Showdown! Keep Your Mortgage vs. Crush Your Mortgage -– Who Wins The Championship?

Should you pay off your mortgage or invest?

Ready to rumble?

There’s a fight brewing. Two contenders have climbed into the ring. Both are clawing for victory. Only one will survive.

It’s a showdown.

In one corner: Crush Your Mortgage, and his team of anti-debt advocates.

In the other corner: Keep Your Mortgage, and his cheering crowd of leveraged investors.

Who will take home the title?
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I’m Upside-Down on My Home. Should I Rent It Out? Or Sell It?

A reader wants to rent out his current home he's upside-down on until the market recovers enough that he can sell it. But is this a good idea?

Should I Rent Out This House?An Afford Anything reader recently emailed me about this dilemma:

He’s upside-down on his home. He owes more than the house is worth.

But he wants to take advantage of today’s low housing prices, which will let him move his daughter into the best school district in town. He can put 10 percent down on a new house in a fantastic school district.

He’d lose money if he sold his current home. There are only two ways he can sell it: either bring cash to the closing table (i.e. pay extra to get rid of it!) or process an excruciating short sale, which would destroy his credit.

Both of those choices are off the table. He wants to rent out his current home until the market recovers enough that he can sell it. But is this a good idea?

Check out the details:


Mortgage + Association Payment:
Vacancy: $100 *
Repairs, Maintenance: $50 – $100 **
Property Manager: $100

Total Expenses: $1,450

This leaves him with $100 – $150 per month in cash flow.

Hold On, Where Did You Get Those Vacancy / Maintenance Numbers?

If the house is vacant one month per year, we can average that out to a monthly vacancy cost of $100. Of course, if it sits vacant for 3-5 months, he’ll be sweating.

The “rule of thumb” is that maintenance will cost 1 percent of the purchase price of the house. Of course, that’s a long-term annualized average. It includes rare, expensive repairs like replacing the roof every 20-25 years and re-painting the siding every 5 years.

Since he has an association payment, I assume his homeowner’s association takes care of all exterior maintenance. That brings his maintenance costs down. (Well, really, it just lumps his maintenance costs into a different category).

Assuming his house is in good condition, his big maintenance costs will rare but costly events like replacing the water heater, buying a new refrigerator, etc. He won’t literally pay $100 every month. Like his vacancy costs, this maintenance cost is a long-term average over the span of many years.

He reported a property management fee of $100 per month in the email that he sent me. That seems rather cheap (it’s only 6 percent of the rent), but some property managers will charge a cheaper fee in a neighborhood with higher tenant quality, so I’ll accept that premise at face value. (Some property managers charge one month’s rent as a “placement fee” for finding a tenant, which is NOT included here.)

So What Do You Recommend?

Here’s my advice:

#1: Use your $100 – $150 monthly cash flow to build some cash reserves. Use this to cover the mortgage payments when your house sits vacant. Vacancy is your single biggest risk, because you’ll have to cough up the cash for two mortgages (your rental house and the home you live in). Strong cash reserves are the single biggest weapon you have against this risk.

#2: Add even more money to those cash reserves so that you can quickly write checks for repairs and maintenance. What if the house sits vacant for 4 months, a tenant moves in, and a week later you need to call a plumber? Cash reserves will help you sleep better at night.

#3: Don’t even think about making “extra” mortgage payments before you have huge cash reserves built.

I’d recommend a minimum cash reserve of 6 months of mortgage payments, and an optimal cash reserve of 8 to 10 months. That way, if you deal with an extended vacancy, you’ll be able to cover the mortgage.

Many landlords “shoot themselves in the foot” by panicking about a vacancy and renting out their home to the first willing tenant that comes along — even if their gut instinct says it might not be a good tenant. That always leads to disaster.

If you have cash reserves to deal with a vacancy, you can take your time and wait for the right tenant — a good tenant — instead of accepting the first person who’s willing to move in.

