Jeremy Quittner: Welcome to Teach Me How to Money. I’m your host, Jeremy. On this week’s episode, we’ll be talking with personal finance expert and author Paula Pant, but before we get going, our term of the week is passive income, so what is passive income? Passive income is different from the wages you’ve earned by working. In that case, you show up and do a job and you get an hourly wage or salary. In contrast, passive income is generated without active participation from you. It could be money you generate by owning an apartment and collecting rent from your tenants. It could also be earnings or dividends from your investments in the stock market. It could even include royalties you make from selling a book or acting in a commercial. If you can, try to develop passive income because it can give you some financial freedom over the course of your life or in retirement. So that’s our jargon hack for the week. Now let’s get to the interview.
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Today we’ll be speaking with Paula Pant. She’s the host of the Afford Anything podcast and creator of the affordanything.com financial information website. Paula talks frequently about the importance of working towards financial freedom by developing passive income. And she knows what she’s talking about. By the time she was 34, she owned eight homes that gave her enough rental income to live on. Today we’ll be talking to Paula about what it means to be financially free and how you can achieve some financial freedom for yourself. Welcome, Paula!
Paula Pant: Thank you. Thank you for having me here!
Jeremy: Oh, it’s our pleasure. So your philosophy is summed up as afford anything, not everything. What does that mean exactly?
Paula: This is the concept of opportunity cost. Every yes to something is an implicit no to something else. So anytime that you make a purchase of one thing, what people often don’t realize is that they are, by making that purchase, not buying something else. And this concept doesn’t just apply to your money. It applies to your time, your energy, your attention, your focus. It applies to any scarce or limited resource within your life. And often these trade offs are not consciously acknowledged. And the way that you see this come up time after time is when people say something like, “Oh, I would love to go to Europe but I just can’t afford it.” Or “I would love to x, y, z.” You know, “I would love to quit my job and take a different job that pays $10,000 per year less, but that I would find more meaningful, but I just couldn’t afford it. There’s no way that I could take that $10,000 annual pay cut.” So people will make these statements while simultaneously having expensive cable packages or dining at fancy restaurants or leasing brand new cars. And what they often don’t recognize is that they can afford it, it’s just that they can’t afford everything, and life is not an endless series of “ands.”
Jeremy: So basically you’re making unconscious choices to have some things as opposed to others and the big items or the bigger dream items that you wish for and think that you can’t have, the opportunity costs would be that you are actually paying for things that you could easily eliminate from your budget or somewhere else, in order to have these larger ticket items or these sort of like dream items.
Paula: Precisely, the concept of afford anything is the concept of making those opportunity costs more conscious, more visible and more part of your deliberate planning process.
Jeremy: So there’s a lot of unconsciousness with people and money.
Paula: Absolutely, yes. I’m a big supporter of conscious spending. So within the personal finance community, people often talk about not buying avocado toast. You know, people often like to nitpick at these small details. But the thing is, there’s a significant difference between sitting down, carefully thinking about your priorities and your values and coming to the conscious choice that going to brunch on Sunday morning with your family and ordering that avocado toast is one of your highest priorities. Like there’s a big difference between making that conscious decision versus absentmindedly buying something and then at the end of the month wondering where all of your money went.
Jeremy: So avocado toast can be an unconscious decision.
Paula: Or a conscious decision. Either one.
Jeremy: Okay, great. So we’re hoping that you can link this to your ideas about financial independence, which seems to be something that you suggest everybody can achieve. And this is really useful to our listeners who, many of whom are struggling with this idea of financial independence.
Paula: Well, financial independence, I define it as the point at which your passive income, which is typically but not always, is through investments, is enough that it creates an elevated degree of freedom in your life. And I think that there are many degrees of freedom that can be created by having better control over your money. And so for example, debt freedom is one level of freedom that you can have with your money.
Jeremy: And what’s, what’s debt freedom?
Paula: Debt freedom is simply not having any debt. And in fact, kind of more granularly within that, there can be multiple degrees of that. So you could have a certain level of debt freedom in which you don’t have any consumer debt, meaning no credit card debt, no car loans, but you do have a mortgage on a rental property, right? That would be one level of debt freedom in which you don’t have any cash flow negative debt. A different degree of debt freedom would be to have absolutely no debt at all regardless of whether it’s cash flow, negative or cashflow positive. That would be a separate degree of it. And then debt freedom as a whole, if you take that entire package, is itself one degree of freedom in this much broader continuum of how better control over your money or more specifically more conscious decisions about how you want to manage your money can create escalating levels of freedom within your life. And so the notion of financial independence, which is having enough passive income through investments that it can support your basic cost of living. That is another expression on this large continuum of money and freedom.
