The Three Legged Stool

Your home is the single most important retirement leg your stool may have.

I was watching one of the network primetime news shows the other day and saw a story about the creator of the 401(K). In the story it was suggested that the 401(k) was never meant to be a replacement to the pension our grandparents knew. I watched the story in amazement as everyone interviewed mentioned what is called “the three legged stool” however none mentioned how real estate can be one of the missing legs. Let’s start from the beginning.

The “three legged stool” concept is simple, Social Security represents one leg, 401(K) represents the other leg and a Pension is now the missing leg. As it turns out, in the early 1970’s when the original 401(k) was introduced to modern America, it was meant to be a tax shelter and a second or third retirement income, never meant to replace any of the
two existing legs. A brief time thereafter, the 401(k) industry began selling the instrument as a vehicle which employers could replace expensive pension plans.

Forty years later, the 401(k) has succeeded in replacing the pension for most, however as this program pointed out is highly venerable to Wall Street and market instability. It seems, fund managers (the people in charge of the 401(k) money) are paid regardless if the fund earns money or not. In fact, it was shocking to see just how much money these
fund managers could earn from the transactions, regardless if the fund earned returns, if it was stagnant or if it crashed.

Obviously, this could not have been the concept of the originator of the 401(k) however as do most investments, someone found a way to exploit the 401(k). The 401(k) is not alone, anyone who worked for Enron knows how a pension plan can be lost as well. The obvious problem with Wall Street is simply the fund managers can earn either way. There is
no clear penalty for loosing the clients money and the enemy of Wall Street is non-security backed investments, such as your home.

Everyone knows homes are also vulnerable to loss in values however the main difference is obvious, we all need a place to live and places to live always cost money. The idea of using your home as an investment is simple, you have to pay either rent or a mortgage so why not use that payment as an investment vehicle. The idea is simple, pay off the home and at age 65 you will have multiple income opportunities while also having a free place to live in your later years.

Imagine you purchased a home in South Scottsdale Arizona in 1991 (during another recession) for $108,000. The home would be approximately 3,000 square feet, three bedrooms, two bathrooms, two car garage and a diving pool. It would be likely a brick home, remodeled then as it would have been close to 30 years old at the time of purchase.

Mortgage rates in 1991 were roughly 9.0%, thus your payment would have been roughly $950 per month with taxes and insurance. This would have been a high mortgage payment in 1991 as the purchase price would have been fairly hefty.  At the time of purchase homes in the same area rented for around $750 per month.

Ten years later you refinance the home, not a cash-out refinance but a refinance to take advantage of the lower interest rates of 7% and lower you monthly payment to $750 per month, with taxes and insurance. You hold on to your home throughout the real estate boom and bust of 2006-2011 and refinance again in 2011 at 5% but this time you lower your
term to 15 years. This lowers your payment again to roughly $550 per month and assuming you purchased at age 30 in 1991, your home will be paid off by retirement at age 65.

Today the home has a value of $266,000 in the area and has a rental value of approximately $1800 per month. For argument sake we will say the home never appreciates another penny (highly unlikely) and at age 65 you own your home outright with no payments other than annual taxes of $3500 and insurance at $75 per month for a total monthly expense of $366 per month.

At retirement you are now left with three options for the home. You can rent out the home and move into an apartment, likely costing you $900 per month in the same area, thus pocketing over $600 per month in cash from the home. You can stay in the home and take out a reverse mortgage, being loaned 70% of the homes value or $186,200
based on the 2012 value (really the market would have increased at least 3% per year over that time period and the home would be worth $414,000.00) and could either take a lump sum payment or receive monthly payments of roughly

$1200 per month for the next 30 years. Or lastly you can sell the home and move into an apartment or purchase a less expensive home.

Hopefully you take option number two and reverse mortgage the home. Before you start shaking your head and saying you do not want the bank to get your home, think about this: First, after you vacate the home (by death or other means) your family has 18 months to either sell the home or give it to the bank. If they choose to sell, the are only required to
pay back what has been lent on the home plus interest. So, if interest rates were at 6% at the time of the mortgage and you were paid $100,000 from the bank, your family would have to pay back $100,000 at 6% for as many years you had the money. On top of the benefit of being able to live in the home, rent free until you choose to leave it you are also
provided a tax free source of income.

Taking the tax free monthly payment of $1,200 per month, adding in your social security payment of $1,500 per month and your 401(k) (let’s say you had $150,000 vested in your 401(k) paying you approximately $1600 per month, you have effectively replaced the third leg of your retirement while having a safe and secure place to live until you choose to
leave. It would not be hard to live well on $4,300 per month without a mortgage payment.

The reality of the concept is this, Real Estate always rises, despite what we have recently seen. Don’t be fooled by negativity, if you do the math the concept always works. Even after what is being called the Great Recession, Americans who purchased in 1991 and sold in 2011 still earned almost 5% return on the money invested. While 5% does not sound
like a great rate of return, keep in mind the average rent for the area was much higher than the mortgage payment and the initial investment was around $3,500 in cash.

As you do the math in your head and begin to think, no they paid $342,000 or so for the money and thus actually lost money in this transaction, let me assure you that you are incorrect. The reason I say you are incorrect is simple, you had to have a place to live and places to live always cost something. The rent is this area, while starting out at just $750 per
month rose with the costs of inflation and today the same building rents for well over $1600 per month. On average over the 30 year period, the home actually would have rented for an average monthly payment of just over $1,000 per month, thus owning over the past 30 years, saved you $18,000.

By using the power of leverage, you were able to borrow $108,000 for just $3,500 and pay a rental payment on a home which after just 360 payments, you now own that is now worth well over $266,000. This actually represents a return on your investment of $3,500 of well over 24.8% compounded interest for 30 years. I ask anyone to give me an investment, which did not perform well but still earned an average of 24% annual interest, compounded over 30 years.

- Jim Lord

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