Saturday, February 21st, 2009
Yes, I used it…the dreaded “M” word.
To be honest, I am sick and tired of everyone and their dog running around spouting off about the housing market and sub-prime mortgages etc. Aren’t you?
The fact of the matter is that for the average person, the only mortgage that actually matters is their own!
A mortgage is a tool used for financial leverage. In fact, it is one of the best wealth creation tools available to the general public. It’s true…if you don’t believe me just try to go to your bank and borrow $100K to invest in the stock market.
Furthermore, the majority of the general public could not afford to “buy” a home without the assistance of a mortgage. A mortgage is a contract between you and your financial institution that says you promise to make the payments in certain intervals for a certain period of time and that you are using the real property as security for that contract.
It is really pretty simple when you break it down.
The key component of the mortgage lies in the fact that it is a financial tool of leverage. You are leveraging the power of your own funds (down payment) and the bank’s funds to purchase real property.
Leverage Can Be Good Or Bad
The leverage that a mortgage provides can be good for you when home prices are rising because if you sell your home for more than you purchased it for, the bank just wants the original mortgage paid off. In this instance you are left with a tidy profit (one that also has tax advantages…but we’ll leave that for another day).
Let’s say we purchase a home for $200,000 and decide on a 5% down payment. Our investment in the home is now $10,000 (plus some incidental closing costs etc.). If home prices were to rise by 10% and we decide to sell our home for $220,000 ($200,000 + 10%) we are left with a profit on the sale of $20,000. A 10% return isn’t that bad! But wait…we actually only put in $10,000 of our money to start with, so we actually doubled our money! This illustrates the positive power of financial leverage.
(please note that this is a very basic example)
Let’s take a look at the negative effects of leverage.
Supposed now that we purchased the same home for $200,000 and decided again on a 5% down payment of $10,000. In this instance home prices drop by 10% and we are forced to sell the home for $180,000. In this instance, not only have we lost the $10,000 down payment, but we still owe the bank $10,000! ($200,000 purchase price – $10,000 down = $190,000 mortgage)
As you can see, the mortgage is a VERY powerful financial tool and has the ability to create exponential wealth if used correctly. It also has the power to decimate wealth as well.
Margin Vs. Mortgage
Leverage can be utilized when purchasing stocks as well; this is called “margin”. Margin has the same basic effect as a mortgage, but is not nearly as much of a concern to the general public. Margin, as a tool of financial leverage is granted to those investors who have proven themselves to be worthy of such credit.
What makes mortgages so dangerous is that they are granted to most anyone in the general public regardless of any evidence of knowledge of the effects of financial leverage. Sure there is a credit check and the bank assesses your capacity to make the payments, but when banks start offering interest-only ARMs and other product to try to make homes affordable, there is bound to be trouble.
Know The Score
In fact, a lot of your ability to qualify for a mortgage and the interest rate you will pay is based on your credit score. The banks have access to your credit score and place a lot of faith on that number when making decisions. Qualifying for a mortgage and getting a great rate can be easy when you have a good credit score. However, the average person doesn’t even know what their credit score is – let alone how to improve it.
Do you know what your credit score is? If you don’t, you can access it here for no cost through Experian. I highly suggest that everyone identifies what their credit score is and learns how to maintain and/or improve it.
On The Other Hand
It is unlikely that large stock brokerages will offer enormous margin accounts to “Joe Common” because he decides it’s “time I started investing in stocks”. Why then should mortgage lenders offer up hundreds of thousands of dollars in “leverage” simply because Joe decides it’s time to buy a house. Or, to make this worse Joe decides…”Buying a house is a great investment”!
I’m not going to tackle the subject of whether or not one’s home should be viewed as an investment; that is best left for another day.
However, if you’re itching for some good discussion, you can read a great debate on this subject at Ramit’s I Will Teach You To Be Rich and a breakdown of the financial decision to Buy vs. Rent from Jim at Blueprint for Financial Prosperity. Trent over at the Simple Dollar also unleashed a similar discussion while reviewing Rich Dad Poor Dad.
Posted in Investment News | 8 Comments »
Thursday, January 15th, 2009
Over the past few months many investors have been questioning their methods of building wealth for the future. With the markets being more volatile than at any time in history, there is no doubt that many people simply feel like running for the exits.
With that in mind, here are three questions that many investors are asking along with answers based on historical statistical evidence.
Why am I still investing in the U.S.?
The message that history has taught us is a simple one. Analysis shows that in the past, when the S&P 500 was trading below fair value and inflation was less than 4.2% which is certainly the case today, there is an 83.3% chance of achieving a positive return.