Jeremy: Interesting. So I was hoping we could have a discussion about passive income. This seems like an enormous mountain to scale or try to climb. And especially for the typical consumer developing passive income from investments or in your case real estate. How do you do that? Let’s back up and first of all define what passive income is and then maybe you can tell me and tell our listeners a little bit about your journey to developing passive income.
Paula: Sure. Well, I think what a lot of people don’t realize is that most people who are listening to this, if they have a 401(k) or an IRA or some type of retirement savings, they have passive income. And so passive income is income that does not derive directly from a- time-for-money exchange.
Jeremy: Time for money being, I show up and I get a wage or a salary for something.
Paula: Exactly. And so if your money, your capital is working for you, then that capital is creating its own income. And so if you have a 401(k) or an IRA or any type of retirement savings for example, then your money is working for you. It is creating growth in two ways. In one way it is, hopefully, creating growth through what’s known as capital appreciation, which is when the value of that money grows over time. So you put your money in an index fund at $10 a share and then a year later you check it and it’s grown to $12 a share and you know you didn’t have to trade hours of your life for those extra $2 per share. Your money has made that. So that’s a form of passive income and that capital growth or capital appreciation is one way in which an investment makes money. Another way in which it does so is through what’s called a dividend or an income stream. And that’s basically a fancy way of saying that your money in addition to, hopefully, appreciating in value over time, might also kick off some additional stream of income. And so if that stock, let’s say has grown from $10 to $12 and it has also paid out an extra .50¢ per share, then those are two separate ways in which that initial $10 investment that you made has grown both in value and through its dividend payout. The point of all of that is that when people say, oh, passive income feels insurmountable, what they often don’t recognize is that they already are making passive income if they have any type of investment. So the only question then is not, can you create a passive income, but can you continue to grow that until it becomes enough that it covers at least your basic cost of living.
Jeremy: I think that I read that you and your husband lived with roommates, well into the point where your passive income was enough to support you. And I’m wondering, can you just tell your own personal story? I think it would help people understand what you did.
Paula: Yeah, absolutely. He and I lived with roommates until he was 34 and I was 31 and at the time that we stopped living with roommates, our net worth, our combined net worth at that time had exceeded $1 million. So we were millionaires living with roommates.
Jeremy: That seems so, you know, counter-intuitive. And I’m wondering, can you tell us why? Why did you just at a point where it seemed like you could easily live by yourself? Why did you continue to have roommates?
Paula: Because there’s an opportunity cost and if we were to pay out of pocket for our own housing costs, then that’s additional money that we couldn’t invest. You know, that’s less money that we can put into the stock market. It’s less money that we can put into buying or renovating another rental property. It’s less money that we can put into growing our own businesses. And so the question became what’s most important? And then we rearrange the rest of our lives accordingly. Living in solitude was less important to us than being able to invest this money.
Jeremy: So why don’t you jump from that to some of your ideas about an anti-budget. A lot of people have trouble with a basic budget. The 50-30-20 budget is the one you read about all the time, but, you have different ideas about how to budget and budget to save. And I’m wondering if you could tell our listeners a little bit more about that.
Paula: Sure. The way that budgeting is mostly taught and talked about is similar to tracking calories or tracking your protein, carbs, fat macros. It requires an incredible amount of measuring and tracking and like intense scrutinizing over every fine detail. And there are some people, some personality types who love that and who find great value in that. And so if it’s working for you, then stick with it. But the issue that arises is that there are many people who simply do not have either the personality type or the interest level, or the level of commitment to stick to a granular line itemed budget. And so what often happens for those people is that they give up on the whole thing. They believe that they need to track every single penny of their spending. And when they fail to do so, they give up and they throw their hands in the air and they say, “you know what, I’m just not good with money.” And they walk away from the whole thing. And that is the situation that we want to avoid. So the anti-budget is a response to that. The anti-budget, which, which I developed a few years ago, is the very simple practice of zooming out and saying, all right, when we budget, what is actually the goal here? The goal is to make sure that we’re saving enough. And when I use the word save, I’m referring to anything that improves your net worth. So it could be repaying a debt and making additional payments on a principle above and beyond the minimum required. That could be a form of savings, it could be retirement investments, it could be literal savings in a saving account. Any net worth improvement is what I mean when I use the word save. And so if the goal is to make sure that we are saving enough, well then let’s cut to the chase and let’s start with that goal. So the anti-budget is that practice of, decide how much you want to save, yank that off the top and then live on the rest. And it doesn’t really matter in terms of that living on the rest component of it. It really doesn’t matter if you are devoting more money towards dog food versus toothpaste versus, going to the movies on a Friday night. That’s not what’s actually important. What’s important is the simple question of am I saving enough? Yes or no?