One of my houses has been vacant for almost three months. (It’s the $21,000 foreclosure, which is in a part of town that doesn’t always attract — um — the most qualified candidates). I’m guessing that the house might sit vacant for four or five months before I get someone in there.

But here’s the thing: Several people said they’re interested in moving in. But none of them have met my tenant criteria. It’s nice to be able to hold out and wait, so that you’ll eventually get the right tenant, not the first one.

Should You Pay Down Your Mortgage or Invest the Cash?

Should you pay off your mortgage as fast as possible, or should you invest the money in the stock market or in investment real estate? Here's how to decide.

Should You Pay Off Your Mortgage or Invest?Touchy subject time: Should you pay down your mortgage rapidly OR invest the cash?

This question always brings out the punches, kicks and jabs. People have STRONG emotions about debt, even low-interest mortgage debt.

Through Afford Anything lens of “Stop Shouting, Start Thinking,” let’s walk through the potential consequences. You decide.

Everything Has Risk. Period.

Most people want to pay off their mortgage for three reasons:

#1: Emotion: Peace-of-mind
#2: Risk-Management: Reduce the chance of a foreclosure
#3: Savings: Lower their interest payments

These are all great reasons. But nothing is the “best” choice in a vacuum. It has to be compared to an alternative.

Alternative #1: Spend the money on champagne and strippers. Obviously a terrible choice.
Alternative #2: Invest the money. Okay, this could be a valid option. Let’s explore it.

Stocks, historically, have yielded an 8 percent long-term annualized return over the past few decades. Legendary investor Warren Buffet predicts that number will be closer to 7 percent in the coming years. For the sake of argument, let’s assume Buffet is right.

Now let’s rephase the question. Are you willing to pay extra to get rid of your mortgage faster?

That’s not a rhetorical question. Missed opportunity has its price. If you’re willing to pay the opportunity cost for the sake of reducing your risk — Great! Go for it! You might be leaving money on the table. If you’re okay with that, then you have your answer.

Notice I asked if you’re willing to pay the opportunity cost. That doesn’t mean you will. No one knows what the future holds. If the markets perform as they historically have done, you’ll miss opportunity. But if stocks tank, you’ll come out ahead.

There’s risk in every decision, even the decision to become debt-free.

Should you save or pay off debt? Or invest? Each option has pro’s and con’s.

Paying off your mortgage has:

  • Guaranteed interest savings
  • Limited upside
  • Unknown missed opportunities

Investing is:

  • Risky
  • Greater potential for upside
  • Stronger chance to capitalize on opportunity

Opportunity Cost

You have $100,000 in cash. (Congrats!) You also have a brand-new 15-year mortgage with a balance of $100,000, at 4 percent. (For simplicity sake, I’m leaving taxes out of the equation.)

Scenario A: You pay off your mortgage. You save $33,143 in interest payments. You invest $739 per month, the amount that would’ve been your mortgage payment. You contribute every month for 15 years and it grows at 7 percent. At the end of the term, your portfolio is worth $237,706. Hooray!

Scenario B: You invest the entire lump sum in the market. You make no additional contributions. In 15 years, your portfolio is worth $284,894. You’ve also paid $33,143 in mortgage interest, which you subtract out. Your net gain is $251,751. Wahoo!

Under this scenario, you’ve lost the opportunity to make $14,045 by paying down your mortgage early. Boo! That’s a strong argument for investing.

On the other hand, you’ve enjoyed peace-of-mind, which DOES have a value. You have less risk, higher liquidity and more flexibility.

Is that peace-of-mind worth $14,045? You decide.

Scenario C: You invest the money. The market tanks. You lose your job. Your house gets foreclosed on. Your spouse leaves you, your dog bites you, and even your goldfish won’t look at you anymore.

It’s a worst-case scenario, but it’s possible. Now the $14,045 looks like cheap insurance.

(What about borrowing to invest in real estate? Here’s my take.)

Quit Being Ideological

You know what’s funny about being a personal finance blogger AND a real estate investor? I hear ideologues on both sides of the aisle.

