Author: Mr. Honu

Categories
Reduce Spending

House Hacking: The Best Way to Save Money For Financial Independence

For most people housing is the biggest expense and it’s therefore extremely important to limit spending on housing so you can save money. If you’re on a path towards financial independence, remember you need to invest money and to invest money, you need, well, money. So you need to spend it wisely and save wherever possible. So back to housing and what exactly is house hacking and how can this help you?

House hacking is a term that has been famously coined by Brandon Turner, former podcast host at BiggerPockets and seasoned real estate investor. It essentially describes several creative ways to reduce your housing expenses.

Let’s go through the different ways you can save money on housing. Depending upon your personal situation, some may be easier or more convenient to implement than others but let’s go through them anyway.

House Hacking: The Best Way to Save Money For Financial Independence

Understanding House Hacking

House hacking is a real estate investment strategy that allows you to live in your property while generating rental income from other units or portions of the property. By doing so, you can significantly reduce or even eliminate your housing expenses, creating a path towards financial independence.

The Benefits of House Hacking

Reduced Housing Expenses

House hacking provides a unique opportunity to minimize your housing costs by leveraging the income generated from renting out a portion of your property. This can free up a substantial amount of money to be invested elsewhere, ultimately accelerating your journey towards financial freedom.

Increased Cash Flow

With the rental income from house hacking, you can generate positive cash flow. This means that not only are you living in your property for free or at a significantly reduced cost, but you’re also earning extra income that can be used for savings, investments, or even paying down debts.

Building Equity

As you make mortgage payments, the value of your property appreciates over time, allowing you to build equity. House hacking enables you to expedite this process by utilizing rental income to contribute towards mortgage payments. This can help you build wealth and create a solid financial foundation for the future.

Learning Real Estate Investing

House hacking serves as a stepping stone into the world of real estate investing. It allows you to gain hands-on experience in property management, tenant relations, and the overall dynamics of the real estate market. This knowledge can be invaluable as you progress towards expanding your investment portfolio.

Consider living with roommates

Rather than renting a studio, you may want to consider renting a house with roommates and split the cost. It’s often more cost effective. I lived several years with roommates at a time where a studio was renting for around $1,500/month in my area, while the rent split among roommates was around $1,000/month, saving $500/month or $6,000 per year. While it looks like a nice saving, it’s nothing compared to what comes next.

Buy a small multi-family

Probably the most popular house hack and considered as the traditional house hack, it consists in taking an FHA loan (if you live in the US) to buy a small multi-family building, for example a duplex or a triplex or quadruplex, live in one unit and rent the other unit(s). If the price is right, meaning that you do not overpay for the property, and the interest on the loan is low enough, it is possible to have the rent cover the loan and some of the expenses and you can pretty much live for free. This strategy works best when buying a home is more advantageous than renting and it usually tends to be in cheaper housing markets. In more expensive markets, the rent will usually not cover the expenses, so while it can still reduce your expenses you’d need to verify how much would pay, should you rent in your area to see if it financially makes sense.

Why an FHA loan you may ask? It allows you to buy a property with just a 3.5% down payment. So if you look at  a $100,000 property, that’s just $3,500 you need to put as a down payment.

When done properly that’s how you can get rid of your biggest expense. The earlier you can do it, the more money you can save and invest.

Rent out rooms

This is somewhat a combination from the traditional multi-family house hack and the renting a place with roommates. Essentially you can buy a home, live in the living room or if the house has a basement, turn it into a livable space. Then you can rent out he remaining rooms. By renting individual rooms it may be possible to cover the cost of the house: loan, taxes, insurance, completely covering your housing cost.

Live-in flip

A live-in flip consists in finding a home below market value that needs to be renovated. You would live in house while renovating it. Live in it for at least 2 years to reduce the amount of capital gain taxes you’ll need to pay when you sell it, if you live in the US, as this relates to the US tax code. Then you finally sell it. The amount of money you make when you sell can cover your housing cost for the past couple years.

