invest in what you know

Imagine you have $500,000 in cash and a mortgage of $400,000 – and no other debt of any sort. Your mortgage is at a low rate and fixed for 30 years. Should you pay it off? This subject is debated endlessly – whether paying off your mortgage early is a good “investment,” since tying up your money by paying off your mortgage keeps it out of the mythical guaranteed-over-20-years 10% return in the market. Fine, you can use whatever assumptions let you sleep at night.
But let’s take that to another level. If you have $30,000 and want to buy a car, and the dealer offers you a ridiculously low rate – say 2% or less – on financing, should you pay cash or finance? And let’s take that another step further – why wouldn’t you use a home equity loan at a low rate to fund your home improvements, or even buying a car while letting your money work in the market?

Creative Commons License photo credit: freeparking

Asking this question is not idle speculation. We DID recently pay cash for a new minivan – we have aggressively managed our cash and savings to put ourselves in a position where we can pay cash for everything. We have no desire to pay off our mortgage early since (a) we plan to move at some point and (b) we have a good rate. But should we have financed the minivan? Was locking up a large sum of cash like that a bad idea? I know it’s a depreciating asset that loses 50% of its value the second we drive it off the lot, yada yada. Our cash is now gone – flown out the door. On the other hand, we can look at our car and say that it’s done and paid for, which is a nice feeling.

I think a person’s attitude towards debt has something to do with the types of investments they’ll make and their risk tolerance. I’ve said before that my family’s beliefs about debt were hard-core fundamentalist: debt was pure evil. Even mortgages were necessary evils. Investing is done with cash in hand; real estate investing is foolish because you can’t play the game without using other people’s money.

I’ve come to realize that one of my greatest weaknesses in terms of wealthbuilding is lack of focus. Bear with me here. I talk with people who invest in real estate and they have a relaxed attitude towards taking out huge debt on investments. They’ve done their homework, studied the market, etc. – and then gotten a mortgage from the bank and bought. This is not something I think I could ever do; yet at the same time I have spent a lot of time trying to educate myself about real estate investing. There is no point. If I am going to continue to build wealth it has to be in ways that I am comfortable with because the necessary focus and discipline aren’t there, otherwise. I hate debt, and investing in real estate requires debt. On the other hand, I have no problem with investing in individual stocks – because I have a deep understanding of financial statements and the operations of public corporations from my experience in auditing. So why don’t I stick with worrying about strengthening my knowledge in the area I understand and appreciate, rather than the one that gives me the heebie-jeebies?

So I sit back and decide that having a unifying principle – like paying cash for EVERYTHING – not only helps me sleep better at night, it makes sense within my realm of understanding and expertise. Liquidity is not my goal: a lack of debt and investments that generate cash flow are. I’m going to stick to investing in what I know, and try to forget about areas that I don’t care for and I don’t understand that well, like real estate. I think I will get rich sooner doing that.

14 comments

  • I kinda wrote about the same thing today. I think it is very important to do with your money what makes you comfortable and what you understand and know about. It would be foolish to do it any other way. It’s also important to understand that what works for one person isn’t going to work for everyone else. I am with you on the no debt stuff. The psychological aspect of having something paid for is worth, to me, whatever minimal loss may come from that choice. Having your minivan paid for is worth it even if it lost value the day you drove away with it. It lost value either way – paid for in cash or not – so take comfort in the security of it being paid for and don’t look back. You won’t ever have to worry down the road that you still owe more on it than it’s actually worth.

  • Well, it all depends on the personality of the person you are speaking with. On one hand the leverage factor can produce extraordinary returns on invested capital provided that the house appreciates in value. On the other hand however, if you wanted to retire, you’d need extra money simply to pay off that monthly mortgage bill.
    I think that you are ahead of 90% of the rest of the people because you realize your shortcomings and act accordingly. You don’t stock up on real estate by overleveraging yourself for the big killing..
    If you want to invest in real estate without thinking constantly about the leverage factor, let others do that for you. Buy a Real Estate Investment Trust or an ETF that covers one.

