Two Commenters Disagree: Why Risk Is Interesting

Recently, two commenters disagreed strongly in a thread about 15 year versus 30 year mortgages. I thought they both made a worthwhile point in a way because they are both looking at risk, but in completely different ways.

Tristan wrote first:

Mortage=Risk,

No Mortgage=No Risk=No interest payments=you work for yourself not the bank.

Debt is never good. It’s enslavement. There is no true advantage to keeping debt.

This was followed by John:

Tristan,
“No mortgage = no risk” is absolutely, 100%, false. It’s actually possibly RISKIER than the stock market (with proper diversification). Because you’re tying up a huge portion of your money in a single investment, you could lose a huge portion of your money if that investment should decline in value for whatever reason. Yes, it’s less volatile than the stock market. But it’s not necessarily less risky. A lot of people are finally figuring that out in the current housing slump. A house is an investment and carries risk like any other investment. I’m worried that you aren’t evaluating risk properly, which could make you vulnerable.

You know what? They’re both right, but they’re both focused on different aspects of risk.

Tristan is focused on personal risk. If you have a debt on an item, that’s a risk – you risk foreclosure, repossession, or damaged credit if you can’t repay. Eliminating that debt largely eliminates that risk. Thus, in terms of direct threat to one’s way of life, debt itself is a risk.

John is focused on investment risk. Owning any asset with notable value is an investment risk, whether it be a home, a stock, a bond – anything. John sees that houses have investment risk just like stocks do, something that a lot of people seem to have forgotten recently as the housing market went bonkers. It’s also a risk from an investment perspective to have a significant part of your investment in one asset.

Tristan’s perspective is the Dave Ramsey perspective. The most important thing is to ensure that your personal ship is righted and you’re not in significant danger of debt swallowing you whole. Pay off all debts above all else, then worry about investing. This way, if something bad happens in your life, you don’t have repossession issues.

John’s perspective is the investor perspective (I was tempted to call it the Robert Kiyosaki perspective, but that’s wholly unfair description in some ways). He sees a house as an investment and sees the housing market having some serious issues, so he would not want to own a house as an investment.

Most likely, Tristan and John are in two completely different financial states and are looking at the risk that applies to that state. I’m betting Tristan has some significant debt load and is diligently trying to pay it off because he doesn’t have a large social safety net. I’d also bet that John has some experience with investing and probably has a larger net worth than Tristan, but is also older and has had more time to build it.

These two views on risk cause a strong disagreement, and it happens more often than you think. For example, in the recent debate about personal comfort and investment strategies, I am looking mostly at the personal comfort risk if an investment disrupts your personal comfort, get out of that investment because stress and lack of sleep are unhealthy physically and psychologically. Meanwhile, a lot of readers are looking primarily at the investment risk – bailing out when the market is sliding can be very financially risky. Which risk is more important? We could yell at each other all day about it and not really change each other’s minds. It depends on who you are.

What’s the point? Risk comes in a lot of different forms, and different forms of that risk monster scare different people. Any financial move you make has several aspects of risk to it. The key is to find the moves that have the least risk for you, and I think for Tristan and John, those moves in terms of a mortgage would be very different.

Personal finance is fun, isn’t it?

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  1. Cindy says:

    “Most likely, Tristan and John are in two completely different financial states and are looking at the risk that applies to that state.”

    Yes, yes, yes! I think it would do us all good to remember that so much about personal finance, investments, and risk really are personal and come from one’s own situation.

    Well put, Trent!

  2. dave lamport says:

    all i read was the green boxes in this article. the first person is right and the second guy is an intellectual knucklehead. any debt is bad. trent, stop putting these articles on your website. if you had to choose between ANY debt and no debt the answer is obvious. 99% of your readers don’t make or have enough money for these hypothetical situations to really matter, money-wise. i agree with the first green box: any debt is slavery. get rid of it, THEN invest in whatever you please.

  3. Brent says:

    I disagree completely on your assumption of the financial state of these two.

    My financial state is comfortable, with a healthy net worth. However, you will hardly ever see an investor liquidating their home to rescue a sinking stock investment.

    If you own your home, risk is immediately less. You can invest and ride the ups and downs of the stock market with risk in only one area.

    If, I choose to delay paying on my home, and instead invest that money, I am leveraging debt to finance another investment. People will justify that, calling it diversification, but it is just compounding risk.

