Tuesday, August 9, 2011

Paying off your Mortgage

I hope to never pay off my mortgage, much to my wife’s chagrin.

 

That may shock some of you. Especially those of you who are familiar with this phrase:

 

“Debt is dumb, cash is king and the paid-off home mortgage has taken the place of the BMW as the status symbol of choice.”

 

That is from Dave Ramsey, radio host and author of The Total Money Makeover, and it is the battle cry of a growing movement away from debt. Indeed, debt is seen as a key cause of our current Great Stagnation. However, I think we may be moving too quickly to eliminate debt from our lives. Indeed, actions like paying off a mortgage may cause harm to your overall portfolio.

 

That harm comes from the extra money you put toward your mortgage. Deciding to put money toward the principal balance of your mortgage means you are not investing that extra money. Instead, the principal balance of your mortgage decreases. Note that this doesn’t necessarily increase the value of your home. Your home will appreciate or depreciate regardless of the balance of the mortgage.

 

Let me use an example to help illustrate this point. This example has two actors: Tabetha and Liam. Tabetha hates debt and will work her darnedest to pay it off. Liam takes a more wealth-maximizing approach. They are actually neighbors buying the same house for $200,000. Tabetha put 10 percent down and Liam put 5percent down. Tabetha chose a 15-year mortgage, so her payments are slightly higher than Liam’s, but she gets a lower interest rate. Liam chose the 30-year mortgage with a higher interest rate, but a lower monthly payment. The info is in the table below:

 

 

 

Tabetha

Liam

Loan balance

$180,000

$190,000

Interest rate

5.5%

6.0%

Months

180

360

Payment

$1,470.75

$1,139.15

 

Tabetha really doesn’t like debt, so she decides to also send an extra $200 per month to help pay off the mortgage. Liam takes the difference between his payment and Tabetha’s and invests it. Liam also sends $200 a month to his investment account which earns about 8 percent annually on average. So how do they look seven years down the road?

 

 

 

Tabetha

Liam

Mortgage balance

$93,581.76

$170,314.83

Investment balance

$0.00

$77,074.13

 

 

Tabetha has made great progress in paying down her mortgage. She has more equity in her home compared to Liam. However, Liam’s investments have steadily grown as he invested the difference between Tabetha’s mortgage and his own, plus the extra $200 a month. If we net the investment balance against the mortgage, he owes about $341.05 less than Tabetha.

 

By pushing the scenario further, we can also test strategies for our current Great Stagnation. Assume that both Tabetha and Liam lose their jobs. Liam’s investment account also took a hit and lost about 30percent of its value. The investment account is now worth $53,951.89. Both Liam and Tabetha are having a hard time finding jobs and each has spent their 12-month emergency-fund money. It is now month 13 since the layoff and Tabetha can’t pay the mortgage. She has substantial equity in her home, but no one will lend her money without some proof that she can pay it back. The house she put so much equity into goes into foreclosure.

 

After 13 months, Liam has also emptied his emergency fund, but now he starts to spend the investment account that has decreased in value. Assuming he only uses the investment account to pay the mortgage, he has 47 months worth of mortgage payments—almost four years. This is probably too optimistic, but if we assume that it takes $2,000 a month to run his household, he has enough money for 26 months, more than two years.

 

This example also works for student loans and any other long-term loan where the interest rate is relatively low compared to possible investment returns. This doesn’t work compared to high cost credit cards, payday lending or other high-cost debt.

 

There are three important considerations with the Liam strategy.

 

1. Sleep. You have to be able to sleep at night, knowing that you are not paying off your mortgage as fast as you could be. Instead you are investing in riskier investments that are volatile in the short term, but over longer periods, they generally appreciate. If your personal preferences are such that you are the happiest paying off the mortgage fast, then Liam’s strategy may fail to win you over.

 

2. Peer pressure. In recent history, peer pressure tended to exert influence toward borrowing more, saving less and living well. Your house could be used as a piggy bank to finance purchases, since house values kept rising. This belief was proven false, but I fear that we are falling to the other extreme. The quote at the top is my best example: “the paid off home mortgage has taken the place of the BMW as the status symbol of choice.” We are now fearful of debt and want to expunge it from our lives. Although paying down debt is a much better choice than getting into large sums of debt, it is still suboptimal (see example above).

