Afford Anything - Ask Paula: Is the Stock Market Going to Crash in 2020? How Should I Invest in a Bear Market?

Episode Date: March 16, 2020

#247: Caroline wants to buy her first home in Denver, CO. How can she calculate how much mortgage she can comfortably afford? Anne plans to retire later this year on rental income (woohoo!). She’s saved up a hefty emergency fund for her properties, and she wants to know 1) if she should invest a portion of this in index funds, and 2) whether she should rebalance her portfolio to account for this huge cash allocation. Anonymous Nurse has over $100,000 in debt, not including their mortgage. They want to invest in rental properties, but with so much debt, they're thinking of selling their home or renting it out. Which option is best given their interest in real estate? Joy wants to know if she should put $50,000 towards her primary residence mortgage, or use it as a downpayment on her first rental property. What are the pros and cons of each option? Anonymous owns a cash-flow positive condo...on leased land. The land will revert back to the owners in 32 years. When is the best time to sell this property? I answer these five questions in today’s episode. Enjoy! For more information, visit the show notes at http://affordanything.com/episode247 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything, but not everything. Every choice that you make is a trade-off against something else, and that doesn't just apply to your money. That applies to your time, your focus, your energy, your attention. It applies to anything in your life that's a scarce or limited resource. And that leads to two questions. Number one, what matters most to you? Number two, how do you align those priorities

with the decisions that you make and the actions that you take every single day? Answering these two questions is a lifetime practice, and that is what this podcast is here to explore. name is Paula Pant. I'm the host of the Afford Anything podcast. Every other week, I answer questions from you, the community. And today I'm going to answer a range of questions covering everything from what should I do with a $50,000 lump sum, to I plan to retire later this year, what moves should I make, to I'm buying my first home, how much mortgage can I comfortably afford? So we're going to cover all of those topics, but first, let's talk about coronavirus and the bear market.

We are officially in a bear market. Our 11-year-long bull run is over. On Thursday, March 12th, 2020, the market dropped 10%, which was its biggest one-day drop since 1987. So let's take a moment to assess the current situation. First, a bear market is not the same thing as a recession. A bare market is defined as a stock market drop of 20% or more from its recent high. And one month ago in February 2020, the Dow is trading at its all-time high. From that all-time high, it's fallen by more than 20%.

That's what makes it a bear. However, we are not in a recession yet. A recession is a period of two or more consecutive quarters of negative economic growth as measured by the GDP. And this means that the question, are we going into a recession, cannot be answered anytime soon, because by definition, it will take at least two quarters to know whether or not we are in a recession. and many recessions are recognized only in hindsight. So I'm sure there's a pun here about hindsight being 2020. So what we know right now is we're in a bare market and we may or may not be heading into a recession.

What we also know right now is that on Thursday, March 12th, when the market closed at 21,200, that put us back to the level that the market was at on June 2, 2017. On that day, the market closed at 21206. So the bad news is we erased three years worth of gains. We are back at June 2017 levels. The good news is, number one, if you didn't invest as much as you've wanted to, here's your chance. Now you get to rewind the clock. You get to time travel back to 2017 again.

And the other piece of good news is that oftentimes people say, hey, I'm worried about getting into the market because this bull run has been going on for too long. People have a fear of heights. historically, bull markets have lasted for on average five years. Our last one lasted for 11 years. And so understandably, that made a lot of people nervous. And around 2014, 2015, people began saying, hey, it's 2014, the bull market has lasted for five years. That means we're scheduled for the next bear.

And around that time, many people, due to their fear of heights and due to the fear of another cyclical pullback, many people stopped investing or reduced their investments around 2014, 2015, 2016. And the people who did that missed out on all of the growth that came from that point forward. And so if you avoided the temptation to time the market and if you invested consistently over the course of the last 11 years, then you've enjoyed all the growth, all the gains, all the dividends that you've accumulated over the last 11 years, which means that those of us, myself included, who invested consistently over the span of the last 11 years, can take heart that that was the better decision as compared to ceasing investments in 2014, 2015, due to a fear of heights. So that's the good news for us.

And then the good news for people who regret that they didn't invest more is that now we've turned back the clock and now you have another shot. But let's talk about going back to our assessment of the current situation. As I said, we know that we are currently in a bare market and we do not know whether or not a recession is forthcoming. And so starting from that place, this leads to three questions. Why is this happening? What should we do next? And, and this is the most common question that I'm hearing, are the markets done dropping or are they likely to drop further? So let's kick off this episode by exploring those three questions. And after that, we'll get to the questions posed by you, the community.

So first of all, why is this happening? As you know, the novel coronavirus COVID-19 is both highly contagious and deadly. And in particular, people over the age of 65 and people with compromised immune systems or chronic conditions such as asthma or diabetes or cancer are especially at risk. Now, there are some people, some prominent voices in the personal finance community who are doubtful or dismissive of. of the threat that COVID-19 poses. They point out, rightfully so, that the media is infamous for its fear-mongering because fear creates ratings. And they will point to the fact that we often see trailers like,

are you at risk of getting kicked to death by a kangaroo? Find out on News 5 at 6 o'clock. But the thing is, the media right now is having its Boy Who Cried Wolf moment, because it is absolutely true that the media habitually overblows a lot of low-likelihood supposed threats. But, like the boy who cried wolf, the fact that they gave us a bunch of false alarms in the past does not change the fact that sometimes the wolf appears. Coronavirus does not care about media credibility. And one of the factors that makes this so insidious is the rate at which it can spread. If you think about the headline, are you going to get kicked

to death by a kangaroo? Well, no, you're probably not. But if you are, you're not going to infect other people with the curse of the kangaroo kick. By contrast, COVID-19 spreads exponentially. Each infected person is estimated to infect between two to three other people. That's exponential growth. So if you've ever looked at a compounding interest chart, if you have a sense of the difference between linear growth and exponential growth, then you understand how quickly this could spread. And that's the real risk. Each person who is infected with the flu, influenza, is estimated to infect 1.3 people, while each person with coronavirus might infect around 2.6 people. And the difference between 1.3 versus 2.6 at first glance may not sound like much, but it's double the rate

of transmission. So think exponentially. If the number of infected people doubles and then doubles again and then doubles again, we get to a very big number very fast. And so one of the other criticisms, and again, there are prominent voices in the personal finance community who have said this, is so what? So what if we get to a very big number very fast? Because if between 1 to 3% of infected people die, that means 97 to 99% of infected people live. Hooray! However, that is not a reason to minimize this threat. First of all, 1 to 3% of a big number is a lot of people. At the low end of that range, at the 1% estimate, this is 10 times more deadly than the flu. Second, fatalities are not the only of severity. It's estimated that in the United States, about 20% of infected people will require

hospitalization. And in northern Italy, around 50% of documented cases are serious enough to require hospitalization. And that severity, coupled with contagion, creates a major risk at a systemic level. It creates the risk that hospitals will become so overrun with patients that they buckle under all of that demand. Our health care system has a limited capacity. It can only see so many patients at one time. And if COVID-19 spreads too quickly, it could overwhelm our capacity. And so the goal, therefore, is to slow the spread. And this is a critical point because, hypothetically, even if we cannot curtail the total number of people who become infected, the rate at which this virus spreads is critical to what's going to happen next. We need manageable

waves of patients. And if the virus spreads too quickly, as it did in Northern Italy, we risk overloading the health care system. That's why this hashtag that's been trending, hashtag flatten the curve, that's why that message is so important because the key message there, the key takeaway, is that even if you don't reduce the total number of cases, it's crucial to slow down the rate at which this virus spreads. And that is why so many events are getting canceled, professional sports, Broadway plays, South by Southwest, and other conferences and festivals. That's why universities are telling their students not to bother returning from spring break and to move out of the dorms

and why school districts and businesses are shutting down, it may, to some people, it may feel like overkill because to those people, they believe that their individual risk of being affected is low, and even if they are affected,

their chances of recovery are high. But we have to look at this not from an individual risk framework, but from a systemic framework. As a society, we cannot let this exponentially infect people. And so as a society, our civic responsibility, our civic duty, is to do everything in our power to stop the spread, to flatten the curve. And so canceled events save lives.