    The home cannot be looked at like another investment. No matter how low the value of that investment may go, it still provides shelter and other needs. When you take debt from your home, and apply it somewhere else, you risk much more than net worth.

    The Ramsey plan provides a happy medium. Once you reach the point of debt free except the house, you fully fund retirement, then focus on paying off the home.

    makes a lot of sense

  4. UncleOxidant says:

    “A house is an investment and carries risk like any other investment. I’m worried that you aren’t evaluating risk properly, which could make you vulnerable.” John

    I think the problem with John’s thesis is that a house isn’t only an investment, in fact I would say that a house is first shelter and the investment aspect is very much secondary – this is what lots of people forgot in the last few years with all of the speculation that went on in housing.

    So I’d agree more with Tristan because you’ve gott a have somewhere to live. Sure you could rent, but that’s another question. If you’ve already bought I think it’s good to get rid of that mortgage. In fact I paid mine off back in 1999. It’s a great feeling to own your house outright and it frees up a lot of money each month for savings and investment.

  5. Kevin says:

    Yes there is a risk your home could lose value. Yes you could lose a large amount of money if the housing market declines.

    Now imagine you carry a large loan on your house and put that money in stocks. Whgat happens if the housing and stock markets both decline. Now you lost a large amount of money on two fronts and could end up upside down on your mortgage.

    The “risk” of your investment on your paid off house is minimal. The risk of using your home equity to finance investing is 1000% more risky I think John is the one evaluating risk incorrectly.

  6. Mark says:

    There is another side to debt. I have a loan on my car with a balance of about $10,0000 at 3.5%. I also have $10,000 in an FDIC insured savings account at 5.05%. After taxes (the car loan is not deductible and the savings interest is taxable) it is a wash. If I paid off the loan I would have no debt and no cash. Now if an emergency came up I would have to borrow the cash, most likely at a much higher interest rate. So, as personal matter of comfort, I choose not to pay the loan off and keep the cash.

    Of course this only works if one has the discipline to not spend the cash.

  7. Dave says:

    A house is only an investment if you sell it.

  8. dong says:

    Trent, I definitely agree that it’s all a matter of personal situation and each situation needs to be evaluated. However, I’m definitely not in the Dave Ramsey school of thought on debt. I don’t believe putting all your eggs in one basket as would the case be concentrating all your extra money to pay down the mortgage in lieu of other investing makes sense. I agree that a Home is not an investment and that why it doesn’t make sense to concentrate on only paying off the mortgage – effectively you’re treating as an investment that earns what ever interest you pay to bank. That’s not diversification and if there’s anything about risk is you wan’t to be diversified. Hell I think if you can you should put something extra towards the mortgage, but paying off the mortgage should not be the only investment being made.

  9. Pat says:

    Great and timely discussion for me. I am sitting on about $70K in a money market at 4.5% and owe about $78K on my mortgage at 6%. I am otherwise debt free and fully fund retirement, etc.

    My intellectual side tells me that I’m not being smart with holding all that cash (I should stick it in taxable invstments, etc.). I can’t write off my mortgage interest (too little), and I am paying taxes on the money market, so the spread between cash and mortgage interest is at least 3%, so mathematically I should at least dump that cash into my mortgage and pay it off.

    From a psychological sense, however, I can’t even begin to describe the comfort that having the money market funds gives me (sense of security, fantasies about quitting my job for a year, no worries about emergency bills, etc.).

    Although I have several hundred thousands in home equity and 401K, I get no such satisfaction from seeing my wealth in these other areas.

    It’s interesting how psychology can impact our investment choices!

  10. brent says:

    Ok, I agree that a home is a home, not an investment.

    But can you please take another look at a statement like “A house is only an investment if you sell it.”

    What if there were another way for you to live? What if you bought a vacant block of land and pitched a tent? Or what if you decided to put your five person family into a one bedroom apartment? Or what if you found some country town shack that had a guaranteed rental cost?

    When you start out paying off your home you make a choice to pour all that cash into your mortgage rather than somewhere else. In that sense it’s an investment. It’s cash that’s now not cash. It’s been frozen into the form of bricks and mortar.

    You COULD have instead bought a big pile of used tyres for $4/each and sold them to the local rubber recycling factory for $8/each – or started a lemonade stand – or invested on the stockmarket… you COULD have done almost anything with that money that now, because you’ve got a mortgage, you cannot do.