Overall there are various ways to reduce or completely eliminate your hosing cost and it’s extremely important to take a hard look at these options as reducing the biggest household expense can go a long way to boost your savings and your investment power.

Sources

[1] https://www.biggerpockets.com/blog/6-house-hacking-strategies-you

[2] https://www.valuepenguin.com/average-household-budget

[3] https://www.forbes.com/sites/davidgreene/2018/12/04/house-hacking-how-financially-savvy-people-live-in-expensive-markets-while-saving-money/?sh=4cd1fc0470f0

Categories
Financial Literacy Investing

The Importance Of Investing And Investing Early

If you’re considering financial independence and early retirement, investing is not an option: you must invest if you ever want to have a chance to reach financial independence, by definition. In its simplest form financial independence means your money is working hard enough to cover your lifestyle so you no longer need to exchange your time for money, meaning you no longer have to work.

Also living of savings can only last for so long and there’s only so much you can save.

If you expect to retire at 40 years old, expect to spend $50,000 per year until you leave this earth, let’s say at 80 years old, to keep the math simple, that’s 40 x $50,000 = $2,000,000 you need to save by age 40. Assuming you start working at age 20, you’d need to save $100,000 per year for 20 years.

Assuming you live a lifestyle similar to what you expect in retirement, you’d need to earn a gross income of around $200,000 per year. Here goes the math:

  • At $200,000, you can expect to pay around 25-30% in taxes. That leaves you with $140,000-$150,000.
  • $40,000-$50,000 of living expenses
  • That lives you with $100,000 saved up.

While a few jobs can allow you to earn this much, it’s unlikely for most to earn such a high income at such a young age.

And that’s where investing comes to the rescue. Sure, you need to work to start earning and saving money, but this money should not sit idle and it should also work for you, so you can reach your goal. Investing will help you boost your income, until it eventually gets you financially independent.

Let’s consider a few scenarios to see how they compare. The first year we start with $5,000 and each year after that we assume the following:

  • Saving $5,000 per year
  • Saving $5,000 per year and investing half of the money at a 7% yearly return
  • Start saving $5,000 per year, and each year increase the saving by $1,000 (So the first year we save $5,000, the second year $6,000, the third year $7,000 and so on and so forth…)
  • Saving $5,000 per year and investing all the money at a 7% yearly return
  • Start saving $5,000 per year, and each year increase the saving by $1,000, investing all the money at a 7% yearly return

Here is the evolution over time:

By saving $5,000 per year, after 40 years you’ll end up with $200,000. Not too bad, but not enough to retire comfortably.

If you just invest half of the money each year, you’d double the money getting slightly over $420,000. It already shows how important investing is.

Now, without investing, but by increasing your savings by $1,000 each year (either by getting a raise, changing job or starting a side hustle), you end up with around $940,000. And this shows how important it is to increase your savings as your income grows.

Then, going back to the $5,000 / yr savings and investing everything, it beats increasing the saving rate and you’ll end up shy of the $1 million mark with around $998,000. Again it shows how important investing is as far as growing your wealth.

Finally, combining both the increase of savings over time and investing show the power of compounding and we’d end up with over $3,000,000 which is more than 3 times the next best results.

Now that growth happened over 40 years and this shows the importance of starting early. The earlier you start, the easiest it will be to grow your portfolio leveraging the compounding effect.

Now 40 years is still a long time, if we want to reduce the time it takes to reach our goal, whatever it is, we realize how important it will be to save aggressively to bootstrap the investment growth.

Categories
Financial Literacy

Buying vs Renting a Home

There is often a hard held belief that no matter what, you should always buy the place you live in, because after all when you rent you just throw money out of the window or rather to your landlord that you’ll never see again. While when buying a home, you always pay part of the mortgage towards the principal so you increase your equity, so you increase your assets.

