We don’t have a spending Problem, we have a Liquidity Problem

October 27, 2020

My Dear Reader,

The tumultuous year that is 2020 has taught us all so many lessons for life, and has unfortunately revealed many problems in the modern world.  The most obvious is the political discourse of the day, but this is another topic for another day.  Instead, I believe that the economic problems that have shown themselves across the nation is the bounty of a generation of depleting resources for the everyday American.  Fundamentally, I believe that the problem is that we in the financial industry have done a poor job at providing our clients with adequate liquidity.  In other words, I believe that we have focused so much on getting our clients up the proverbial mountain, that we have forgotten how much it means to get them their own money back.  This doesn’t mean abandoning all forms of investment or stuffing money into mattresses, but it does start with a proper financial education.  

Opportunity cost is seldom explained by the financial community. If your financial advisor has already explained this to you, or you know what it means, thank him or yourself; not understanding it can cost you hundreds of thousands of dollars over your lifetime. The basic premise is that every dollar you spend today could have been invested to yield increasingly more money over time. This is a sobering fact: every dollar spent today will never again be able to work in your favor. For instance, $100 invested today at the market average rate of return of 7.91 percent will be worth about $1,000 in thirty years. So, every payment made today with your own dollars hurts you in the future. This is why excessive taxation, especially personal income tax, is so harmful to all levels of society. USA Today estimates that the average American pays roughly $10,000 in personal taxes per year. If we use this number and apply the current market average rate of return of 7.91 percent, that one year’s payment of $10,000 costs $96,463 thirty years later. Albert Einstein once called compound interest the 8th wonder of the world. Yet it is surprising how few people are able to take advantage of it. The idea of a compound interest is that over time, starting slowly, the interest gained from an investment will compound exponentially if left untouched. But an investment that is interrupted will reset the compounding effect, and will forever damage the earning potential of that investment. Opportunity cost and compound interest are the two most basic wealth building fundamentals, and I believe in every purchase we make, we are contributing to opportunity cost and stopping our compound interest.

For example, when we buy a car, traditionally we have two choices, either paying cash or financing.  When we pay cash for a car, we do so in the hopes that we will avoid paying interest to the bank or financial institution.  However, in doing so, we greatly exacerbate the opportunity cost of losing the cash as a leveraging tool.  If we take a 25 year old who has $100,000 in an account that compounds at 7.91% annually, and compound that number for 30 years until he retires, he will have earned $981,410. However, if we make just one payment for a car, even if we use the average price of $20,000, this man will only earn $785,128 over the same time.  This number is if we only purchased one car for this man’s entire life.  But what if he gets married? What if he needs to purchase a car for his son? Maybe like the average American, he’ll have two kids and need a car for his daughter as well.  What about college for both his kids? Obviously, this is why the American family has been losing cash reserves over time, as data from the 1990s will show. We have, in the financial industry, pushed more and more for investment products to outpace inflation, but because they are not liquid in many cases, we are forcing families to pay for their basic needs through opportunity cost or financing.

To wrap up this article, and to punctuate my argument on liquidity, I want to make one final point around mortgages.  To start, I asked my friend and mortgage professional, CJ Wyatt his thoughts on the two most popular mortgages, the 15 and 30 year mortgages.
“Truth is there are differing thoughts on the 30 year mortgage. Some people think you should only do a 15 year mortgage because 30 years is borderline highway robbery, which there is some truth in that. However, if banks did not offer 30 year mortgages, then a LOT of people would not be able to buy homes in our housing markets. Since the majority of people do not stay in a home for 30 years, most people will not pay off a mortgage until they have enough equity in a home they can downsize and pay for one cash. This is normally after buying and selling a few times and the kids have left the house. This is one reason why I have heard some people call for a 40 year mortgage. The housing prices keep going up, yet income levels are [not] quite following this trend. However, if some people think a 30 year mortgage is bad, they will lose it over a 40 year mortgage. I am on the fence on a 30 year mortgage, but our economy and market cannot survive without it. I have had very few individuals do this in 5 years, so I think it is necessary, even though I completely understand why some are opposed. Keleigh and I will pay over $300,000 extra for our house if we pay it by the schedule for 30 years, but we feel more comfortable with the cheaper payments just in case something terrible does happen.”

What CJ is driving at is that there are people who solely look at the cost of the mortgage in terms of interest, but the benefits of leaving less money to debt service can be immense.

For instance, let’s take two brothers, Orville and Wilbur, who both think they are in the right. Each brother is going to buy a $500,000 home in Florida. Orville decides to get a fifteen year mortgage, so he can pay off his home faster and then invest the money that he would have been spending on his mortgage. His brother Wilbur decides to get a thirty year mortgage and invest the difference that he saves per year over Orville. To make it simple, both have a $500,000 loan with a flat 5 percent interest rate. Orville will pay $3,953 to the bank every month and Wilbur will pay $2,684. If we assume there were no market crashes at all and both earned the current average rate of return at 7.91 percent Orville will make $1.3 million in the fifteen years after paying off his house. Not a bad sum. 

His brother Wilbur will invest $1,269 every month, as this is the difference between the brothers’ interest payments. Wilbur will have made $1.8 million by the time his house is paid off. Put simply, it’s because Wilbur has a fifteen year head start on his brother, and the better the market does, the larger the gap becomes.

The solution runs much deeper than the contents of this article, however, I believe that this helps to prove the fact that most of us don’t have a saving problem, we have a liquidity problem.

To your Creation and Potential,

Kevin Prendiville