Jeremy: Interesting. So part of your message is also about crashing out of the cubicle and developing other ways to make money. Can you tell our listeners a little bit about your story? I think you were a newspaper reporter. You weren’t earning that much, but you saved aggressively. Then I think you went on a travel journey and found another way to be in to make money. And I’m wondering, can you just briefly tell that story so that people can understand more of the depth of your message?
Paula: Absolutely. So my first job, I made $21,000 a year as a newspaper reporter. That was my full time salary and that was in 2005. Oftentimes when I hear people say I made $21,000 a year, they’re referring to like 1975 dollars. I mean even when you adjust that for inflation, I think that’s the equivalent of approximately $26,000 or $27,000 annually in today’s dollars. And so I wasn’t making very much money and I worked at that job for three years. At the time that I quit that job, I was making $31,000. And that is the highest amount of money that I’ve ever earned as a full time W-2 salaried employee working for an employer. And so, I basically, as a newspaper reporter, I could recognize that the traditional path of being employed full time in a salaried position was not going to be a big money maker for me. And so I realized that what I needed to do was create multiple streams of income if I wanted to be able to have more flexibility, more money to invest because I’ll take a brief pause here. Going back to the question that you asked earlier about how to develop passive income and how to deal with the retirement savings crisis. There are only two ways to save money. You can either earn more or you can spend less, or you can do a combination of the two. So during the time in which I was making between $21,000 to $31,000 annually, I had the spending less portion of my life under control. I had the frugality aspect nailed. So it became clear to me that the most powerful lever that I could pull was the earn more lever. And so based on that, I started freelancing. I started writing freelance articles for magazines and for websites and developing those multiple sources of income because that was a powerful way to be able to make more money and therefore be able to save more money. You know, for anybody who’s interested in crashing out of the cubicle and quitting their job, don’t rely on simply your full time employer to be your sole source of income.
Jeremy: So at what point did you decide that you wanted to develop passive income through real estate and looking at an environment where people are having trouble increasingly just affording a first home, an increasing pool of people who are permanent renters, et cetera. How did you do it? How did you decide that would be your goal for developing passive income?
Paula: I didn’t pre-consciously, it wasn’t a premeditated goal in any regard. I was trying to cut my expenses and I realized that if I bought, instead of buying a single family home, which is what most people do, they save up money, they buy a single family home and then they themselves are on the hook for paying the out-of-pocket mortgage payments every month. That’s a huge expense. And so I was trying to cut my expenses and I realized that if instead, I bought a triplex, which is a building that has three autonomous units in it. If I bought a triplex for the same price as a single family home, and then I rented out two of those units and then I lived in the third unit with roommates, then the combined rent from those other two units, plus my roommates would bring my personal out-of-pocket expenses down to zero. And so I don’t really understand, or at least I didn’t at the time, how anyone would have enough money to be able to pay their own rent or their own mortgage out-of-pocket. That is a huge burden on your personal budget. And if you can avoid that by house hacking, which is the term for the practice of filling your space with enough tenants and roommates that you don’t have any personal out-of-pocket housing costs. Well, that’s an incredible way to save money because then your out-of-pocket housing expenses are zero.
Jeremy: Paula I was wondering if you could help us with a listener question. This person writes in to say, I want to invest, but I don’t want to wait until I’m at retirement age to use my money. So what can I do? I kind of liked this question because it brings up the idea of investing for short and long term goals. But I think the listener may be confused by the difference between a retirement account, which you can’t touch until you’re 59 and a half without paying penalties and a brokerage account where you can use the money at any time. And then, of course, there’s a Roth IRA, which is a retirement vehicle where you can use the money without penalties after about five years. So I’m wondering if you had any insight for this listener who wants to invest but doesn’t want to wait until retirement age to use the money?
Paula: Yeah, absolutely. So all of the vehicles that you named, including and especially the taxable brokerage account is a great way to build investments while not being beholden to the 59 and a half age requirement. If you think about it, a retirement account is essentially a deal between yourself and the government in which the government gives you a tax advantage in exchange for you promising not to touch that money until you reach a certain age. And so, if you are willing to give up that tax advantage, then you don’t have to wait until you reach that certain age. And that is functionally how a taxable brokerage account operates. It’s just an account that you open with any brokerage of your choosing in which you can invest money. Now the thing to keep in mind is that the way in which you invest your money should be appropriate to the timeline with which you want to use it. So if you plan on tapping this money within the next, let’s say three years or five years, then because you have a shorter time horizon, you’re going to want to invest it more conservatively than you would if you wanted to touch the money in, we’ll say 10 to 15 years.
Jeremy: Great. Paula, thank you so much. We’ve been talking with Paula Pant. This has been a pleasure speaking with you and thank you for speaking with us at Teach Me How To Money!
Paula: Absolutely. Thank you for inviting me on the show!
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