But canceled events, of course, have a major economic impact. For example, Austin, Texas estimates that canceling South by Southwest is going to cost the area about $350 million in lost revenue. Fewer people eating at restaurants, fewer people drinking at bars, fewer people taking Uber or Lyft rides. or staying in hotels or Airbnb's, and that's lost revenue. They're not going to make that up with double the attendance next year. These cancellations have an irreversible economic impact, and when you ripple that out to the many event cancellations nationwide, the many business closures nationwide,

it's clear that self-isolation results in economic contraction, and it's not just domestic consumer spending that's going to be affected. Big Fortune 500 companies like Procter & Gamble that sell products overseas are going to, see and are seeing demand decline worldwide. Manufacturing and production will slow down every corner of the economy is and will continue to be affected. People will lose their jobs, and in particular, hourly workers, service workers, tips workers are the most economically vulnerable. And as a side note, if you are a landlord and you have the flexibility and the financial security to be able to do

this, if you are a landlord and one of your renters is temporarily out of work, consider deferring their rent or giving them reduced rent while we are dealing with the worst of this pandemic. Again, I know not every landlord can afford to do that, but if you have the financial security to be able to do so, this is your opportunity to be the landlord that you want to see in the world. But that aside, let's get back to talking about the market, because it is absolutely true that many people are going to lose their jobs, or at a minimum have a temporary reduction in their working hours. And it is equally true that consumers will most likely be spending less money when they are isolating at home. And so the carnage on Wall Street right now

reflects this recalibration of expectations around how much money businesses are going to be bringing in this year. The price of a stock, the valuation of a stock, reflects the general public's best estimate of how much money that company is going to earn this quarter or this year or in the long term. And stock prices also reflect the rate of growth that the public expects this company to achieve. So how much are they going to earn and how fast are they going to grow? The answers to those questions or the estimates of the answers to those questions get factored into stock prices. And so when the market drops, when prices fall on Wall Street, investors are basically saying, Hey, we've changed our minds about how much money we think your business is going to bring in this year.

We think that you're not going to sell as much, and we think that you're not going to grow as fast. That's what happens when the market declines. And frankly, both of those statements are probably true. The drop in stock prices reflects changed fundamentals. The key question is how much less will companies sell this year? and how much slower will they grow? That's the question that distinguishes a rational correction from an overreaction. But those questions, how much less will you sell, how much slower will you grow?

Those questions are impossible to predict with any degree of accuracy, which is why when people ask, do you think the markets are done dropping or do you think they're going to drop further? What that question is really asking is, do you think, as an aggregate, that company shares are priced at a level that reflects the amount of business that they're going to do and the rate at which they'll grow. And we can't answer that question right now because we don't know the rate at which COVID-19 will spread. If it spreads too quickly, then we become the next Northern Italy, and that is terrifying. If you want to really bum yourself out, read articles about what's going on in Northern Italy right now. And so canceled events don't just save lives. They also ultimately, in the long term, will save the economy by virtue of slowing the spread of the disease. The best thing that we can do, both for the economy and for public health, is to slow the spread of the disease. And that means that the temporary economic crunch that's caused by canceled events and by self-isolation is ultimately in our

long-term economic best interest. But the temporary crunch will last and must last for however long it needs to in order to slow down the spread of COVID-19 to a manager. level. And so the question of, are the markets done dropping is inseparable from the question of how well are we managing the rate of infection? And for that reason, it is critical that we socially isolate now in order to slow the rate of the spread of this infection. And I know I totally understand that many people are rightfully concerned about the economic impact that that's going to have on servers and bartenders and hairdressers and pet store owners. And I applaud you for your concern about supporting local businesses and caring for the most low income and most economically vulnerable people in our society.

And if the objective is to protect the most economically vulnerable, we must slow the spread of this infection. Because if we don't, we become the next Italy. And it will be 10 times worse. The economic fallout, the loss of jobs, the loss of income, and the preventable loss of life. This is the moment when as a society we determine our fate. As a precautionary measure, I am completely isolating myself inside of my home for at a minimum the next 10 days. I'm not going to the gym. I'll work out at home. I'm not going to the store. I've got what I need.

I'm not going to restaurants or bars. But I will happily Venmo some money to a friend who's a server who needs the help. Or buy a gift card for a locally owned restaurant so that the owner can get some income right away. And I know that isolation is not quote unquote required for individuals who believe that they do not have this, but, and this is critical to understand, a person can be asymptomatic or mildly symptomatic for 14 days, which means that over the span of 14 days, they can be a carrier that is spreading that disease to other people without knowing it. They can feel perfectly healthy and still be spreading it. And to be frank, if you're young and healthy, as I am, self-isolation, social isolation, is not something that you're doing for yourself. It's something that you're doing for the rest of society. It's something that you're doing so that you don't make sick people sicker. So I get it if you're young and you're healthy and you think you're invincible.

That's awesome. But please do it for grandma. But let's get back to talking about the markets. specifically the current very volatile bear market that we're in. What should we do next? Seven pointers. First and most importantly, do not panic sell. Don't convert paper losses into real losses.

Now, I know that that is repeated to the point where it's practically a cliche. Do not panic sell. But let's pause and think about the psychology of panic selling. Because oftentimes people don't think, oh my goodness, I'm so scared this money that I worked hard. for is now gone. I'm just going to pull everything out. I mean, some people think that. But there are others who panic sell in the form of thinking that they can outsmart the market or thinking that they can time the market. And so the thought that runs through their head is, you know what, I'm going to sell now. I'm going to wait for prices to drop and then I'm going to buy again.

Do not do that. That's a no. That's a hard no. If you sell and then prices rise, you're screwed. If you sell and prices drop, you'll likely continue to wait, most likely for too long, at which point prices will rise and you'll be screwed again. So the first pointer is do not panic sell, do not try to time the market. Number two, make sure your investments are matched to your goals. Your asset allocation should reflect your timeline to withdrawal. What that means is that if you are five years away from retirement, your 401k and IRA and all of your other retirement-related accounts should be asset allocated very differently than someone who's 30 years away from retirement. People often say to asset allocate in a way that reflects your age,

but really more so than age, it's timeline. Number one, because you might be retiring at the age of 40 or 45 or 50, rather than the more conventional mainstream ages. And number two, because you also have buckets of investments that are intended for shorter-term goals, such as money set aside for college in a 529 plan. So if you think of your buckets of money as short-term, intermediate term, and long-term, the way that you manage that money should reflect the timeline of each bucket. Money that you need in the short-term, and by short-term, I mean in the next five years, should be mostly in cash or cash equivalents. Money that you need within the next five to 15. years, or five to 20 years, if you want to be conservative, that money should be invested

in a more conservative manner. It shouldn't necessarily be kept in cash, but it should be invested conservatively. And money that you do not need to withdraw for 20 years or more can be invested much more aggressively because you have time to recover. So, make sure that your investments are matched to your goals and timeline. That is tip number two. Tip number three, Keep dollar cost averaging into the market. Dollar cost averaging is the practice of investing the same amount of money every paycheck or every month, every regular periodic increment of time. And the beauty of that strategy is that when stocks are cheap, that same $500 or that same $1,000 will buy more stocks. And specifically, I should make a note here when I say stocks, I'm referring to index funds.

I'm using stocks as a broad term to refer to the equities market. So let's say that you are dollar cost averaging from your paycheck into a total stock market index fund. At times in which that index fund is trading at a low price, that same $1,000 picks up more shares. And at times at which it's trading at a high price, that same $1,000 picks up fewer shares. And so dollar cost averaging is an automated way to take. advantage of sales and discounts and deals like what's happening in the market right now. The market is on sale relative to what it used to be. And dollar cost averaging is a methodical way of being able to take advantage of that.

