which is, what if you paid everything off right now? The benefit of doing that, of course, is that it would accelerate your cash flow.

The minute that both of those rentals are paid off, your cash flow is going to go through the roof. and that means that you'll be able to save even more rapidly for the next two purchases. The drawback is that that strategy will take several years, and over the span of those years, what's going to happen to housing prices? There's no way to know. Will they stagnate and be basically at the same level that they're at today? Maybe.

Will they rise? Maybe. Will they fall? Maybe. We have absolutely no way of knowing. And so, especially with this pandemic going on, I would not rush to buy today due to a fear that it might be more expensive in a few years. I would rush to buy today if the local area has turned into a hot buyer's market, which would allow you to negotiate harder, potentially get bigger discounts off the asking price, get more concessions. But at the end of the day, it's tricky to make to speculate.

on what the future might hold. All we can really ever know is what's the deal that's in front of us right now. If you were to buy a house today, what property would it be and how good is that deal? And rather than judge that deal relative to where it might be in the future, instead, just look at it for what is right now and ask yourself, is this a good deal for me right now or not. And if it is, then go for it. interest rates are at a historic low. They're at the lowest that they've been in 50 years. So, yeah, if it's a good deal and you've got once in a generation low interest rates, go for it. But if it's not a good deal, you don't force yourself to buy a bad investment just because you want to pick up something this year. That's also not a sound strategy. So if you don't find anything that's good, then you don't find anything that's good. You don't find anything that's worth buying. And then you shape your next steps from there. So thank you, Ingrid, for asking that question. And congratulations again on having your first two rentals and being on the path to double the size of that portfolio. That is our show for today. Thank you so much for tuning in. My name is Paula Pant. This is the Afford Anything podcast.

If you enjoyed today's episode, please share it with a friend or a family member. And you're working from home right now. If you're sitting at your laptop or desktop listening to this podcast while you work, then take a moment to you. go to afford anything.com slash iTunes and leave us a review. We love reviews. Thanks again for being part of this community. My name is Paula Phant and I will catch you in the next episode.