Buying vs Renting a Home

Housing Is Your Biggest Expense

For most households, the money spent on the place we live in is the number one budget, taking roughly 30% of the annual expenses. It’s therefore extremely important to spend wisely on housing and it’s often where a lot of money can be saved.

As seen here, regardless of whether you are buying or renting, the place you live in is never an asset and always is a liability, short of house hacking (more on that in another post). A home takes money out of your pocket, so it’s a liability from a cash flow perspective.

That said, while the place you live in is always a liability, the game is to reduce such liability, to save as much money as you can.

And in reality the answer to the buying vs renting argument, is always: it depends.

It depends how much the home cost versus how much you would pay to rent a similar home.

Let’s look at the usual associated costs in each case:

Renting Costs

The renting costs are usually straightforward: the rent you pay to your landlord.

Buying Costs

When buying a home, there are several expenses associated with owning a home also known as unrecoverable costs:

  • The closing costs when buying a home
  • The mortgage payment
  • The home insurance
  • The property taxes
  • Miscellaneous maintenance expenses

So to figure out whether you should buy or rent you need to figure out if the buying costs or higher or lower than what it would cost to rent a similar home in the same area, for the time period you expect to live there.

There are plenty of calculators out there to help you estimate whether you should buy or rent, but the rule of thumb is: if in your area real estate is very expensive (e.g. the San Francisco Bay Area circa 2020 where a 1200 sq. ft home is worth +$1,000,000), it will usually be more advantageous to rent. Conversely if real estate is much cheaper (e.g. in Memphis, TN circa 2020 where a 1200 sq. ft home is usually worth around $90,000), it will usually be more advantageous to buy.

Now there are always exceptions: you may be able to find a cheap house in an expensive area or find an extremely cheap rental in an area where real estate is cheap. That’s why you should always run the numbers, but hopefully that gives you the feel and the basics on how you should allocate your housing costs, which is for most households the biggest budget expense.

The 5% Rule

If you want a quick and easy rule of thumb to figure out whether you should buy or rent, Benjamin Felix at PWL Capital came up with the 5% rule, which estimates that homeowners usually spend 5% of the house price annually, between taxes, maintenance, opportunity cost.

Therefore if the annual rent is less than 5% of what the house would cost, it’s usually preferable to rent.

If the annual rent is more than 5% of what the house would cost, it’s usually preferable to buy.

For example, let’s take a house that would cost $100,000 and the monthly rent is $700. The 5% rule says, the rent should not be more than 5% x $100,000 = $5,000 annually. The rent annually is: 12 x $700 = $8,400. Hence in this case it would be interesting to buy the house rather than renting, according to the 5% rule.

Now let’s take a house that would cost $1,000,000 and the monthly rent is $3,000. The 5% rule says, the rent should not be more than 5% x $1,000,000 = $50,000 annually. The rent annually is: 12 x $3,000 = $36,000. Hence in this case it would be interesting to rent the house rather than buying, according to the 5% rule.

Of course the 5% rule is an oversimplification and it’s just a quick guideline to get a back of the envelope estimate. As mentioned above it’s important to get the actual numbers (as taxes may be different based on where you live, the financing cost may be different…) to have a more accurate estimate on whether it’s financially more advantageous to buy or rent.

Categories
Financial Literacy Investing

What Are The Main Investment Types?

We’ll try to list the main investment types out there, how they function, i.e. how do you make money from them and we’ll try to classify how passive they are and the usual expected volatility.

What Are The Main Investment Types?

1. Real Estate

There are several ways to invest in real estate, from land acquisition, land development, single family rentals, multi family rentals, office rentals, industrial rentals. While there are a lot more hybrid investment types from house hacking to vacation rentals, we’ll only go through the main investment types in this introductory post.

1.1 Single Family Rentals

This is probably the most straightforward investment type in the real estate space: acquiring single family homes and rent them out. The business is simple: rent the home and maintain it in habitable condition for the customer.

The owner of the rental also may also profit down the road by selling the property for a profit if it appreciates.