So that is tip number three. Tip number four. Do not get discouraged. There's a quote, a famous quote from Sir John Templeton that says, the four most expensive words in the English language are, this time it's different. And yes, it's absolutely true that a bare market triggered by an infectious disease is fundamentally different than a market collapse that's triggered by subprime mortgages. The government can't bail out the CDC. You can't write a check and magically come up with a vaccine or a cure.

The money will help, but money alone will not slow the spread. And so because of that, there are people who are worried that this time it's different. that this is not going to be like the Great Recession of 2008. If you are plagued by that fear, remember that the historic returns from the overall market include many, many Black Swan events. The Dow Jones Industrial Average was first published on May 26, 1896, and at that time it was an index that followed the 12 largest companies in each sector of the U.S. stock market. Now it looks at 30 companies.

And so we have historic data about the markets going back to 1896, which means that when we talk about the long-term trajectory of the market, we're including the flu pandemic of 1918, we're including World War I and World War II, and the Great Depression. All of that is reflected in the data that we have going back to 1896. And what we've seen going back 120 years is that sometimes it does take a while to recover. the worst period that we faced the longest recovery time was 1929 to 1955, beginning with the stock market crash that heralded the Great Depression and ending 25 years later when the markets finally recovered back to their 1929 pre-crash levels.

That 25-year period, that is historically the most extreme case that we've seen. But there are many, many other drops, including the Great Recession in 2008, from which we're, we're going to be. we've recovered quickly. The 2008 Great Recession, we recovered in six years. And so, of course, we do not know the future. Absolutely nobody knows the future. But we do know what happened over the span of the past 120 years. And we know that the market consistently, relentlessly, has gone up over time. And so as long as you have a long time horizon, going back to what we talked about earlier, as long as you make sure that your investments are matched with your goals and your timeline, then don't get panicky about this Black Swan event because we've had many Black Swan events in the past,

and all of that is factored into the historic returns that we've seen. By the way, in the show notes at Afford Anything.com slash episode 247, I'm going to link to a really great chart that shows the Dow Jones Industrial Average from 1896 through today, and that has points all along the chart that show what made you. major news event was happening at various points of market runups and market pullbacks. So again, we'll link to that chart at afford anything.com slash episode 247. So that is the fourth tip. Do not buy into the idea that this time it's different.

Maintain a long-term view. Tip number five. If you are excited about the prospect of buying on the dip, as I am, do not give into the temptation to blow your emergency fund on buying on the dip. I'm sure there are a few who are chuckling right now because that's exactly what you were about to do. You're looking around for cash because you totally want to buy on the dip, you totally want to take advantage of the fact that the market is on sale right now. That's great, assuming you do not need that money for at least 20 years. Your emergency fund, I know it looks like a big pile of cash that's

just sitting there while this tempting sale is going on. But remember, every bucket of money has a purpose. And the purpose of your emergency fund is not the bucket of cash that you keep such that you can take advantage of low valuations. The purpose of your emergency fund is so that you can have cash on hand to pay your bills. So start with the end in mind. Remember that every bucket of money has a purpose and do not raid your emergency fund to buy on the dip. That is the fifth tip. Number six, keep the vast majority of your portfolio in index funds rather than individual stocks.

And if you insist on buying individual stocks, confine this to a tiny portion of your portfolio, definitely less than 5% of your total overall portfolio. And designate this as pure play just for fun, this is your gambling money. if you want to indulge a wild hair and do a little bit of speculation, then confine that to one or two or three percent of your portfolio. Keep the rest of it in broad market index funds. I suppose this is the point at which I should add the disclaimer that this is not financial advice. Please consult with a licensed financial advisor before making any moves. This is for entertainment purposes only.

I am not licensed. I am just some random person with access to the internet. And this show exists solely for entertainment, and that's it. So there's my disclaimer. And with that disclaimer said, for the sake of being entertaining, stick with index funds. That is tip number six. And finally, tip number seven. Diversify and round out your portfolio by adding some rental properties into the mix.

Rental properties provide stability in a volatile market. Number one, they have low correlation, a drop in stocks, a bare market. market does not correlate with a drop in rent. In fact, on the contrary, what we saw in 2008 is that the Great Recession correlated with increased rental prices because during the Great Recession of 2008, fewer people were buying homes, which meant that more people were renting. And yet, builders were not building. So there was no new housing supply. And so when demand increases and supply stays the same, well, what happens? Prices rise. So in the Great Recession, rents rose in many markets across the U.S.

Now, that's not to say that stocks have an inverse correlation with rental properties. I'm in no way saying that. But I am saying that they have low correlation between the two. So the market might be roller coastering, fluctuating by 2,000 points in a single day, but that's not going to change the fact that your rental income is relatively stable, steady, and predictable. And rental income is received as cash, and cash is your best ally, especially at shaky times. Cash has low volatility and high flexibility. So round out your portfolio by adding rental properties into the mix, if you are so inclined to do so.

That is tip number seven about how to navigate this bare market. So we are going to take a quick break right now to hear a word from our sponsors, and when we come back, We're going to hear from Caroline in Denver who wants to figure out how much mortgage she can afford. We're going to hear from Anne, who plans to retire later this year. We'll hear from an anonymous nurse who has more than $100,000 in debt, excluding her mortgage. We're going to hear from Joy, who is receiving a lump sum payment of $50,000. And we're going to hear from another anonymous person who owns a cash flow positive rental condo, but it's on leased land. We'll discuss all of those questions right after this.

Oh, and by the way, if you want to chat with other people in this community, head to Afford Anything.com slash community. We have some great discussions going on right now about the bare market pullback and about whether or not there's a recession looming and about what to do. So afford anything.com slash community to talk about all of these issues with other people in the community. And with that said, we're going to hear from our sponsors, and then we're going to answer today's questions. We'll come back to this episode after this word from our sponsors.

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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. We are back, and our first question comes from Caroline. Hi, Paula. Caroline here, long-time listener and big fan of your show. My question is about buying our first home in Denver, Colorado, which as you know is a pretty tough real estate market. Prices are high and homes go fast, and because of that, our down payment will be likely in the 10 to 12% range. My question is actually related to DTI and how much house we can actually afford. Our annual income before taxes is approximately $155,000 per year, and our only monthly debt is a $300 car payment, which we tend to overpay and have to have about three years left. With those numbers, what do you think is a comfortable mortgage loan

amount for us? Or more generally, what percent of our income should we allocate towards the mortgage each month? Do we factor this before or after tax? I know comfort levels differ between people, but I'm interested in your opinion on debt-to-income ratio in general and what amount is actually affordable in a situation like ours. Thank you. Caroline, first of all, congratulations on buying your first home. This is a fantastic time to buy. Mortgage interest rates are a at a 50-year low. So with regard to borrowing, the timing could not be better. And speaking of borrowing, congratulations on having the rest of your life set up in such a financially sound way. You're making a combined $155,000 a year, and your only debt is a car payment. You said it's about $300 a month.

It should be paid off in about three years. So your only debt is about $10,800 on a car loan. That's fantastic. It sounds like a great starting point. So congratulations. on all the work that you've done to get you to the point where you're at right now. So let's talk about your questions. You've asked, what is a comfortable and reasonable mortgage loan amount? What percentage of your income should you put towards this mortgage? What's fascinating about this question is that if you Google it, if you Google how much mortgage can I afford,

what you'll see is that people often conflate that question with the question of how large of a mortgage could I qualify? for. And that in terms of the articles that are written about this topic, that for years has bothered me to no end because the question of how much house would it be wise for me to purchase is a fundamentally different question than how much will the banks let me borrow. And unfortunately, a lot of the article writers out there treat these two questions as though they are synonymous and interchangeable. They are not. So let's look at how large of a mortgage could you likely qualify for so that we know the upper end of the range.