Finance bloggers, as a group, tend to have knee-jerk reactions to the word “debt.” Debt bad! Debt bad!

Real estate enthusiasts tend to have the opposite reaction. Gimme leverage! More and more and more leverage!

Half the emails I receive about this topic come from people who say, “Are you going to pay off your houses as fast as possible?” The other half ask, “Why aren’t you borrowing more?!”

Don’t make decisions based on ideology. Everything financial, even debt payoff, comes at a price. Everything carries risk. Risk wears different costumes, appears in different forms. But it’s there.

Avoid knee-jerk reactions and zombie ideology. Weigh the risks. Make a spreadsheet. Calculate missed opportunities. Imagine the worst-case scenario and ask yourself if it’s something you can live with.

Make choices based on information, not ideology.

Then decide for yourself.


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Investing 100 Percent of My Income: May Edition

investing 100 percent of my incomeTime for the next edition of Investing 100 Percent of My Income, and I have just one question:

How is it June already?!

For those of you who are new readers: Will and I are a couple who have pledged to live on one income and invest the other. He gets a steady paycheck, while my income fluctuates because I’m self-employed. So we’ve decided that in 2012, we’ll live on his income and invest 100 percent of mine. (This makes financial planning a heckuva lot easier!)

By the end of last month’s update, I maxed out my Roth IRA, renovated a rental house with a 14.8 percent cap rate, and paid quarterly taxes.

That was the easy part. Those were no-brainer moves.

Now comes the hard part. It’s time to make strategic decisions about how to invest the rest of my income for the next 7 months of the year. Here are a few lessons I’ve gathered:
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Why Dollar-Cost Averaging Stinks

dollar cost averaging or lump sum investingA few months ago, I stated that it’s a good idea to invest in the market in small bites over time, rather than diving in all at once. This method is called “dollar-cost averaging,” and it’s a popular strategy in personal finance circles.

But a widening body of evidence suggests that you should dive in headfirst instead of dipping your toes into the market.

The Background

Dollar-cost averaging supporters say that if you pour every dollar into the market at the same time, you might accidentally buy at the worst moment, when the price is peaking. If you buy stocks in small increments over time, though, you spread out your risk.

For example, a person with $5,000 who wants to invest in The XYZ Index Fund might:

Invest the entire $5,000 on Jan 1 at a rate of $50/share. This is called “lump-sum” investing.

– OR –

Invest $1000 on Jan 1 at $50/share
Invest $1000 on Feb 1 at $53/share
Invest $1000 on March 1 at $46/share
Invest $1000 on April 1 at $48/share
Invest $1000 on May 1 at $48/share

Average cost per share? $49 dollars. You’ll also own more shares. The same $1,000 will buy you more shares when prices are low and fewer when prices are high.

Conventional wisdom says that this strategy — easing into the market — is the best way to invest.

After I wrote about this a few months ago, one Afford Anything reader brought some research to my attention. The research he encouraged me to read makes a compelling case that dollar-cost averaging might NOT be the best practice.

Rogue Research

In 1993, a pair of researchers from Dayton, Ohio imagined what would happen if they converted $120,000 from Treasury bills into an S&P 500 index fund.

They ran two scenarios: what happens if they invest the lump-sum on January 1, and what happens if they transition the money over the span of a year? They ran a historic analysis covering every year from 1926 to 1991.

The result? “Based on historical evidence … the odds strongly favor investing the lump sum immediately,” the researchers wrote. The lump-sum strategy won two-thirds of the time.

The following year, another research duo ran a similar comparison. They concluded that dollar-cost averaging “is mean-variance inefficient compared with a lump-sum investment policy.” That’s researcher-lingo for “c’mon, throw your chips in the game.”

Around that same time, a different research team showed that there’s no statistical difference between dollar-cost averaging and throwing money into the market at random intervals.