 

3. Discipline. Liam put the difference between Tabetha’s mortgage payment and his payment—$331.60, plus an extra $200—into his investment account. Additionally, Liam put $10,000 less into his down payment, opting instead to start his investment account with that lump sum. The discipline to put the lump sum and the monthly payments into the investment account was essential to his success.  If the money had been spent on anything else, Liam would be worse off financially compared to Tabetha.

 

My hope with this Financial Tip of the Week was to demonstrate that debt is a tool. It is neither good nor evil. Debt can be used to lengthen an unsustainable lifestyle or enhance wealth creation. The good or evil action depends on the user (like so many things in life!).

 

Notes: Liam and Tabetha are fictitious, and there are many assumptions in this example. Markets generally don’t steadily rise 8 percent a year, they fluctuate. We’ve ignored private mortgage insurance, taxes, inflation, emergency fund amounts, increase in house value, etc. This does not make the example useless, but you cannot apply it to your own life without tweaking all those factors to fit your scenario. A good financial planner dreams of spreadsheets and should be able to model the situation to give you a clear outlook.

 

BONUS CONTENT

 

You’ve read this far, you deserve something special. Some may ask the question: “Sure, Liam looks better, but once Tabetha gets her mortgage paid off, she can invest her whole payment!”

 

Well, let’s break out the spreadsheets.

 

Tabetha pays off her mortgage in the 149th month.  She actually has $201.44 left over that she immediately puts into her investment account. Every month thereafter, she invests the whole $1,670.75 into her investment account. By the time Liam’s mortgage is paid off, 30 years after the homes were bought and about 17.5 years after Tabetha paid off her mortgage, Tabetha has amassed $352,731.08 in her investment account and a paid-off house. At the same time, Liam has a paid-off house and has amassed $901,638.67, almost $1million.

 

The difference between Tabetha and Liam’s account balances is more than half a million dollars. Liam and Tabetha had the same amounts to either invest or pay off debt, as well as the same amount of money to put toward a down payment or invest. They both earned 8percent on their money. Tabetha had a lower interest rate and paid $68,740.35 in interest. Liam had a higher interest rate and paid $220,092.56 in interest. So what caused Liam’s investment balance to be so much higher than Tabetha’s?

 

Time.

 

Liam’s money was working for the full 30years. Tabetha only had 12.5years. Albert Einstein, when asked “what is the most powerful force in the universe?” supposedly replied “compound interest.” Whether the quote is urban legend or true, compound interest combined with time is extremely powerful. Tabetha’s extra payments still couldn’t keep up with Liam’s investment account. Truly, the power of compound interest over time is often described as the snowball effect.

 

More Reading:

 

The second book that spurred me into personal finance was Ric Edelman’s The Truth About Money. Now in its 4th edition, it first introduced me to the concept of never paying off your mortgage. He actually has an entire webpage devoted to this concept.

 

Here is the spreadsheet that outlines the above example.

 

Andrew Zumwalt, M.S.

Director of the MoTax Education Initiative

162 Stanley Hall

University of Missouri

Columbia MO 65211

Google Voice #: 573-234-4268

Fax: 573-884-5768

 

 

13 comments:

Mike said...

So I'm a long time subscriber, ever since the Iowa State director published these tips at my alma mater. This is really the first time that I've disagreed with a tip.

Like your examples lay, mathematically, what you've analyzed is exactly what many millionaires have used as strategy to build wealth and the word is bascially 'leverage'. Tippically, there's nothing wrong with that, but the average amercian doesn't have the financial teachings from a young age to be able to leverage properly. They don't take the extra money saved from paying additional to the mortgage payment and invest it, rather they go to the closest Best Buy and finance a television for 0% for their new home, and then have the idea 'wow!, same as cash', and uses that extra money at the furniture store at 0% again. They're sent a bill for the minimum payment, thinks "that's it!" and before you know it 12 months has past and they're interest rates on purchases is now 24%.