Now, lenders will look at what's referred to as your front-end debt-to-income ratio and your back-end debt-to-income ratio. We'll talk about both, but let's start with the front-end DTI, as it's known. This is also sometimes called the mortgage-to-income ratio, and the formula is your monthly housing expenses divided by your gross, meaning pre-tax, monthly income. Most institutional lenders, meaning most banks and credit unions, prefer a maximum front-end DTI of 28%. Now, Caroline, you and your spouse or partner make a combined income of $15,000 a year.

That's $12,916 per month. So the formula for you would be X divided by $12,916 equals 0.28. That's the formula that you would use to calculate the maximum amount that lenders are likely to loan you. And in your case, that means that that maximum monthly payment would be $3,616. Now, that figure includes the principal interest, property taxes, and homeowners insurance on the property, as well as any required HOA payments associated with the property. So the sum total of all of that, in your case, can't exceed 3616 per month. But as I said, that's the upper end the range because the question of how much will a lender allow me to borrow is not the same thing

as how much do I want to borrow? And so to answer that much more subjective question of how much do you want to borrow, we need to zoom out and look at the bigger picture of your overall budget and your goals. Now, the way that I do this is I like to start with what I call the anti-budget. The anti-budget is a very simple budget that essentially has two categories, spend and save. And it starts with savings. So what percentage of your pre-tax income do you want to save? There are many people who spend first and then save what's left over. We're going to take the opposite approach.

We start the anti-budget by using savings as the very first top line item. And in this context, when I use the word savings, I mean anything that improves your net worth. So this includes retirement contributions. It includes HSA contributions. It includes additional payments that you make on your car loan above and beyond what's required. And it also includes literal savings in a savings account. Anything that improves your net worth is included in this bucket of save.

So the first question that you ask yourself is, how much of my income do I want to save every month? Then the second thing that you do is take a look at last year's tax return and find your effective tax rate. Now, your effective tax rate is different than your tax. top marginal tax bracket because all of your income gets taxed at that top marginal level. So take a look at your effective rate and now you have two big percentages. You know what percentage of your income you pay in taxes and you know what percentage of

your income you want to save in the broadest possible sense of the word. So subtract both of these out from your pre-tax income and the remainder is yours to spend. So for example, if your effective tax rate plus your target, you're a tax rate plus your target, get savings rate equals a combined 50% of your pre-tax income, then the other half is left for spending. And now that you know how much money is left for spending, it becomes easier to take a more close-up look at how you want to divide that up. Because let's say that you were to go by the lender's front-end DTI formula. Hypothetically, let's say that you were to devote 28% of your pre-tax income to your mortgage. That means you'd be left with only 22% for everything else,

food, clothes, travel, entertainment, utilities, random stuff from Amazon. So if that 22% feels like too little, then dial back the housing percentage. But deciding your ideal housing percentage needs to be in the context of the entire anti-budget. And the anti-budget starts by determining what you want your ideal savings rate to be. Now, I mentioned that there's both a front-end, debt-to-income ratio as well as a back-end ratio? The back-end ratio is calculated as your total monthly debt expense divided by your pre-tax monthly income. And lenders want this to be no more than 36%. Now, you mentioned your car payment is $300 a month. $300 a month is 2% of your monthly income, 300 divided by $12,916. So your car payments are 2% of your monthly income. If you were to take

out this mortgage, the full mortgage amount of $36.16 per month, Plus also pay another 300 a month for your car payment, then your total monthly debt payments would give you a back-end ratio of 30%. So that's well under the 36% threshold, which means that in terms of qualifying for a loan, you're unlikely to encounter resistance from the banks. Again, whether or not you want to take out a loan that big is a different question. So a few other things to think about as you try to decide how large of a mortgage you want to take on.

one is how secure are your jobs, both of your jobs? What is the probability of a layoff or downsizing? And if one of you gets laid off, how robust is the overall industry? How long would it take to find another job in the same area, geographic area, that would pay a similar rate? That's one question to ask yourself, and the other is, do both of you want to and plan to stay in the workforce full time? or is there a chance that at some point in the future you might go to one or one and a half incomes? Now, from this perspective, the most conservative approach would be to get a mortgage based on one person's income rather than both people's income. That way, if one person does get laid off or decides to leave the workforce, the other person can support the mortgage payment on their salary alone.

And as an added benefit, this approach also boosts your savings rate, assuming that you divert some of that money into savings. which leaves you better prepared for an emergency and better prepared for retirement. The drawback, of course, is that this means that you would buy a significantly cheaper home, which you may not like as much. And that can work against you because if you dislike it enough that you have buyer's remorse and then you end up selling that home quickly and then you end up moving, well, then ultimately, this costs more money down the road due to the high transaction costs of selling and the very real costs of moving.

So you're looking for that sweet spot of a home that you like enough that you're not going to cut and run, but that ideally is less expensive than 28% of your combined pre-tax income. Here's a less extreme iteration, kind of an alternate framework for thinking about housing costs. As I mentioned, when lenders calculate that 28% in the front end DTI, they're including five factors, the principal, interest, taxes, insurance, and HOA payments. Oh, also I should add, if you have PMI or MIP payments, that's included in there as well. So six factors, really. But they are not including other housing-related expenses, such as utilities, maintenance, repairs, home improvements. None of that is included in that 28% amount.

Again, the lenders are only looking at your mortgage, including mortgage insurance and your HOA. But you yourself privately, you can adjust these numbers. You might decide that you want all of your housing costs, including utilities maintenance repairs. You might decide that you want all of that to be a maximum of 28% of your income. And so, for example, if you think that utilities, maintenance, and repairs are going to occupy 6% of your overall budget, then subtract this from the 28% and then shoot for a mortgage that occupies no more than 22% of your pre-tax income, which in your case is 2,841 per month. So that's a hypothetical or illustrative example of a way to start with the DTI framework,

but then tweak it so that your housing expenses can be kept a little bit more in check. Now, with regard to estimating these amounts, utilities are fairly easy to estimate. ask the seller for a copy of their electric gas water from the previous year. You'll see the actual numbers of what they spent. That'll give you a good starting point. Repairs, maintenance, home improvements, that's a little tougher to estimate because so much of that depends on the condition and age of the property. There are highly generalized rules like 1% of the cost of the property per year, which means $83 per every $100,000 of house per month. That's a generalized rule, but it is meant to be taken with a grain of salt because housing prices fluctuate and that fluctuation in price does not impact the ongoing operating expenses of that home.

If a home doubles in value, that doesn't mean that the cost of repairs and maintenance and home improvements are also going to double. So you can use that as a very, very rough starting point, again, 1% of the cost of the property, which means $83 per month per $100,000 of house. but just know that that is a highly imperfect number that should be adjusted upward if it's an older home or in poor condition with a lot of deferred maintenance and maybe adjusted downward if it's a newer home or it's been very well maintained. So those are the factors that I would think about as you decide how much of your income you want to devote to housing. Thank you so much for asking that question, Caroline. And again, congratulations on being ready to buy your first home. Our next question comes from Anne. Hi, Paula. I'm planning to retire in late 2020 primarily on rental income. I'm pretty cautious and feel that our approaches to investment are similar, so I'm interested in getting your input on some of my plans. I live in a high cost of living area and have invested in multifamilies. I've built out a 10-year plan for all cap-backs and maintenance basically from the bottom up for each individual property, including everything that could possibly need replacing, roofs, renovations, painting, new appliances, heating systems, etc. It's highly unlikely that I would have all. It's highly unlikely that I would have all.

of these contingencies happen in the next 10 years, but would rather be safe. I have about 75% of that total 10-year CAP-X budget sitting in cash, about $180,000. Then I've built the balance of that cap-ex plus regular maintenance and vacancy into my monthly retirement budget, which is about $1,500 a month. This way I can live on the bigger part of the cash flow of the rentals. All of the properties are in very low-interest fixed mortgages, and I have over 40% in total equity. I've built up my fire budget and I've been living within those means for discretionary spending for the last year to be sure I'm budgeting right. My plan is to have the multifamily rentals cover my basic needs over the next 10 years and explore some fun interest for part-time work, which would be gravy. After 10 years, I will consider

whether to keep those properties or start to solve them off if it feels like too much work and if selling makes sense for my financial goals at that time. So here are my questions. One, do you have anything else I should be thinking about and saving for while I have a great income. Number two, right now I have that chunk for CAPEX sitting in a high-yield savings account. However, given that it's 10 years of possible spend, I'm wondering if you think I should put some portion of that, maybe 30% into index funds to gain better growth. This would still leave me with about seven years in cash, just trying to be spart about that money. I do have a 401k and also a chunk of money in index funds already, almost all of which is in stocks versus bonds given my heavy cash position.

