This is a guest article by Christian of Money Obedience. If you enjoy this article, please consider subscribing to the MoneyObedience RSS feed.
My parents offered a very important piece of wisdom to me: Even if everybody is doing something, you do not have to do it, too.
Unfortunately I usually applied this advice to the great parties that were going on in town, where “everybody” showed up except for me. Like any teenager, I did not really appreciate the deeper meaning of this sentence until much later. It still doesn’t make much sense in connections with all the great parties that went down without me — maybe I am missing something — but I have applied the saying to many different areas of my life including personal finance.
It is so easy to get caught up in things like the housing frenzy, which seemed to give everybody who was in it overnight riches. Why not participate? “Everybody is doing it. Everybody is making money.” I think I stood aside then partly because my parents insisted often enough that I did not have to participate even if “everybody” else did. The other reason was that I could not see house prices going up for long when new houses were being built left, right, and center. But I am sure some who invested in real estate must have seen the same thing and yet they still invested in real estate.
It’s not like I didn’t feel any pressure to participate. All my in-laws became real estate investors and were getting rich. So, at times I felt stupid when “everybody” was making money hands over fist in real estate a few years ago. During that time my wife and I also bought a home, but we did not follow the prevailing trend to buy as much house as possible.
Instead, we bought a house that was well within our financial means. We did not think of ourselves as real estate investors; we viewed ourselves as future homeowners. My wife and I wanted to buy a house for our family because we needed a home and not a way to easy riches. We bought the house even though we knew that the housing market was in an unsustainable frenzy.
We didn’t feel like we participated in the speculation. We were “real” buyers.
Crazy stuff was happening then, but I could not see myself going along with some of these things. For example, I could never imagine to follow the majority when 82% of all refinancing were cash-out mortgages in the first quarter of 2007. Why would I want to take out a larger loan in refinancing, when I had done so well paying off my debt already? It makes no sense to me personally, but it did to all the people who joined the majority. All these missed parties paid off. I stood aside.
And now I feel like I am outside the mainstream again. Just as it was in fashion to be invested in real estate a few years ago, it now seems to be in fashion to deride real estate in general. After all, our most recent history teaches us that real estate led us to the current economic problems.
We humans have a tendency to give too much value to our most recent experiences which is why it is not so surprising that so many commentators are cautious about real estate investing right now. But let’s be daring and go back a little further than 2000 or 1990. Let’s look at our parents and grandparents. How successful were they in real estate investing?
In days gone by people did not invest in real estate. They, like my parents, got themselves a nice little house with a good enough down payment and then they made their mortgage payments month after month until the mortgage was paid off. They did not know what an interest-only mortgage or a cash-out mortgage was. From what I can tell, my parents did very well with their real estate investing. They ended up living in a house free and clear when they retired, which allows them a pretty comfortable standard of living and which also frees up enough money to indulge our kids with toys.
My parents ended up being pretty successful real estate investors, but they were not true investors. They were homeowners, plain and simple, just like their parents were. This real estate investing technique has worked very well for many decades. It worked until we forgot to understand that our parents’ and grandparents’ real estate wealth did not come from investing. It came from buying a home and paying it off with a mortgage that forced them to pay interest and principal each month. Nothing fancy here. Their house was not a drag on their finances as many argue now, their house was a piggy bank.
One way or another they spent money on living somewhere. Just like we do. But they used their monthly mortgage payments to accumulate wealth over time. These payments were not viewed as a drag on their finances; they kind of became forced savings. How can this make sense when they are paying interest, an expense, and not receiving income?
Here’s an example. Nicole pays $1,200 in interest and a minimum of $350 in principal right now. If we assume that another adequate living space would also cost around $1,200 a month to rent, we can view the $1,200 in interest payment as rent payments. (I am ignoring taxes to keep thing simple.) The $350 reduces the principal of her loan. Eventually she will own the house free and clear without a mortgage attached to it. Her net worth — everything she owns less the stuff she owes — will look pretty good then. And all she did was pay back a loan, month after month after month. But she actually added $350 a month to her net worth or savings without knowing it.
All we need to do is be sensible. We don’t need to gamble on real estate riches. At the same time we don’t need to be scared that buying a house will destroy our wealth for sure. We need to step aside and ignore the prevailing fashion of the times and just manage our own personal finances. That includes buying a house with a solid down payments and making sure that we can afford the monthly payments. That has worked so well for so many generations before us. It should work for our generation, too.
Updated December 20, 2011 and originally published April 6, 2010. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.