    When the time comes to move, retire or die and the housing bubble has burst and it turns out that bricks and mortar are worth HEAPS less than used tyres, lemonade or stocks… then, in that sense, it’s an investment.

    Any time you turn cash into something solid you’ve made a choice about what to do with that cash and you can’t unmake it. In fact, leaving it as cash is its own choice.

    You can’t avoid financial risk.

  11. Eileen says:

    Yes of course, everything is risky. There is not a single choice we make in life that doesn’t carry a potential risk that another choice may have actually been better/safer/more profitable. John is evaluating the risk of a paid off mortgage as a lost opportunity to potentially have the money working harder for you. Tristan evaluates the risk of worrying that you’ll lose your house.
    The fact is clearly illusstrated the last few weeks on the stock market–John’s theory could fall apart in 24 hours due to market volatility.
    And I totally disagree with the theory that Tristan MUST be under a heavy debt load and John is not. Quite frankly I think the opposite is equally possible. The only thing that is true is that they have different risk tolerances.
    If I had to pick though, I would side with Tristan. If an economic crisis happened he still sleeps at night not worrying about his mortgage. You cannot put a price on that.

  12. Trent Trent says:

    I love watching articles that really bring out a diversity of opinion.

    Dave Lamport said “trent, stop putting these articles on your website. if you had to choose between ANY debt and no debt the answer is obvious.” Uhm, based on the comments, there is a wide diversity of opinion out there, so to say that I should stop putting these articles on my site is extremely arrogant and narrow-viewed. It’s pretty obvious that there are lots of different perspectives out there and sometimes it’s good to take the blinders off.

    For example, if I had to choose between no debt and no investment or a 3% debt and a 10% investment, I know what I’d choose, and it wouldn’t be debt-free.

  13. plonkee says:

    “For example, if I had to choose between no debt and no investment or a 3% debt and a 10% investment, I know what I’d choose, and it wouldn’t be debt-free.”

    Exactly, sometimes the maths is just better.

  14. Engineer says:

    Trent, I agree with your last comment in response to Dave. Seems that some people have a religious-like view to debt.

    There’s actually a personal risk to paying off the mortgage early. In the event of a catastrophic event, such as a medical situation or extended job loss, your liquid funds to handle the situation have been reduced by having paid off your mortgage. Leaving less room to sell your investment if you need to. This is not against paying off your mortgage early (I paid mine off early). Just pointing out the personal risk involved.

  15. Trent Trent says:

    Engineer: many people have almost religious-like views about all sorts of personal finance issues. Trust me – the last several months of writing this blog has shown me that there are lots of different PF perspectives and many people treat their perspective as being gold. I personally don’t – that’s why I’ll state a contrary opinion and allow comments that strongly disagree with me.

  16. Kevin says:

    show me a 3% debt and a guaranteed 10% investment and I would side with you. However those numbers are not realistic.

  17. Tristan says:

    I just had to reply. You guessed wrong about my debt load. LOL. I am thankful to say that, thanks to much sacrifice, Dave Ramsey and God, we have zero debt.

    We own two rental properties. We did have a mortgage but we paid them off in full in five years. It’s amazing what you can do when you live like no one else and prioritize. We did all that on less than $40,000 a year. People made fun of the clothes I wear and the car I drive but I laughed back at them.

    You are absolutely right. I would rather have a debt free place to live and food to eat when the crash occurs, than to have investments and live in a shelter.

  18. Tristan says:

    I have to add this response to Engineer who said:

    “There’s actually a personal risk to paying off the mortgage early. In the event of a catastrophic event, such as a medical situation or extended job loss, your liquid funds to handle the situation have been reduced by having paid off your mortgage. Leaving less room to sell your investment if you need to.”

    If you have no payments you can save everything you make. In an event you will have all your savings and income to handle it and no worries about becoming homeless. That makes more sense than having debt and some savings.

  19. Tristan says:

    I’m sorry for the multiple replies but this is really bugging me.

    You said John is focused on the investment. The rental properties we own are are multi units. Now keep in mind we own them free and clear now. After taxes and repairs it’s all profit. I think that is a pretty good investment. I didn’t need to hang onto the mortgage for fifteen years to make that investment pay.