Do you think I should rebalance that now for more bonds, even though I have such a high cash position? I know I will need to do so once that 10 years closes in, but for now, do you think my mix looks okay? Thanks so much for your help here and for providing us all with such great content. I've loved listening to your podcast, and it's been the biggest influence on my fire plans. Anne, congratulations on being on the brink of retirement, early retirement. That's fantastic. And you mentioned that you plan to retire primarily on rental income. As I mentioned earlier in this episode, the benefit of rental income is stability in a shaky market.

If the bare market lasts for a long time, then that rental income can spare you or save you from having to convert paper losses into real losses. relying on rental income in a bare market allows you to refrain from cashing out your holdings or at a minimum cash out a smaller percentage of your holdings, which means you've got more money in the markets that can participate in the recovery. So I'm very happy to hear that rental income is a big part of your early retirement plan. Now, to your questions, you asked, is there anything else I should say for while I have a great income? I love the fact that you've been practicing living on your financial independence budget. You've been living on this amount for a year. You've done a test run to see if the retirement budget that you made for yourself is realistic.

And the fact that that test run has worked out, the fact that you're successfully living on this money is proof of concept. So what you've done is a very, very smart way of preparing for early retirement, the practice of spending a year doing a dress rehearsal of your retirement budget. So in terms of is there anything else that you should say for? There are only three things that come to mind. One, make sure that you have savings for any health expenses that you can reasonably foresee. Two, have savings for anything that might trigger a major lifestyle change. So for example, if you have a sibling who lives in Spain and in year two or year three of your retirement, you find out that your brother or sister is sick.

and you need to suddenly move to Barcelona to take care of them, that's going to be a major lifestyle change and it's going to trigger some spending shocks. So to the extent that you can reasonably foresee any of those types of events occurring, amass a savings bucket for those contingencies. Essentially, you're saving for forced lifestyle changes or lifestyle changes that are based on circumstance rather than discretion. And the third thing is if there's any chance you might want to buy any more rental properties, and I'm not getting the impression that there is, but if there's any chance that you may want to buy any more rental properties, the easiest time to do it is while you still have your current income and your current salary at your current job. So if you're considering it, do it now.

Now, the second question that you asked, you mentioned that the $180,000 that you've saved for CAPEX is currently. in a high-yield savings account. And you asked if you should handle a portion of this more aggressively. I like your suggestion of keeping at least seven years worth of anticipated cap-ax expenses in cash or cash equivalence, such as laddered CDs, or you could put a portion of it into tips with a five-year maturity. You could put the five-to-seven-year portion of that in tips with a five-year maturity.

but generally speaking, cash and cash equivalents are an ideal place for anything that you might need to spend within the next seven years. If you want, you could put the last three years into bonds or bond funds, or you could even put a very small amount, maybe one year's worth of CAPEX, into a broad market index fund. If you really want to tweak around the edges, you could do that. But remember, a strong cash position allows you to take a more aggressive position with the rest of your portfolio. The fact that you know that you have 10 years worth of CAPEX set aside as an emergency fund means that the remainder of your portfolio, the non-emergency fund, non-cash reserve portion of your portfolio, can be invested more aggressively because you don't have the risk of needing to draw down from that at the worst possible to. time. And so in that manner, a barbell allocation like what you described where one end of the barbell is cash and the other end is heavy equities, that barbell allocation means that your cash indirectly is contributing to your growth. It's not directly doing so by making a lot of money or creating a lot of compound growth in and of itself, but indirectly it is contributing to that by virtue of allowing you to position yourself more. You're

aggressively with the non-cash reserve non-emergency fund portion of your portfolio. So I see nothing wrong with keeping all 10 years in cash if that's what you want to do. But if you want to be a little bit more aggressive than that, laddered CDs, tips, bonds, bond funds. But with that, I'll say, embrace the fact that liquidity and flexibility comes with a price. Its price tag comes in the form of opportunity cost, and the liquidity opportunity cost premium is, in many cases, a very reasonable one to pay. So finally, your third question, you said that you have a 401k and a chunk of money that's in index funds already, and almost all of it is in equities. Should you rebalance for a heavier bond allocation? Now, first of all, let me clarify the difference between rebalancing versus

making a strategic change to your asset allocation. Rebalancing is something that everybody should do, always, periodically, because rebalancing is simply the act of getting your portfolio a with your target asset allocation. So regardless of what asset allocation you have decided in advance that you want, you know, maybe you want 90% stocks, 10% bonds, maybe you want 7030, 60, 40, regardless of that, rebalancing is just the periodic exercise where you get everything in line with that predetermined allocation. And so should you rebalance, yes, in the sense that this is something that everyone

periodically at least once a year should incorporate. into their practice. But I think what you're actually asking is a different question. I think you're asking, should I rethink what that predetermined asset allocation should be? Essentially, you're asking should I set different asset allocation targets than the ones that you currently have? And my answer to that is a question back to you, which is what is your timeline for withdrawal for specifically this money that's in your 401k and any other money that you have in index? funds. It sounds like you'll be living primarily on rental income, at least for the first 10 years. And so the impression that I'm getting is that you don't plan to draw down from

these funds, or at least not draw down heavily from these funds, anytime in the near future. And by the in the near future, I mean in the next decade. So when do you plan to start drawing down on these funds? Your answer to that question will inform what the asset allocation, the target asset allocation ought to be. Because If you plan on not tapping that 401k until you're 65, well, I don't know how old you are, but that might be 20 years, 25 years, 30 years away. The other note that I'll add here, depending on how much you're currently making and how much you're able to currently save, is that your equity's position has gone down in the two weeks prior to this recording. I'm recording this

in March 2020 at the start of the bear market. You've definitely lost some serious value. Again, it's only a paper loss, so as long as you can hold onto it for the long term and participate in the recovery, you'll be set. But in the meantime, while you are still at your current job, a sort of side door method of rebalancing could be to bias new contributions towards bonds or bond funds. Again, the success of that depends on how much you can contribute. But if you can de facto rebalance by virtue of directing new contributions to the asset class that you want to shore up in your portfolio, then that's a very workable strategy for rebalancing. But I mean, again, that being said, all of this depends on when you plan on drawing down that money, because if you don't plan on

drawing it down for another 25 years, then it might make sense to bias new contributions towards equity index funds now while the market's on sale. So again, timeline is everything. Start with the timeline, then decide what your target allocation is going to be, and then either trade your existing holdings or bias new contributions in such a way that you can reach that target allocation. Thank you for asking that question, Anne, and congratulations on being on the verge of early retirement. We'll come back to this episode in just a minute. But first, our next question comes from an anonymous nurse in West Virginia.