1.2 Multi Family Rentals

Similar to single family rentals, but the asset is in general an apartment building. Duplexes and triplexes, smaller buildings, also qualify as multi family.

1.3 Land Acquisition

This is usually an appreciation play, where one would simply acquire land hoping to sell later in time, for a profit, if the land appreciates in value over time.

There’s one main exception regarding agricultural lending, where one can lend its land to a farmer to exploit the land. The owner of the land receives a rent and in exchange the farmer can exploit the land growing crops or farming livestock.

1.4 Land Development

Land development consist in acquiring raw land and developing it, usually bringing electricity, water and sewer to sell it to a real estate builder to then build and sell buildings, often multi family or single family homes.

1.5 Office Rentals

This is similar to multi family rentals, in the sense that this involves usually bigger buildings, however they’re usually leased to companies or specialized professionals.

1.6 Industrial Rentals

This is similar to office rentals, but concerns industrial buildings usually leased to companies. In this categories we usually have warehouses or industrial buildings able to house machinery.

2. Stocks

Stocks are usually fractions of a company traded on an exchange.  By buying the stock, you buy a fraction of said company.

2.1 Regular Stocks

By buying the stock, you expect the company to do well and have its share price increase to later sell it for a profit.

2.2 ETFs

ETFs or Exchange Traded Fund are usually funds that invest in several companies/stocks or track some indexes. It allows you to own a pool of investments without the hassle of having to buy every single one of them individually.

Similar to stocks, you’d buy the ETF expecting it to go up in value to sell for a profit.

2.3 Dividend Stocks

Dividend stocks are stocks that pay a dividend, sometimes monthly, but usually quarterly, as long as you’re holding the stocks. These stocks are usually from more established companies, with proven business models, where the growth of the stock usually lower but compensate for it with its dividend.

Dividend are taxed differently than capital gains from selling stocks for a profit and can be interesting in that regards.

Also several dividend companies tend to increase their dividend over time. Dividend aristocrats are dividend companies that have increased their dividend for at least 25 years.

2.4 REITs

REITs or Real Estate Investment Trust are companies that invest primarily in you guessed it, real estate. To qualify as a REIT must have at least 75% of its income derived from real estate and it must distribute at least 90% of its taxable income as dividend to its shareholders.

REITs income is usually taxed as income, unlike dividends and based on your tax bracket, it may be advantageous to hold them in tax preferred accounts such as a 401k or an IRA.

3. Bonds

Bonds are loan to a government (government bonds) or to a company (corporate bonds) for a certain period of time (maturity)and you receive interest (the coupon) , until the loans matures at which point you receive the principal payment.

4. Leveraged Financial Instruments

4.1 Options

Options, commonly on stocks, but can also apply against other financial instruments, are just that: option (not obligation) to buy (call option) or sell (put option) at a given price (strike price) until a certain time, the expiration date.

These investments are usually more volatile and riskier, because of the leverage builtin into the contract.

4.2 Forex

This is the currency market, where ones can profit from the gain of a currency against another. While usually reserved for more advanced investors, the concept is often eye opening that whatever you own that changes in value is a paired trade. When the USD/JPY forex pair trade goes up it means the US dollar goes up against the Japanese yen. When your home goes up in value, it means your home value goes up against the dollar. At which point you want to ask, is the house gaining in value or is the dollar losing in value?

Forex symbols are usually traded with leverage which can increase the risk if not managed carefully.

4.3 Futures

Futures are contract, usually on commodities but also on stock indexes and currencies. The contract establishes the price of an amount of a commodity at a certain date, e.g. The June 2020 Gold contract, at $1583, establishes the price of an ounce of gold by June 2020.

The market allows producers of such commodities to lock in a price for their production, while speculators, often blamed for commodities volatility allow the market to exist in the first place.

While not perfect, it should be noted that the existence of the market allow producers to hedge their production and many producers would not be in business without the existence of the futures market.

Futures , like the Forex, are usually traded with leverage which can increase the risk if not managed carefully.