A bevy of other studies followed. By December 2001, a research team threw their hands up and said: Fine, fine. Maybe lump-sum investing helps you GAIN MORE. But does dollar-cost averaging help you LOSE LESS? In other words, is it a risk-mitigation technique rather than a growth technique?

They ran a study based on this question – and discovered that the answer is no. “We find loss aversion still does not explain the existence of the dollar-cost averaging strategy,” they wrote.

But Why?

What’s the problem with this seemingly-sound strategy? You miss the opportunity for gains when most of your money is sitting in cash or other low-risk vehicles. Over the span of a year, that missed opportunity is likely to cost you more.

There’s some evidence that suggests that the market tends to move in spurts. Missing a few critical days of gains each year will create a disproportionate impact on your portfolio.

Furthermore, there’s a low likelihood that you’ll happen to put your money in the market at the worst possible moment.

But here’s the most compelling “why” argument that I heard: Your asset allocation is wildly askew while you’re dollar-cost averaging. You’ll be disproportionately overweight in cash or cash equivalents during the year that you’re easing into the market. And as we all know, you’re at a huge disadvantage if your asset allocation is too far off-kilter.

The Bottom Line

It’s important to remember that this warning against dollar-cost averaging applies only when you’re comparing it to a lump-sum investment.

If you’re averaging into the market as you get paid, then you’re simply investing money as you get it. There’s no better alternative to that. You can’t invest money that you don’t have yet. Plus, dollar-cost averaging your paychecks won’t throw your asset allocation askew.

But if you happen to have a cool stash of cash lying around – perhaps from a tax refund or something else – don’t be afraid to toss it into the market immediately. Protect your asset allocation, not your averaging method.

What To Do When The Market Is In Free Fall

Anyone with a pulse – your co-workers, your neighbor, your third-grade teacher – is fretting that stocks nosedived this week.

Actually, “nosedived” is an understatement. It plummeted. Plunged. Tumbled. Crashed. You get the picture.

From the Associated Press:

Gripped by fear of another recession, the financial markets suffered their worst day Thursday since the crisis of 2008. The Dow Jones industrial average fell more than 500 points, its ninth-steepest decline ever.

The talking heads on television are whipped into frenzy, issuing the usual Armageddon advice: Brace yourself! Stuff cash under your mattress! It’s 2008 all over again!

This is the typical scaredy-cat, knee-jerk advice you should ignore.

The Chinese word for “crisis” is the same as the word for “opportunity” (At least I assume that’s true; I learned it on The Simpsons.) You might want to apply that thinking to the stock market.

Here are 4 tips on what to do when the market is in free fall:

Tip #1: Remember It’s Easier to Lose Than Gain.

I don’t just mean that it’s easier to lose money than to make money in a general sense (though that’s also true!). I mean that when stocks sink 50 percent, they have to rise 200 percent just to break even.

“Huh?,” you might be thinking. “How is that possible?”

Let’s say you have $100 in the stock market. The market declines 50 percent. Now you only have $50 in the market.

To get back to your original $100, the value of your $50 stocks now have to DOUBLE – in other words, the market has to rise 200 percent.

What does this mean for you? First: its a reminder that there’s no such thing as easy money in the stock market. (As if you needed another reminder!)

More importantly, it’s illustrates: Don’t lock in your losses. Stocks rise and fall. In 2007 the Dow traded above 14,000. By 2009 it collapsed to 6,500 – yes, a decline of more than 50 percent.

A lot of people feared that doubling their money was impossible. They pulled out when the Dow was at 6,500 and locked in their loss.

Within two years, the market doubled to 12,700. What happened in the last two weeks – the quick pullback to 11,300 — is just a dip in the big picture.

If you held onto your original 2007 stock – never selling, never panicking, never trying to “time” the market – you’d endure a bumpy ride, but you’d ultimately be okay. Your portfolio, at least as of July 2011, would be close to where it stood in 2007.

But if you panicked and sold in 2009 when the market was low, you would have locked in your losses and missed the rebound.