I've started giving every anonymous caller a nickname, so I'm going to take a question. the highly creative route of calling her West Virginia nurse. Here she is. Hi, Paula. Thank you for your podcast. Your backstory is such an inspiration to me. It just made me so motivated to get a handle on my finances. I do have a couple of questions about my situation. My partner and I are nurses living in West Virginia. We'll probably be here about five to ten years depending on if we stay here for grad school. We are in a pickle when it comes to our finances. I personally have about 20 grand in credit card debt. I have 80,000 in student loans, and I'm also paying on my car. We also bought a house, so we are also paying on our mortgage. We are also engaged to be married in about

two years, so we are saving for that as well. We have an aspiration to start a rental property, business because we love real estate. We love to start investing in it. However, I know we have a lot of debt. So we're just not sure what we should do with our house to gain more extra money to put towards this business. Should we sell it and just start going back to renting and saving? Or should we use it as our first rental property since we already have it and we already know like the ins and outs of our house. And we know how much it will cost to keep it running. It is in a Class B neighborhood.

It's 10 minutes away from the hospital, 10 minutes away from downtown, and there's a lot of health care professionals in this area. So we think that it has good potential. However, we also, you know, I think we need some extra cash flow. We bring home about $5,000 a month together, and we pay $1,200 on our mortgage. So most of the rest of the money goes straight to debt, like it goes to the other debts. So we're not too sure which way we should go, which would get us on the right track to start our rental property business.

We hope to retire about 50 to 55. We are close to 30. Since I do love real estate, I was thinking about possibly getting a real estate license so that I can be an agent part-time. And that can last forever. I can even use that when I do retire, you know. So I was thinking it wouldn't be a waste of time, but I just don't know if I need it. So any suggestions, I'd greatly appreciate it. I can't wait to hear from you.

And I hope you have a good day. Bye-bye. West Virginia nurse. First of all, congratulations on everything you've built up to this point. You have a great career. You've purchased a home. You're getting married. You're looking at new businesses that you can start, new ways to earn money.

So first and foremost, congratulations on all of the hard work that you've put in that has brought you to this point. You have a lot of options and a lot that's going for you. Now, you mentioned that you earn a combined $5,000 a month and you pay $1,200 towards your mortgage. And the rest of the money goes straight to your other debts. I love that you're doing that. Keep that up. That's awesome. Drawing from that earlier question, the question that Caroline asked earlier in this episode,

about what percentage of your income should go towards your housing payment. You've got 24% of your income going towards your mortgage. That's pretty good. But given how much debt you currently have, the way to fast track that debt payoff is by reducing the amount of money that you pay every month towards your personal housing expenses. And so I love the idea of you using your current home as a rental property, assuming, of course, that you could find some other place to live that would be significantly cheaper. So the question I would ask you is, if you didn't live in your current home, where would you live, how much would that cost, and how much extra money could you save each month?

And part of that question has to factor in not just what the rent would be in some alternate place where you would live, but how that alternate place that you would live would impact other areas of your budget. So, for example, you mentioned that your current home is 10 minutes away from the hospital and from downtown. So I imagine that your commuting costs are quite small. If you were to rent another place that was further out, estimate how much additional money you would be spending on gas or any other ways that it might affect your budget, any other ways that living in a different place might cause you to spend more than you are spending now, and then lump that all together as the cost of renting some other place. And it might be the case. In fact, I suspect it probably is the case that even when you have all of that lump together, renting a different place would still ultimately lead to net savings. So hypothetically, if you and your partner could live a little bit further away and you could rent a place in that location for, let's say, 700 a month, and let's just estimate that means that your commuting costs would rise by $100 a month. And, you know, even though for the most part you're going to maintain the same great habits that you have when it comes to bringing your lunch to work with you, making coffee at home, all of that, let's just say that living a little bit further away, spending more time commuting, let's say that that might cause you to spend an extra $50 a month on the occasional like, oops, I forgot to bring lunch to work with me, or, oh, I have this shift that's starting at six in the morning and we don't have any. coffee at home, I really need to stop and grab something at Starbucks before I go in.

Right? Like, let's just say, hypothetic, and I'm just making up these numbers, and I'm making up this situation. I'm just trying to illustrate the point that changing your location changes not just your housing cost, but also other ancillary costs as well. That's really what I'm trying to illustrate. So let's say that you rent another place that's $700 a month, you spend an extra $100 a month in commuting costs, you spend an extra $50 a month on additional food and beverage costs, that still means that the total cost of where you live, including those ancillary additional expenses, comes to $8.50 a month. And what's really cool about your situation is that when you're evaluating whether or not to use your current home as a rental

property, you're asking a fundamentally different question than somebody who's asking, like, should I purchase this home for use as a rental property? The question of should I buy this home for that specific purpose is a question that requires a bunch of analysis around the cap rate and the performance of that home. But what's really cool about your question is that fundamentally your question is, would it be worth it to reduce my out-of-pocket housing expenses? Because if you can rent in a different location and you can pay 8.50 a month, and you're renting out your current home for $1,200 a month, well, that's an extra

$350 that you can put towards paying off your debt and saving for a wedding. So I would say, yes, absolutely, if you can save a few hundred dollars a month by renting a different place for yourself and using your current home as a rental property, well, hey, that's an extra few hundred dollars a month. That's going to help you get to your goals a lot faster. Now, in terms of what to do with that money, the first thing that I want you to tackle is that credit card debt. Credit card debt has a high interest rate, and hopefully your debt is currently on a card that has either a low rate or a 0% introductory teaser rate. Hopefully that's the situation, but even if it is, that 0% introductory teaser rate will ultimately expire and will turn into a high

interest rate. And so you just want to get rid of that credit card debt immediately. Make that your number one priority. Other than that, with regard to the student loans, the car loan, and the mortgage, the urgency of those, in my view, depends on the interest rate. If those student loans are at a 3% interest rate, which is historically the rate of inflation, then I'm really not too worried about it. On the other hand, if they're at a 6% or 7% interest rate, then I would make that a much higher priority. So what I'm hearing in your question is that you're balancing a bunch of goals, right? Pay off the student loans, pay off the car loan, start a rental property business. You've got many goals, all of which are great. And so then the question is really, it turns into a

question of ordering. All right, here's my list of goals. Which one am I going to tackle first? You put all those goals on a sheet of paper and then you order them. And then you focus all your energy on the one goal that's at the top of the list. Do that till it's done and then move on to the next one. Now, as far as what order these goals should be in, I mean, number one, definitely the credit card. But after that, it's really a very personal choice. You know, once you're done with the credit card debt, do you want to tackle the car loan? How quickly could you pay it off? If you did pay it off, let's say you could pay it off in a year, would that give you a bunch of extra cash flow within your budget so that in year two you could save the money that you were spending on a car loan to put towards your upcoming wedding?

Right? Maybe that's the strategy that you want to employ. Or maybe that car loan is at such a low interest rate that it's going to fall all the way down to the bottom of your list. So as you're ordering that list, the questions to keep in mind are what's the interest rate on the loan? How much cash flow is this removing from our paychecks? And how quickly can we get this paid off so that we can use that cash flow for something else? And the way that you order all of the goals on your list, the student loans, the car loan, the wedding, buying another rental property, or paying off your current mortgage, like the way that you number those will be a reflection of interest rate, cash flow timeline. So that's what I would encourage you to do. You and your partner both,

sit down and make a list of every goal, how much money it will take to be able to achieve that goal, what the ideal timeline is, and how, like a waterfall effect, how achieving one goal can accelerate the progress of another. So, for example, how paying off a car loan could then accelerate the progress of saving for a wedding. So spend some time with that. Sit down and make that list and decide how you want to order it. But definitely credit card debt is the number one thing. That's the only absolute.