All the signs and tools that we have to work with indicate that coming out of this crisis there will be significant upside in the U.S. equity market.
How can I keep investing when the economy is in the tank?
This one is easy, stock markets are leading indicators and as such stock markets will likely recover before the ensuing economic recovery. While it is impossible to identify when these recoveries will begin, missing out on the sharp returns that often occur in the early stages of a stock market recovery, is a mistake that investors make very frequently.
How am I ever going to bounce back?
We must remind ourselves that, as a long term investor, it is important to continue to follow the forward looking strategy that was implemented before they felt the emotional pressure of daily market volatility. A very compelling fact to reference is the asymmetrical nature of bull markets vs. bear markets.
The average bull market gain of 79% far outweighs the average bear market decline of 28%. And the length of the average bull market is 34 months long vs. the length of the average bear market of only 11 months.
While these questions are not intended to completely sooth anyone’s concerns about the health of thier portfolio, it is always nice to know what history has shown. Even though history cannot predict the future, it is the best information that we have to qualify our decisions with.
Posted in Investor Education | 3 Comments »
Sunday, December 14th, 2008
Saving money around the holiday season is a very common theme this year and retailers are doing their best to entice consumers to open their wallets with sales and discounts that many thought we would never see.
Many, if not all, online stores are offering free shipping and the savings on non-essential items like video games and electronics is virtually unheard of.
Holiday Incentives
Many traditional retailers are offering incentives on financing. Just what a nation that has lived on credit for the last ten years needs – more debt. I do believe that the main stream media, with a the constant barrage of negativity toward the economy, has scared the average person into saving more money. (The only good thing the media has accomplished over the last few months.)
Some recent statistics show that many Americans are not taking on any credit card debt this holiday season and that is certainly something that has changed from recent years. With mortgages getting harder to qualify for, the importance of a good credit score has finally hit home with American consumers.
Many consumers have also said that they are planning to spend significantly less money this holiday season overall. Again, a profound change from the overspending that plagued recent years.
Will this Be Lasting Change?
One has to wonder if these changes will become habits that will last and be ingrained in the generation like the spendthrift and frugal survivors of the great depression era, or if the ideals of the recent “have it now” ideology will return with a vengeance at the end of this economic downturn.
I must say that I personally do not know which one is the lesser of the two evils? There must be a reasonable balance between spending and saving that will both benefit the economy and businesses as a whole and the individual. That is the balance that we seek as a society.
Today’s Investors Will Benefit
I am certain that this economic downturn will offer today’s young investors, who continue to buy stocks, an opportunity at wealth in their later years.
No matter how much money you spend this holiday season, I urge you to not only look in your favorite stores, but look at them as well. Who knows, the best bargain you find this season may be that beaten down retail store stock you’ve always shopped at!
Posted in Saving Money | 3 Comments »
Thursday, December 4th, 2008
As an investor, you come up with an overall approach to meet your objectives and then bring in the stocks, bond, real estate etc. to your portfolio to execute the plan. Of course you expect that there will be frustrations along the way – just like we can’t control the weather, we can’t control the markets. But, if you are willing to put up with the frustrations, by the end of your investment time horizon, you should be able to enjoy the retirement you’ve always dreamed of.
Historical Statistics
Anyone investing for a long time should expect markets to go down sooner or later, but the long-term trend has always been up. In 183 years of equity markets in the U.S. performance was positive 70% of the time and negative only 30% of the time. Years like the one 2008 is shaping up to be are extremely rare. In fact, the only complete calendar year that lost over 40% was 1931. Conversely, the market improved by more than 40% ten times.
The chart below shows the frequency of positive and negative calendar year returns in the U.S.
There are two key messages to take away from this chart:
- The market performance of 2008 is well outside the norm. Looking at history, it seems unreasonable to expect such negative returns to keep recurring.
- Investors often focus on average returns, but the long-term experience of the market is very different from the average. The average U.S. equity calendar year return is approximately 8%, but in any given calendar year there’s less than a 25% chance of a return in the range of 0 to 10%. Returns outside that range should be expected – both positive and negative.
Additionally, what you can’t see in the chart is that four of the five best years (over 50% return) occurred immediately following a negative year.
With 2008 being the worst calendar year in recorded history for equity returns, do you think that the possibility is increased for history to repeat itself with 2009 rebounding with a potential 50%+ return? While we have history as a guide, only time will tell if these statistics will hold true in the future.
Posted in Investor Education | 5 Comments »