In the end, you are your own biggest threat to your portfolio. The best way to avoid the “threat of yourself” is to stay the course. Which leads me to Tip #2 …

Tip #2: Stay the Course.

Don’t forget the fundamental rule of investing for the long-run: Stay the course. Don’t get scared.

Sure, the market is dropping now. But compared to where it was one year ago, it’s still doing very well:

the stock market, 2010 - 2011

As this chart shows, a year ago — on August 4, 2010 — the Dow Jones traded at 10,680. It went on a bumpy ride, sinking in September, but over the long haul it’s been steadily climbing.

Let’s look at the last two years:

stock market 2009-2011

Again, it’s been a rough ride, but the market has rewarded people who have stayed the course.

“But we’ve been in a recovery for the past two years!,” I can hear you protesting. Okay, fair enough. Here’s the past 5 years:
stock market 5 years

On August 7, 2006, the Dow Jones traded at 11,088 … close to where it’s trading now, five years later.

This means your initial investment will have “held steady,” so to speak, over the last five years, and the DIVIDENDS you earned on that money would have accumulated throughout. If you started investing 5 years ago — at the beginning of one of the worst periods of U.S. stock market history — you’d still emerge with a gain.

Tip #3: Use “Averaging” to Your Advantage.

Let’s say you invest $200 per month in a mutual fund. When the market is low, like it is now, $200 will buy 40 shares of XYZ Fund. In six months, when stock prices are high again, that same $200 will only afford 30 shares of XYZ Fund.

In other words: by being consistent, you automatically take advantage of sales. When prices are low, as they are right now, you pick up an “extra” 10 shares.

I’m a huge fan of ETFs, which are like mutual funds, except that they have lower fees (which means you get to keep more of what you make).

One drawback to ETFs, though, is that you have to buy them in “whole” shares. You can’t just contribute $200 a month; you have to buy 1 share, or 5 shares, or 10 shares, regardless of the cost.

In this case, buy a consistent number of shares at regular intervals.

Let’s say I buy 10 shares at the top of the market for $40 per share, and 10 shares at the bottom of the market for $20 a share. On average, I’ve paid $30 per share. My risk of buying at the “wrong time” is minimized.

Tip #4: Take Advantage of Sales.

You’re eager to take advantage of sales at Macy’s – why should buying stocks be any different?

You’ll never be certain whether or not you’re at the bottom of the market. That would require predicting the future, which is impossible.

But when you see that stocks are plummeting -– when the price of gold shoots up, bonds soar, and all the talking heads on TV are crying “the sky is falling!” -– it might be a good time to buy some stock.

Tip #4 – Part 1: Now – this is important – ONLY buy stock in a down market IF you have the patience to hold it for a long, long time. Like 10 years or more. This is a long-term strategy.

Tip #4 – Part 2:Also, don’t buy all at once. Ease in slowly. Maintain your “averaging” technique – buy 10 shares a day, or 10 shares a week, over time. This will help minimize your risk of making a huge purchase before the market plummets another 5 percent.

Tip #4 – Part 3:Third, ignore individual stocks unless you’re extremely well-versed in this arena. Individual companies can fail — just look at Washington Mutual. Minimize your risk by sticking to broad-market index funds or ETFs, which track a huge basket of stocks.

Tip #4 – Part 4:Finally, only do this with a small portion of your total portfolio: what I call “fun money.” This can be a few hundred to a few thousand dollars that you set aside for snapping up extra ETFs when the market makes a historic plunge.

Hey, the stock market is having a clearance sale right now. If you’ve got some “fun money” and you’re willing to stay in for the long haul, then this isn’t a crisis. It’s an opportunity.


For a little historic perspective: Do you remember the ONE WEEK in March 2011 when the market plunged from 12,200 to 11,600 and then skyrocketed back to 12,100, all the the span of the same week? Read about it here.

Joanne Courville of New Orleans committed the classic error of getting scared and missing the rebound. Read about it here.