Now, to your final question, you said that you love real estate, which is awesome, and that you've thought about getting a real estate agent's license. do you need one in order to become an investor? No, absolutely not. I myself have an agent's license. And as a rental investor, it's done almost nothing for me. It's given me direct access to the MLS. It's allowed me to write my own offers. And more than anything, it gave me a boost of confidence. But to be perfectly honest, I would not get a license purely for the sake of hoping that it will make you a better real estate investor. There are two different skill sets.

Being an agent is being an agent, and all of the skills and the training and the education is built around being an agent. And that is fundamentally a different skill set than being an investor. So I wouldn't get it just for that purpose. But what I hear in your question is that it sounds like you would be really excited to be an agent as a side hustle. Like you'd be excited about the actual process. practice of being an agent. And if that's your motivation, that's a much stronger, much better reason

to get that license. But again, I will temper that with the question, if your goal is to have a side hustle that makes money, then what side hustle could you choose that best fits your schedule and allows you to make the most money per hour of your time? That's the key question to ask. And maybe the answer might be being an agent, but agents, especially at the beginning of their careers, do a lot of unpaid work. They frontload the workload while they're looking for clients and generating business. And then once they get a client, they often have to be able to answer their phone for an unscheduled call at a moment's notice. They might have to deal with certain urgent situations that come up. And sometimes they'll take a buyer around to 10 different houses and then the

buyer ends up not buying anything, in which case they've just essentially wasted all of that time. I mean, you could argue it's not a waste of time. That's just part of the business. But, you know, you don't get paid until the deal closes. And oftentimes deals don't close. For one reason or another, you're representing a seller and the seller isn't getting offers at the price that he or she was expecting. And so they decide not to sell. So if you get a license, know that that might happen. And then ask you, yourself, are you so into this as a side hustle that you'd be cool with that because you love real estate, you love the idea of being involved in this industry in some form. And in spite of

some of the drawbacks, you would absolutely love this type of work. Like if that's the feeling that you have about it, then go for it. But if by contrast, you want a side hustle with flexible hours in which you're working for yourself that allows you to make as much money as you can so that you can then use that money to buy your own investment properties. Well, if that's the case, then choose the side hustle that has the best shot of helping you make the most. Two really good resources for finding side hustle ideas. One is Chris Gillibow's podcast. It's called Side Hustle School. He also has a great website associated with it, sidehustleschool.com. The other resource is Nick Loper. He has a podcast and a website called

Side Hustle Nation. Both of them were previous guests on this show. We will link to those episodes in the show notes. Chris Gillibow is going to be a guest in an upcoming episode. As well, that'll be his second appearance on this podcast. And both of them are fantastic resources for finding an idea for a side hustle that fits your schedule, fits your talents, sparks your interest in creativity and curiosity and allows you to build something scalable, something that's going to bring in awesome money that you can then use to build your real estate business. So thank you, West Virginia nurse, for asking that question. And again, congratulations on your career, your home, and all the opportunities that are in front of you.

This is a very exciting time when you've got so many roads ahead and they're all good. So big congratulations to you for building that and good luck with everything that lays ahead in your future. Our next question comes from Joy. Hey, Paula. I am mildly obsessed with your show. I love all of the content that you put out every Monday and the first Friday of every month. My family is very grateful for the guidance that you provided.

It's definitely something that I want to give you credit for for us being in a good position now. So the only debt that we're currently holding is the mortgage on our primary property. We have it on a 15-year loan at a 3.9% interest rate. And the current principal that we owe is around $178,000. So our question is, I was a surrogate last year for an amazing family. And we are wanting to complete the process again, sort of starting the first steps. And so we're thinking about what would be the best way to use the funds that we're going to receive from this journey again.

So it's around 50,000. And so we're thinking that one of the two options that we could do would be to take out a good chunk of the principal on our home. Currently, our payments are around 1,700 a month. And it would be great to get closer to getting that money back in. Not having to pay a mortgage is extremely satisfying to me or the feeling of it would be. The other option that we're kind of looking into, that makes me very excited, though, as well, is going into real estate. So I've always loved homes. I've always, I don't know, I'm obsessed with real estate investing.

And so I'm just thinking this could be our opportunity to be able to really start and dive into that journey. So we would have enough to be able to make a down payment on a home as well as have an emergency fund for that property for it to cover any capital expenditure. So I'd feel comfortable enough to be able to start that. So I was wanting to know what your thoughts are the pros and cons are of either attacking the principal on our mortgage or to start the journey into real estate investing. I would love to get any feedback that you have to provide. Joy, thank you so much. First of all, I'm honored that I could play any type of role in helping you and your family improve your financial situation.

But all of the credit, all the congratulations, goes to you because you're the ones who took action. You're the ones who actually did something and making improvements to your financial life. That's a long-term project. It takes perseverance, persistence, consistency. And you've done it. So big congratulations to you for that. Now, I love the question that you asked because you're choosing between two excellent options.

So let's walk through the pros and cons of each. If you use this $50,000 to make a giant lump sum payment towards the principal of your home, the advantage is that you will pay significantly less money in interest over the life of that loan, and you will have that loan paid off. a lot faster. So applying this $50,000 towards your $178,000 balance is going to, number one, shorten the clock on your mortgage, and number two, save you a bunch of interest money. The drawback, though, is that it does nothing to improve your current cash flow. Even after you apply this $50,000 towards the principal, you would still have to make a payment of $1,700 per month, every month towards that mortgage, and that $1,700 a month payment would go on for many years.

And the interest rate that you would be saving is 3.9% on a primary residence mortgage. You would definitely be saving interest, and that interest savings does amount to thousands and thousands of dollars. But it is, relatively speaking, a low interest rate, not that far away from the historic rate of inflation. And wiping that out would make a lot of sense if you could wipe out the entire, thing because then that would free up your cash flow. Wiping out the entire mortgage would free up $1,700 per month. But putting this $50,000 towards your mortgage without paying off the entire thing could be described by some people as sort of the worst of both worlds, because you've got a bunch of equity that's tied up in your home, which is underperforming what it otherwise could be

doing in an alternate long-term investment. And yet, despite having that equity tied up, there's no change to your monthly out-of-pocket cash flow. That would be the drawback to applying this money towards your mortgage. You know, if your situation was that you could wipe out the entire mortgage in one giant lump sum, I'd say go for it. And there are people who will disagree with me on that. There are people who will say it doesn't make any sense to wipe out a mortgage or to pay off a mortgage because you can arbitrage the interest rate. But Joy, as you said, not having to make a monthly mortgage payment would be amazing. And if you can wipe out the entire mortgage in one fell swoop, then you can free up a substantial amount of cash every single month. So I would have no

hesitation if you could wipe out the whole thing. The thing that makes me pause is the fact that this would not benefit or impact your monthly cash flow situation. And it wouldn't. benefit it for many, many years. So those are the pros and cons of applying this money towards the principal balance on your mortgage. Now, let's look at the other option, which is applying it towards a rental property. The advantage is, as you've said, you love rentals, so this is something you're excited about doing. You have enough money to both make a down payment and also have an emergency fund, and that is a very strong starting point. And this money, by virtue of being used as the down payment on a rental property would be working for you,

accumulating growth, accumulating gains in a way that having it tied up as equity on your balance sheet, it would not. So those are the three things that I like about the idea of using this for a rental property. And although I do not believe that a person should make decisions based on current prevailing interest rates, I will add in here the note that interest rates right now are at the lowest point that they've been in 50 years. So if you are going to buy a rental property, and it sounds like that's something that you do definitely want to do, there's a good chance that you'll be able to pick up a rental property with a pretty sweet interest rate. Now, that being said, the interest rate on a rental property is going to be higher than the interest rate on a primary residence mortgage. And so once you buy that rental property, if you want to make additional payments towards the principal on either of your two homes, it will most likely make more sense to make those additional payments on the rental rather than your primary residence because the likelihood is that the interest rate on your rental is going to be higher than the interest rate on your primary.