  20. UncleOxidant says:

    Trent: I think a good post would be about how Tristan managed to buy two multi-unit rentals and pay them off very early on a $40,000/year salary. Now that’s what I call frugal!

  21. Tristan says:

    Uncleoxidant, I will tell you how I did it. I won’t go into my private details but a rough overview will suffice.

    Family said we were crazy for not living in a high priced state and buying a half million dollar home. Well first off, would couldn’t afford that. Second, I can’t see working my whole life for one house just because family lives down the road. They aren’t paying my living expenses and I want more out of life.

    I put 20% down on two fixer upper, multi units in the Midwest.If you shop carefully you can buy one for $20,000. I lived in one and used cash to fix them. I didn’t have cash saved. I just saved for cabinets then installed them. Then moved on to the next item. Always using cash. I charged low rents. I increased them as the apartments improved. Other than improvements, I put all my husbands income (I don’t work) plus collected rents on the mortgage.

    I’m currently living and renting a place in California for a while. We made the decision to come care for my mother in law who is not well. When the time comes to move back to the midwest I will buy more properties and repeat over and over.

    The most important thing we did was learn the difference between needs and wants. We wanted to live in California but needed to live where homes were reasonably priced. We shop at goodwill. We spend $25.00 a week on groceries. We don’t eat out or go out. We make our own fun at home. We have day trips instead of vacations and we buy used cars.

    At one time we moved across the U.S. for a job that fell through. We ended up homeless for a while. Once you’ve been there you know that having paid for assets and no risk is a much smarter move than holding debt and “investing” in other things. I remember my grandparents talking about life during the Great Depression. When I was homeless I experienced the real desperation they had told me about. I learned that risk is only fun when everything goes right.

  22. UncleOxidant says:

    “I learned that risk is only fun when everything goes right.”

    Exactly right. An now it’s time for this generation to learn the same thing.

  23. Rob says:

    I’m glad at least one person brought up liquidity. You want some of your assets to be liquid (eg emergency fund) or you are again, exposing yourself to a risk (liquidity risk, who would’ve guessed).

    By having a loan, you’re exposing yourself to all the factors associated with credit risk. If you have no cash, you’re exposing yourself to liquidity risk. By investing in something, you’re exposing yourself to financial risk.

    So how is it that some of you are arguing that not paying off your loan and using it to invest in stocks is not MORE risky than paying off your entire debt. Anytime you take your cash (hopefully not all of it), all else being equal, and invest it in something inherently risky (stocks), it is more risky than paying off a loan (less default risk). That IS the reality of the situation.

    Whether you’re okay with that risk is another question and is up to you.

    A lot of you guys are confusing risk with risk tolerance. Yes, some you’d rather have some debt and invest some, but that doesn’t mean you’re not in a more risky position than the guy who paid off his entire debt. Of course, as some of you pointed out, your return will probably be a lot higher than the no-debt guy if everything goes well. However, you risk to lose a lot more if things don’t.

    On a side note, diversification only works well with things that are not correlated. As we’re seeing today, mortgages and stocks are tied a lot more than we thought eh?

    Another thing, diversification only saves you if you can sell your investment. If your home is your shelter and you can’t/won’t sell it, the whole being diversified thing doesn’t really work now does it? Why? Because the point of diversification is that you can minimize unnecessary risk by offsetting returns (that are negatively correlated (eg stocks and bonds). If you can’t realize the gains or losses on the investment by selling, diversification fails to be a factor.

  24. PJA says:

    Trent and Tristan: how about an interview with Tristan – would love to hear more details of her story and approach :)

  25. dave lamport says:

    this is a question for pat. if you had no mortgage would your take out a $70,000 dollar loan against your house to put into a money market account that returns 4.5%? if the answer is no, then you should probably go ahead and use your money to pay off your mortgage, because it amounts to the same thing. and like tristan the peace of mind you’ll have will be far and above what you have now.

  26. Duane says:

    I believe a healthy portfolio contains a mix between assets and debt. You can make debt work for you when over 70% of your assets are owned free and clear.

    In the case of a home loan, this should be considered as shelter first, inflation hedging second and lastly as an investment. The first two effects are far more likely outcomes of owning a primary home.

  27. John says:

    Hi,

    I actually agree with a lot of the analysis above. I will say that Trent’s summary of my situation is mostly correct (I do tend to view my house as an investment). A few points:

    – I do have a pretty high risk tolerance. I’m quite comfortable with investing a large percentage of my income in stocks, etc rather than real estate, if I think that’s the best move.