5. Alternative Investments

This involves structured financial products in various area, such as art, real estate, marine, legal… It often involve lending money to a third party using various assets from the third party as collateral.

It’s usually reserved to accredited investors, i.e. investors earning more than $200,000 annually if single ($300,000 if married) or have more than $1,000,000  in assets excluding the primary residence. Or institutional investors like investment banks, pension funds and so on.

6. Private Equity

Private equity is generally speaking part of the alternative investments class, but probably deserves a note of its own. Like for alternative investments, these investments come mainly from accredited investors or institutional investors. There are 2 main segments in private equity: one for early stage companies or startups, one for later stage companies and distressed companies.

6.1 Early stage companies or startups

That’s usually where venture capital and angel investors come in. They will pool money or invest their own money to help develop early stage companies, usually in the hope the resell it at a higher price to a bigger company or take it to the public market, where they can exit their position.

The game in startups investing is that most of your investments will go to zero, but the few who survive will make a disproportionate amount of money.

If you want to put some rough numbers, successful startups investors, often see 90% of their investments go to zero. 9% percent of their investments get a 10-50x returns. And 1% turn into a 100-2000x returns and sometimes more.

The downside is that there’s usually no liquidity, so it’s very hard to liquidate your holdings and it’s usually a long game. It will take usually more than 5 and often around 10 years for those early companies to mature to the point where you can expect those enormous gains.

6.2 Distressed companies

Another side of private equity is to invest in failing or distressed companies. Investors usually buy the debt of a company at a steep discount and will try to turn the management around and eventually turn it into a profitable company again, so they can eventually collect the debt repayment.

If that ideal scenario fails and the company is forced into bankruptcy, investors will try to recoup some money during the bankruptcy process.

7. Institutional Investments

This are types of investments reserved for institutions (e.g. CDS), usually due to the amount required to participate in such investments which can range from several hundreds millions of dollar or billions of dollars and sometimes require special licenses to be allowed to participate into such investments. We won’t discuss much about these but it’s good to know that they exist because they can have some influence into other types of investments accessible to the general public.

Conclusion

We’ve presented most of the common investment classes. As far as building a passive income portfolio, we’ll talk more about rental real estate and stocks. We’ll also touch upon alternative investments and also discuss some opportunities with leveraged financial instruments when they arise.

Categories
Financial Literacy

The Fastest Way To Pay Down Debt

If you have several outstanding loans, what’s the fastest way to pay them down? How should you prioritize which loan to pay down first?

The most efficient way to pay down existing debt burden is better known as the debt avalanche method.

It goes like this:

  1. Make an inventory of all the debt you have and their associated interest rate.
  2. Keep paying the minimum payment on all debt to avoid any fees and deteriorate your credit score.
  3. Focus on one loan at a time and make an extra payment on the loan that has the highest interest rate. Keep doing it until the loan is paid.
  4. Congratulations, you now have one loan paid off. Move to the next highest interest rate loan and use the extra cash freed from the minimum payment of the loan you just paid to pay this second loan even faster.
  5. Rinse, repeat, until you do not have any more outstanding debt, paying each loan faster by redirecting the extra cash from each paid off loan towards paying the next one.

This strategy minimizes the amount of interest you pay by targeting the loans with the highest interest rates first.

Some argue that in the battle towards paying off debt, the psychological aspect may be more important as it is often a marathon more than a sprint. And therefore seeking early sign of encouragement may go a long way to stay on the path of debt freedom.

In that regards the debt snowball approach is sometimes considered. The principle is similar to the debt avalanche method but instead of focusing on the loan with the highest interest rate, you’d focus on the loan with the smallest balance. So you more quickly scratch a loan off your list as an early encouragement.

However Mr. Honu is way too cartesian to allow extra interest payment to run and would focus on the debt avalanche method instead. But that’s just me. The debt snowball can be a decent alternative and is certainly better than letting your debt run away.

There are more resources on the debt avalanche and the debt snowball on the internet.