Quiz: What’s Your Risk Tolerance? Find out here.

Why Market Timing is a Terrible, Horrible, No-Good, Very Bad Idea

Let’s chat about the question on everyone’s mind …

What the Heck Is Up with The Market This Week?

Or: Why Market Timing Is a Bad Idea

Investors have been optimistic this year, despite a sagging U.S. housing market, 10 percent nationwide unemployment, and turmoil throughout the Middle East, particularly in Egypt and Libya.

The Dow Jones Industrial Average peaked on Feb. 18 at 12,391, and was holding a respectable — and normal — 12,213 on March 9.

Then the earth shook, and stocks plummeted — all the way down to 11,613 a mere week later, on March 16. The world held their collective breath as Japan, battered by an earthquake and tsunami, sat on the brink of a nuclear disaster. While U.S. stocks took a heavy beating — a fall of 600 points in a week! — it was nothing compared to the merciless sell-off of Japanese stocks. On March 9, the Nikkei was sitting pretty at 10,589. Within a week it was gasping for life at 8,605 — a loss of almost 20 percent.

And now, as time passes and we collectively start forgetting about nuclear Armageddon, stocks surge again — up almost 2 percent today (in one day!), to a Dow Jones average above 12,000 again. (Ah, a return to normalcy!) The Nikkei is back up to 9,206. The MCSI Japan Index Fund (EWJ), a passive fund tracking a huge basket of Japanese companies, is still down almost 12 percent from its high – but has risen 2.4 percent today alone.

(A little note about stock gains and losses — when you LOSE money, you have to GAIN exponentially just to break even. Think about it: you invest $100. You lose 50 percent. Now you have $50. You have to gain 200 percent — double your money — to get back to your original $100.)

Focus on the Fundamentals

So what happened? Why such an enormous swing over the span of a week? None of the fundamentals changed. Every company that lost stock value after the Japanese tsunami — Google, Wells Fargo, Visa — maintains the same fundamentals as they did a week ago. Their skills and talents haven’t changed. Their debt-to-asset ratios haven’t changed. Nothing changed, except that a wealthy nation in the Pacific experienced a tragic and expensive disaster from which they will ultimately recover.

So why the sell-off? Simply put, investors are speculating — gambling — about the future. They don’t know what’s going to happen; no one does. All they know is that there’s uncertainty — and when there’s uncertainty, there’s a chance to make a profit.

So they start buying and selling like crazy. Investors prone to nervousness pull their money out. Investors who love to bargain-hunt pour their money in. Trading volumes skyrocket; firms that charge $7 – $10 per trade start grinning ear-to-ear. For these firms, bad news is great news.

Of course, we live in an automated age, Not all of this buy-sell frenzy is the result of Average Joes at their laptops selling off Sony and Hitachi stocks in $1,000-dollar increments. Much of this frenzy we see isn’t done by people at all, but rather by software algorithms that are programmed to read charts, predict patterns, and make buying-selling decisions based on these patterns. These algorithms don’t take nuclear annihilation and tidal waves into account; they simply look at patterns in stock charts and trade huge sums of money based on raw data. Then Average Joe sees the sell-off on the news and thinks, “Oh man, other investors are getting scared, and stocks are starting to tank — maybe I should move my 401 (k) into cash.”

Stick To Your Guns

Unless you believe in chart-reading and other forms of sooth-saying (perhaps you can read my palm or check my horoscope for more stock picks), you — YOU, the average investor — is best off sticking to your original investment plan:
1) Allocate your assets according to your age and risk tolerance,
2) Rebalance once every year or two, and
3) Leave your portfolio alone.

In the span of the last week, the Dow Jones has crashed from 12,200 to 11,600 and then surged back up to 12,100 (today). If you were to buy or sell based on that frenzy of speculation, there’s a good chance you’d lock in your loss and miss the recovery. If you stayed the course, you’d be fine.

