Security vs. Risk

In our society today, the word risk has a horrible connotation.  Why?  People associate risk with irresponsible behavior and high failure rates.  In the financial world the term risk simply means uncertainty.  If we can predict an event with accuracy on a regular basis, the event is considered low risk.  Conversely, if we cannot, it is considered high risk.

Right now in my life I crave a certain amount of security.  I would prefer to have a large amount of security.  However, security can be just as damaging to your overall financial health as risk can.

If you save too much of your money without growing it, and you have a fear of the “risk” associated with higher yielding accounts or even the market, you may see a decrease in your buying power due to inflation.

True story, I swear, but when I worked with the bank I remember I had a client who distrusted banks and anything financial.  Well, instead of putting her money into investments and higher yielding accounts, she put it in a drawer of a table.  No joke, one day her house was hit by a tornado.  Her money flew throughout the neighborhood, raining down on her joyous neighbors.  Well, she thought she was doing something safe and secure, but she wound up losing a good amount of savings in the process.

I feel that If you never take any risk, you will never move forward.  These “risks” you take could come in almost any form – asking for a raise, moving to a better neighborhood, starting a new company, investing in the market, selling your home.  Because you do not know the outcome of any of these events, they all have inherent risk.

If you never ask for a raise, will your employer likely give you the value that you create? 

No.

Why not?  Your employer is most likely a smart businessperson.  They will pay you the least amount possible to keep you happy and productive. 

Nevertheless, if you walk into any of these major decisions lightly, and without thought of the possible various outcomes, the events can be disastrous.  For example, take the person who decides to begin flipping homes – with no previous experience, and without considering current market conditions.  I think the increase in foreclosures paints the picture of those who went into a speculative market uninformed.

What is the solution?  Balance.

In order to move forward, to truly succeed, you have to take risks.  Otherwise you wind up burying all of your savings in the yard and perhaps losing its location at worse, and at best, seeing a vast decrease in your buying power.  However, you do need some security, some soft landing for the hard times.  I really believe a good reserve fund will give you that security, as well as the capital and flexibility to take other financial risks without devastating yourself if the results are not as favorable as you hoped.

A Bigger House is Not Always Better

People seem to go batty over the fact that the interest on your mortgage is deductible. They also seem to do the same thing over the the capital gains deferral for your primary residence. But just because you can sell your house, take a profit, and buy a bigger house to have *more* of a tax deduction, that is not necessarily a good thing.

Let’s say you have a $200,000 house. You put 20% down, so you have a $180,000, 30-year fixed mortgage at 5% (for the purpose of round numbers). Your payment is: $966.

Suddenly, your house appreciates. You can now sell it for $250,000. Rather than taking the capital gains and paying down a mortgage on a similar house, you decide to capitalize on this, sell your home, and trade up. After closing costs and fees, you have about $60,000 to put towards your next house. So you buy another home with 20% down, the new home being worth $300,000 with a 20% downpayment = a 30-year mortgage of $240,000.

At the same interest rate, your payment is now $1,395. You have just increased your overall debt by some $60,000, and your monthly cashflow has been stretched an additional $400/month. That is a 44% increase in your mortgage payment.

For what? A bigger house? Do you really need that much more room?

Let’s look at another scenario. Say you capitalized on your gains and rolled it into another, similar priced house. You take the $60,000 to pay down your mortgage, so your total mortgage on a $200,000 home is now $140,000. Your payment on a 30-year 5% fixed rate mortgage is now $751. That is a 22% decrease in your payment.

Now, here is why trading up really is dumb sometimes:

If you took that extra $200 per month and put it into a high-yield savings account at 5%, the compounding interest would give you $167,448 in 30 years! That is more than your new mortgage! And if you took the money you would be saving by not “trading up” to the bigger house ($1395 - $751 = $644) you would have $535,970 in 30 years. So, even if you can afford the bigger house, if you decide to save the money, rather than dump it into a bigger home (with higher costs of heating, etc.) you can have almost half a million dollars. Just see what you are giving up!