So to the extent that you can bias your debt towards your primary residence, that strategy allows you to then preserve your money, including preserving your stronger equity positions for your investment properties. Those are the advantages to using this money to purchase a rental property. The disadvantage, of course, is that any type of investment, rentals included, always come with risk. Taking out a mortgage is inherently risky. It carries leverage risk.

and investing in rental properties is inherently risky. You could have a prolonged vacancy. You could have higher repair and maintenance costs, higher Cappex costs. And, you know, that downside is not specific or unique to your situation. It's just inherently the downside of any and all rental property investing. All investing, all investing, whether it's stocks or bonds or real estate, all investing carries risk. And specifically in the world of real estate, when you combine risk with leverage, you compound or amplify that risk.

And so I would say that that would be the drawback to using this money as a down payment and an emergency fund on a rental property. And again, that drawback is really not specific to your situation. It's more of just a general caution about rental investing. But I do really like the idea of buying a rental property. I love the fact that this is enough money that you would have an emergency fund from day one. I think that's critical. And having a good emergency fund is an important way to offset or reduce some portion of that risk that I just talked about. And it's also important.

It's critical that you're excited about it. Like, that's the thing about rental property investing is if you're not into it, you're not going to do well in it. But I can tell from your question that you're excited about this. And that excitement at a very practical level means that if you have to stay up, late writing an email to your agent or putting together the documents for the loan approval. You know, if you have to stay up late, if you have to wake up early, you're more willing and likely to do it to follow through with it. Like that's the practical advantage of being excited about the thing that you're going into

is that the mundane hour by hour, day by day work of it doesn't feel so much like work. Like it doesn't feel so bad. It's actually kind of exciting. So those are my thoughts, Joy, on your question. And again, congratulations on everything. You're choosing between two fantastic options. So congratulations. And please call back in a few months and give us an update. Let us know what you decided to do and how it worked out. And that's true for everyone who's called into today's episode and anyone who's called into any of our past episodes. Call us back. Give us an update. Let us know what decision you made and where you are now. Thanks again, Joy. Our last question today comes from an anonymous caller. And since I give every anonymous caller a nickname, I'm going to call this person the least land landlord.

Hi, Paula. I'm calling because I'm a big fan of your podcast. And in particular, I really enjoy the way that you think about and analyze investments. And I have an investment question. 15, 16 years ago, I moved to a city with a high cost of living, and I bought the smallest apartment I could. It was a one-bedroom condominium for 100K. Within a few years, I'd paid it off, and when I left that city a few years later, I began renting it out. And this little condo has been doing incredibly well. It nets after I

take out vacancies and taxes and condo association fees, everything, it nets. It nets. After I take out vacancies, it nuts roughly 10K per year. So far, so good. However, there is a catch. This condo and the entire apartment complex is a co-op and it was built on leased land. That means in about 32 years, the entire complex is going to revert back to the owners of the land. So I'm having a hard time determining when and how to think about, and when to sell this apartment and how to think about this investment. On the one hand, there's a bit of inertia.

There are transaction fees if I decide to sell it and it's doing pretty well right now. On the other hand, I feel like it might be a ticking time bomb. Eventually, the retail value of it is going to approach zero as the end of the lease becomes due. So my question is, when should I consider selling this apartment? If I sold it today, I could probably sell it for around 150K. And that's been the sale price pretty, it's been pretty stable sale price for the last few years. But again, I'm anticipating that at some point that's going to start to drop. And as I look at this apartment, how do I compare it to other types of investments? I know how to calculate a cap rate on a really, real estate investment, but I don't know how to do that in a way that's comfortable to this one. Even though it's netting 10,000 a year, it's not really a 10% cap rate because the underlying investment is losing value. In any case, I would really appreciate your advice on this and what you think I should do and how you think I should evaluate this kind of investment. Thanks.

Least land landlord. That is quite a catch. The first thing I'll say is, Congratulations on the numbers that you've just described. You bought this for $100,000, paid it off, and now it nets $10,000 a month. So you're netting after expenses. You're netting 10% of the value of the asset every year. That is a fantastic return. So congratulations on finding that. Now, that said, you are absolutely correct in that the fact that this condo

belongs to a building that is a co-op built on leased land. What that means is that in 32 years, if the ground lease expires without getting renewed, that means that all structures on and capital improvements of the land, which means your building, which means your condo, all of that gets forfeited upon the expiration of the ground lease. it gets forfeited to the owners of that land. So if the ground lease expires, if it doesn't get renewed, then technically, legally, yeah, you're not going to own it anymore and neither is anybody else. That whole building is going to revert to the owners of the land.

But the good news is that doesn't happen very often. Oftentimes, the ground lease gets renewed. Now, it's possible that that ground lease will get renewed at a higher rate, and that higher rate will be passed on to all of the owners of the units within that building in the form of monthly maintenance fees or association dues. That's certainly a possibility. And the factor that makes that possibility more likely is that the co-op is in a tough negotiating position, right? When it comes time for the co-op and the ground leaseholders, the land owners, when it comes time for them to renegotiate that contract, well, the co-op owners are in a tough position because

they can't walk away. Their options are we renew this lease or we lose our units. And so the structure of the deal, the structure of that negotiation is set up in such a way that the landowners could raise the cost of that ground lease considerably. Now, that being said, if they raise it too much, then there could be a lot of pushback. There could be lawsuits. It could become very messy and very complicated. And so the best case scenario is that the land, Landowners want to avoid that. They want the deal to sail through in a manner that's simple and quick and clean and creates as little controversy as possible. And if that's the case, then it's possible they might renew the ground lease at the same rate or at a reasonable rate raise. That would be a fantastic case scenario. The worst case scenario is that they just don't renew the ground lease and it expires and then you lose your condo. And that is a risk. It's a real risk. And because, Because of that risk, units in co-op buildings oftentimes tend to decline in value as you approach the expiration date of the ground lease, which means that over the span of the next 32 years, there is a reasonable likelihood that the value of your condo adjusted for inflation will decline in value due to the fact that that risk is more and more. and more eminent as time goes on.

When something is going to happen 32 years into the future, it's much easier to shrug off that risk. If something's going to happen five years in the future, that's a lot scarier. And so to your question of when should you sell, if I were in your shoes, I would be watching the value of the other units very closely. I would be watching what they're selling for. Don't look at the asking price. Look at the recently sold price. And observe, if you're the other units in your building are continuing to hold their value for now, or if you're starting to see a slight decline. Again, adjusted for inflation. So if you're looking at this in a few years, the nominal price may be higher, but the inflation adjusted price may be lower. So what I would

do if I were in your shoes is watch the other units very closely, and when you see values start to decline, I would seriously consider selling because the risk that that ground lease might expire and that you would then have to forfeit the property, that is a very real risk. So, yes, you're making a great return on that rental unit, but I would still sell it sooner rather than later. So thank you for asking that question, leased land landlord. And congratulations on having this rental property paid off free and clear that's bringing in such great passive income. That is our show for today.

If you have enjoyed today's episode, please do three things. Number one, share this with a friend or a family member. If any of the questions or the discussion that we've had today remind you of somebody in your life, if there's someone that you know who you think would benefit from hearing something that we've talked about, please share this episode with them. You can always send them a link to the show notes at afford anything.com slash episode 247.

If you want to learn more about rental property investing, we have a free seven-day series, a seven-day email series, that walks through a lot of the questions that you might have as a beginner rental property investor. How do I find properties? How do I finance them? How do I build a team? So we have a free seven-day email series, which you can get at Afford-anithing.com slash VIP list. That's afford-anything.com slash VIP list.

We also have a course on rental property investing. It's a 10-week-long online course. We will be releasing it this spring. We don't know the dates yet, but we will announce those dates first to the people who are on that VIP list. So if you want to be the first to hear about it, go to afford anything.com slash VIP list and jot down your best email address. Thanks again for tuning in. My name is Paula Pant. This is the Afford Anything podcast.

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