The more you listen to the news, and buy and sell based on what algorithms across the country are doing, the more likely you are to ruin your returns over the long run. Stick to the fundamentals of investing, and have faith in the market to recover from its momentary crashes and surges.

But I want to be part of the action!

Final note: If you have an appetite for risk and gambling — and you really want to get in on the fun! — commit a tiny amount of money to “playing” the market (and treat it like a game!) When the tsunami hit Japan, I bought two stocks: the MSCI Japan Index (EWJ) and Hitachi, Ltd. (HIT), a Japanese electronics maker. I spent only as much money as I’m willing to lose (i.e. not much!), and I consider these purchases to be “fun” money, NOT money for retirement or short-term savings.

If I Had $1 Million Dollars, I’d Go Into Debt

Yesterday I read three great posts all on the same topic: what would I do if I won a million dollars?

  • One blogger says she’d pay off debt, save for retirement, take a vacation and remodel a home.
  • Another blogger would “stare in sheer disbelief at the balance in my bank account.”
  • And a third blogger would be watching penguins in Antarctica.

So I decided to write my own post: what would I do with a big, fat million?

Caution: The answer might shock you.

I would willingly – deliberately – go into debt.

Note: All figures are based on 2011 retirement limits.

#1: Pay about 33% in taxes. There goes $330,000. Bye-bye!

#2: But wait! I can reduce my tax burden by maxing out my Solo 401(k). As of the time of this writing (2011), that’s a $16,500 tax deduction!

#3: If I got that million prior to April 15, I could retroactively max out the previous year’s Solo 401 (k). Another $16,500 in deductions!

#4: If I win the million between Jan. 1 and April 15, I’ll retroactively max out my previous year’s Roth IRA. There goes $5,000!

#5: Max out my Health Savings Account (HSA) contribution for a $3,050 tax deduction.

#6: Gee, how much do I have left? My taxable income, thanks to all the deductions, is $963,950. The top tax bracket is 35%, but it’s marginal, so let’s say I’m paying, effectively, 33% in taxes — I can kiss $318,103 goodbye.

#7: Now I have $645,847 remaining. (Wow, a million goes fast!)

#8: My goal is financial freedom, which comes from a steady stream of passive income for the rest of my life. There are a few ways to achieve this:

  • Laddered CD’s, which are the safest but lowest-yielding
  • Bond funds, which are also fairly safe but low-yielding
  • Exchange Traded Funds (ETFs) that track stocks that pay high dividends
  • Real estate: Become a landlord, collect rent. To make this “truly passive,” hire a property manager.

I have a pretty high risk-tolerance. So I’d skip past the laddered CD’s and bond funds, and divide the money equally between rental properties and commission-free ETFs that track dividends — like Vanguard’s Dividend Appreciation ETF (stock symbol: VIG) or Vanguard’s High Dividend Yield ETF (stock symbol: VYM).

So … how much do you make each month?

Let’s assume I put half the remaining money into ETF’s that track dividends: that’s $322,923 into dividend-yielding ETFs. Assume I get an average of a 4 percent dividend payout each year: that means I’m collecting a cool $12,916 every year without having to lift a finger.

If the stocks within that fund rise, great. If they fall, boo. But stock growth isn’t the point; to me, that’s only a hedge against inflation, nothing more. The point is that they’re sticking almost $13,000 in my pocket each year.

But … that’s not very much!

(Wo)man cannot live on $13,000 alone. Which is why I’ve diversified, and invested the other $322,923 into rental properties.

There are two ways I could do this: buy houses in cash, or cut the money up into lots of little down payments and take out a bunch of mortgages. Because I’m 27, I’m going to take out a bunch of mortgages. That’s right … If I had a million dollars, I’d go into debt.

Let’s investigate both of these scenarios:

The Cash Scenario:

I buy a triplex in Atlanta for $220,000 and spend $100,000 fixing it up. (Poof! There goes all my money.)

