To Pay or Not To Pay Off Your Mortgages: Part II
In Part I of this article, I mentioned that we've all been
taught by our parents, grandparents and conventional wisdom that
we should pay off our home mortgage in order to own our home
free and clear so that the bank can never take our home from us.
I explained why that thinking is outdated. In this article, I'm
going to present some ideas on using mortgages as a tool to
increase wealth.
I want to say up front that I'm not advising you to go out and
do the things I'm talking about without first getting educated
as well as consulting with a trained and licensed professional.
While I firmly believe that what I'm going to tell you is a
great strategy for increasing wealth, there's also no one
strategy that is right for every person since we all have
different goals which require different plans of action. Also,
it would be very easy for a dishonest or unskilled financial
advisor (loan officer, CPA, financial planner, etc.) to take
advantage of you or mistakenly put you into a product that costs
you time and money instead of helping you to become financially
independent.
Before we start talking about liberating your equity and
investing, let's make sure you have your financial house in
order. It won't do any good to take equity out of your house to
start investing if you're burdened by a massive debt load and
forced to use your credit cards every time an emergency comes
up. I recommend a three-step model to my clients that
conservatively builds a solid financial foundation before
leveraging equity to increase net worth. This three-step model
has the following parts, in order of priority: develop a
cushion, get rid of "bad" debt and create and maintain
liquidity.
I believe it's absolutely essential for everyone to have a small
cushion in a savings account to cover life's little emergencies
and make sure they don't automatically reach for a credit card
or borrow money. We're not talking about a lot of money here -
usually around half of a family's monthly income. If the
family's combined income is $8,000 a month then $4,000 should
cover it. If the income is commission-based or somewhat
irregular, it's a good idea to increase the cushion to a month's
income.
Next, get rid of all "bad" debts - debts without tax advantages
which means everything except the mortgage and maybe student
loans (car payments, credit card debt, etc.). These should be
paid off before moving on to the next step. If you're investing
in the market instead of paying down a credit card that's
charging you 20% interest, then you would have to make over 20%
on your investment in order to come out ahead! You're much
better off eliminating the credit card debt first so that you
can invest your extra cash flow. This can be accomplished by
using the equity in the home, but there are also different
methods to pay it down month by month. My favorite is the
snowball method, which involves making the minimum payments on
all debt while paying as much as possible each month toward the
debt with the highest interest rate. Once that debt is paid off,
keep paying the same amount each month but pay the extra toward
the next-highest interest rate. You'll be free of "bad" debts
before you know it and will have the little rewards of paying
off debts along the way to keep you motivated and focused on
your ultimate goals.
The final step before beginning to invest is creating and
maintaining liquidity. I advise you to have six month's salary
in a safe, liquid place such as a certificate of deposit, money
market fund or other conservative liquid investments. This
allows you to be prepared and have cash available for things
like business opportunities, helping out friends in need or
taking some time off for a vacation. It might be needed for
extenuating circumstances like a job loss, health issues or
major unexpected expenses. You will have a significant safety
net and will sleep better at night!
After these three steps are accomplished we can then consider
investing. Depending on your financial goals and tolerance for
risk, I advise looking at a mix of stocks, bonds and real
estate. You should always take some time to educate yourself
before jumping into any type of investments. There are plenty of
resources available to learn about investing in stocks and
bonds. I also recommend working closely with a financial planner
to help you navigate the financial markets. At January Financial
we are very passionate about investing in real estate and are
here to be a resource to you in that area.
Generally speaking I believe people should be financially
diversified, which means your assets shouldn't be tied up in any
one asset - especially your house! By liberating the equity from
your home and investing in different asset classes and areas,
you reduce risk while increasing your potential return.
Investing in stocks allows you to take part in great businesses
and share in their success, without the time and energy of
actually working on the business. Investing in bonds provides
steady income while lowering the overall risk of your portfolio.
Finally, real estate in my opinion offers the most accessible,
least risky, most exciting way to get rich slowly.
In Part III I'm going to cover a few of these reasons as well as
why I think everyone should have investment real estate as a
significant portion of their portfolio.