    – I disagree with some of the commenters above that do not view their house as an investment, but not in the way one might expect from my earlier comment. I don’t view it ONLY as an investment, but as BOTH an investment and a place to live. I’m perfectly willing to “lose” money on having a nice shelter (in the form of interest payments), in much the same way that I would “lose” money if I was renting. But I only want to lose money up to a point…mainly near the point where I could break even by doing something different (such as renting for a lower monthly payment). When making a big purchase like a house, I evaluate all the opportunity costs (like how much could I make if I rented instead, and invested the difference in the stock market) along with my expectations of the likelihood of the home going up in value.

    – I don’t expect to stay in the same house forever at this point in my life; my career is changing too fast for me to be able to expect that. So that’s definitely a part of it.

    – I’m considering the effect of leverage on my investment returns on the house. Having a relatively smaller amount of equity in your house can actually magnify your investment gains (or losses) if the house goes up or down in value between when you buy it and sell it. I want to have enough equity that I have some safety against downturns in the housing market, but not so much that I tie up the majority of my wealth in the house. Also, because the home equity is less liquid, it’s harder for me to redirect it in the future to some other investment that I think will do better. This could reduce my total investment returns, because I might not be able to put the money to work in the most efficient way possible.

    Again, I agree with everyone who says this has a lot to do with psychology and differing risk tolerance. For some reason debt creates an irrational insecurity in many people, and I totally understand why that type of person would want to pay down all their debt to “feel safer”. I, by contrast, feel safer having more money in liquid assets, even if that means I retain debt longer. I can then handle any personal emergencies that life throws at me with no problem. I also like to “globally optimize” my finances, looking at the best places in every area to put my cash.

  28. Pat says:

    Dave Lamport,
    You make an excellent point…I would not borrow money against my house to earn 4.5%…at the same time, the psychological effects of my relatively safe cash stash may exceed the psychological effects of having no mortgage (I have one of those corporate grind jobs that pays well but entails long work weeks and a long commute…the fantasy of quitting for a year and living off savings is a powerful one that keeps me going many days!)

    I’m pretty sure I’m going to pay down half my mortgage, keep the rest in cash for a new roof, braces for the kids, etc. and keep up my frugal ways which have allowed me to build this up in the first place. At worst case, it will be another 2 years or so before I can retire the mortgage.

    I’m still in it for the long haul (IRA and 401K maxed) in fairly aggressive stock portfolios.

    The comments on Trent’s original post have been very enlightening. There is no “right” way to invest when taking personal risk tolerance and psychology into account.

  29. dave lamport says:

    pat, as trent points out, personal finance IS personal. it sounds as if you have a good idea of what you want to do with your money, and it certainly seems like a good idea to at least pay off half of your mortgage. good luck with that.

  30. Rich says:

    Great discussion.

    I’ve got a slightly different perspective, I think. I like to think of things in terms of cashflow, as narrow-minded as that may sound.

    I don’t mind debt–especially my low fixed mortgage in this environment–but I do prefer to have the flexibility of a large net positive cashflow. At the moment, I don’t have that because of mortgage payments. So, despite the advantage of the low fixed debt, I’m leaning toward more of an early payoff so I can put the whole mortgage payment toward other investments.

  31. Jon says:

    Rob has some great points and I’d like to add just one more. The original comment by John had a slight error which I’d like to point out. He seems to have confused the issue of mortgage vs. non-mortgage with that of home ownership vs. renting. Let me explain.

    If you get a mortgage to buy a house, and the house drops in value, the mortgage does not go away. You are still obligated to pay back the original value plus interest. If you pay in cash and the house goes down, you’ve lost the same amount of money.

    However, if you decline to buy a house and simply rent, then you have eliminated the risk of housing downturns.

    What mortgages do from an investment perspective is increase leverage (and thus risk) for speculators. In other words, if you have $10k to invest, and you invest in a house (also taking on a $190k mortgage), you are taking a serious risk. If the house drops 1%, you’ve lost 20% of your investment.

  32. Big Bear says:

    A house is only an investment if you sell it.

    Dave @ 8:59 pm August 18th, 2007
    This is not a correct statement. Anything is an investment that you put money in to. A house is only an asset if you sell it, and only if you sell it for a profit.

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