I collect $1,000 per month from Unit 1 (a 2-bedroom), $800 per month from Unit 2 (a 1-bedroom), and $650 per month from Unit 3 (a smaller 1-bedroom). Gross monthly rent: $2,450.

I pay $250 per month in insurance, $200 per month for water, and $300 per month in property taxes ($9,000 per year). I also assume a 10 percent vacancy rate. I manage the property myself because I don’t want to lose another 10 percent to a property manager.

This means each year, I’m collecting a net total of $17,460 on my investment of $322,923. This is actually a better return than the $13,000 a year I’m getting from my dividend ETFs, which makes me happy. Between the ETF’s and the rental property, my million dollars is netting me a total of $30,460 per year in passive income. If I wanted to hire a property manager and make the investment TRULY passive, I’d net $28,714 each year.

(Now are you starting to understand why so many self-made millionaires drive 10-year-old used Toyotas?)

But let’s say I want to “live large” — or at least live a lifestyle that requires more than $28,000 a year. What’s a girl to do?

The Debt Scenario:

I chop up the $322,923 into a series of down payments for multi-unit houses. (Multi-unit houses are the best rental properties because your overhead is lower … you only have to replace one roof, maintain one yard, pay one insurance policy.)

Each multi-unit property I want to buy costs $300,000. I plunk down a 20 percent down payment on each — that’s $60,000 per house. At that rate, I can afford 5.3 houses (let’s call it 5 houses, after closing costs).

Because I’m getting an investor loan, rather than a primary mortgage loan, my interest rate is higher: 5.5 percent, rather than the 4.5 percent that homebuyers with good credit are receiving in 2011. I get a 30-year fixed-rate mortgage, and don’t have to pay primary mortgage insurance because I’ve plunked down 20 percent. This means my monthly mortgage payment is $1,362.

My insurance, taxes and water for each house remain the same, at $700 per month in total. My gross rental income for each house remains the same, at $2,450 per month.

Add my expenses: $1,362 + $700. Subtract these from my monthly rental income: $2,450. I’m now left with $388 in my pocket each month.

Multiply by the 5 houses I own: this means I receive a passive income of $1,940 per month … which equals $23,280 per year.

Add this to the yearly $13,000 I’m getting from that dividend-paying ETF, and I now have $36,280 per year in passive income.

Debt Can Be Awesome — In Moderation

By financing those 5 properties — rather than paying in cash for 1 — I’m adding $6,000 to my pocket in passive income each year.

As the years pass by, and inflation kicks in, I can increase the rent (at the rate of inflation), though my fixed-rate mortgage payment will stay the same … which means the amount I’m collecting will grow every year.

At the end of 30 years, when I’m 57 years old, I’ll have 5 houses completely paid-off and will be raking in an extra $81,120 per year ON TOP OF the inflation-adjusted $36,280 I’m already collecting.

($1,352 monthly mortgage x 5 houses x 12 months = $81,120 per year).

This is why access to credit can be a very, very good thing.

Anyone can be wealthy if they live long enough.

Thanks to compounding interest — which Albert Einstein famously said is “the most powerful force in the universe” — anyone could be wealthy if they live long enough.

Unfortunately, life is short. And if you get started investing late in the game (i.e. past age 30), your investing life is even shorter.

That’s why access to credit can be so powerful. It accelerates time by letting us borrow money to invest. For every dollar we put in, we can buy 5 investment properties instead of 1.

Obviously, access to credit can work against us as well … when we use that credit to buy weddings, trips to Aruba, and jewelry. But used wisely, credit can be the key to riches.

That’s the principal behind micro-loans in developing countries: that millions of people are poor precisely because they CAN’T go into debt. That global poverty is partly the result of a lack of access to credit.

On a personal note, one of my biggest frustrations is how hard it is to secure a loan to buy investment real estate. Banks want 25 percent down payments, 18 months of work history with the same employer, a strong monthly salary, and … on and on.

If I had a million, I’d leverage it. I’d go into debt. And I’d come out stronger in the end. But I’d still be driving a used car.

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