  • When I bought my car five years ago, I was ready to pay cash. But then I thought, “Well, what if they’re offering 0% financing? [As some dealers were not too long before that] Wouldn’t it be dumb to pay cash?” I wasn’t sure what to do, but it became an easy decision when I found that they were offering a rate of 6% or so. I paid cash.

    Some might call that a mistake, saying I could get a 10% return on the money I’d be borrowing at 6%, and maybe that’s true…or maybe not. What’s the term of a car loan? 4 years? You don’t know what stocks will do over that time. For me, any potential gains weren’t worth the risk. I’d rather pay cash and be done with it.

    But a 6% car loan is different from a 6% tax-deductible mortgage that you probably couldn’t pay off anyway, and you’d still have to pay property taxes even if you did. And if you pay off your mortgage, you’d better not forget to pay your property taxes on time!

  • lol you use yada yada, havn’t heard that in years. I think I am going to try to start using it more often.

    You do bring up a good point about financing on cars and home improvement etc. I think that eventually if people put everything on credit, they would get too much debt and not have the funds to pay it off. Paying in cash makes sure you have the funds to buy whatever you are purchasing. It would make sense to finance everything that you can get a good rate on, but I could see it causing people to spend more than they should making it a bad idea.

    I don’t know anything right now, just a little bit of everything. What should I be investing in? 🙁

  • MoneyEnergy

    I’ve thought about this problem before too; I used to always say that I was never going to buy a car unless I could pay cash for it. I don’t know why, it just made me feel superior to my money, like I was really in control of it.

    But it’s a very good point about not tying up your buying power like that. For the same amount of cash you could buy two income-producing assets that would generate cashflow right away.

    But what you’ve said still holds; if one isn’t comfortable with a certain segment of the market, just don’t go there. I think that as long as you aren’t three levels removed from the money – eg., investing in re-bundled debt instruments, etc. even more complicated investment moves are ok. I know for me it’s all about the dividends:)

  • From someone who also pays cash (I also use revolving credit, paid off at the end of every month), I hear that such behavior damages my Fair Isaac credit score, because I have no history of payments on long term debt (the mortgage was paid off almost a decade ago).

    Given my approach to debt, I normally wouldn’t give a flying leap about my credit score. However, I do ask “What if . . .?” And I intend to retire to a high-cost area at some time in the future, and I acknowledge that I may need a mortgage, or at least a bridge loan, to do so. I wonder if I might not get the best rate, because I would be considered, um, a credit risk?

  • Though this may be sound advice Steve, I don’t think it is.

    Maybe it’s from my personal growing up. My father is a real estate agent and he’s often showed me statistics that 90% of all wealthy people got that way via real estate investments. Even Ray Croc that founder of Mcdonalds said his business was not selling hamburger, it was real estate.

    Real estate does tie up a lot of money, but then again without debt there cannot be great gain (Unless you win the lottery or something along those lines).

    If you’re feeling uneasy about investing in the real estate game I suggest you take what knowledge you have now and buy a small apartment, or maybe a duplex and rent them out. See how you fare for a while and then move up from there.

    All things being represented, I think having tried a bit of everything best suits the fuel to get up the road of wealth. Not saying diversifying your portfolio to the point of flimsy ridiculously small amounts invested in every little thing, but also saying that one should not always eat at one table primarily.

    Haha long comment, sorry man!

    Hey I am doing interviews with internet marketers and pro bloggers. If you want to be interviewed, let me know my friend! 🙂

    Hope all is well!
    -Greg the Writer

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  • You drive a minivan? You used to be so cool…. 🙂

    Seriously, our next vehicle will undoubtedly be a minivan.

    Greg the Writer – I wouldn’t be surprised if a lot of people who earned their riches got that way by taking large risks via real estate, financing their own business etc. My question would be – how many other people are there who took large risks and didn’t succeed with their strategies?

    Mike

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  • What about options ?
    Your loss is limited and profit could be really huge.
    I think it`s better than using a primitive bank debt.

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