See, this is a mental game. Period. You've mentioned Ramsey as an example, and like he has said if we knew math the correct way then there wouldn't have been so many foreclosures and meltdowns. The Big Megabanks for example, as Clark Howard calls them. They leverage their eyeballs out, and what happened? Failures. But we as the typical households can't expect that bailout, I take that back, it's called bankruptcy.

I'm a avid financial talk listener, and over the years the tunes of Suze Orman, David Bach, and others have really changed. They were outrageous believers of leveraging debt to investments, but in the 2008-2010 timeframe, their advice rolled a 180 degree flip. Orman arguing for a 'cash movement' and Bach signing "Debt free for life" books. These are not more than financial personalities, true. But they trend topics towards Americans feelings and that feeling is that banks have screwed us enough.

Using your same example for Liam and Tabatha, but let's imagine they did this in the mid 90's, by 2008, Tabatha has about paid up her mortgage if not already complete and now is able to beef up every account she has. The next year rolls around when unemployment rates rocket past 9% and both are taken under the knife for job cuts. Which do you think will come out better? Tabatha with nothing to pay but food and utilities (plus taxes of course) or Liam who's juggling a mortgage payment for a 200k house with 15 more years to go, burden with the thought of draining her investments (cashing out prematurely in panic when the markets are down mind you).

Debt can be a tool, but Mr. and Mrs. Average Joe isn't trained well enough for it. I'm not saying that no one is capable of it, but let's face it, true financial discipline is is rare.

Nadege Uwase said...

Wow, I would have never thought of it this way. But I guess it makes sense, you always here about how your should pay yourself first. It makes sense the Liam is looking to the future and not just now. Thanks for sharing this.

Dean D said...

Agree with you most of the time, but this one doesn’t quite work for me.
Despite this example, I have no regrets about paying off our house in ~10 years while still saving and investing.
Key: buy less house than you can “afford” and pay it off in a responsibly timely way, so you’re not paying 3X the price of the house in order to borrow money for 30 years.
Save and invest at the same time, living "below your means.”
Admittedly, our family has been very fortunate with steady jobs and stable income.
Do with less now, so you can invest AND pay off your house. Having no mortgage gives you remarkable financial flexibility.

Selena Manchester said...

Haste makes waste. Getting out of debt and paying off the mortgage is good, but rushing out to do so might be counter-productive. In the end, it does feel like a complex mental game. You have to plan accordingly, and find the best routes to deal with the situation. Having extra money and maximizing your funds can be a good idea.

Gmac Home Loans said...

Behind the argument for not paying off your mortgage is the reasoning that you could invest the extra money and earn a higher return, while keeping your money more liquid. That may have been a good reason in the past but the rate of return on investing now is more questionable, compared to the fact that every dollar paid to reduce a mortgage balance provides a guaranteed return equal to the interest rate on the mortgage.

Randy Robinson said...

It's true, debt can neither be all-good nor all-evil. It still depends on who spends the money and how it is to be spent. Like in this issue with mortgage, a person should balance finances to have enough money to repay the debt and buy necessities.

Mike Bishop7 said...

Great post, thank you for sharing this with us! home retention team

Lora Holmes said...

Debt has always been associated with a lot of negative stuff. Hence, people want to avoid it as much as possible. But if it’s handled properly, debt can actually give you leverage. Liam’s strategy is the perfect example of this. Instead of prepaying the mortgage, he invests it in something that goes up in value. In the end, he’s the one that has more flexibility in paying off his mortgage.

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Fermina Dazey said...

“I hope to never pay off my mortgage...“- Don't we all? Hahaha! Anyway, what you shared here is very interesting. I definitely see the huge difference between Liam's and Tabetha's situations. Indeed, the concept of compound interest is something all of us should think about.

Pay Lay Ale said...

Assuming an 8% return is something that has only happened during a small part of human history (1980-2000). It can't be sustained on an indefinite basis. In fact, the return for the S&P500 since 2000 is only 26%. That's less that 2% per year!!!!! That's about half the return of what a 15 year mortgage would be!

http://www.advisorperspectives.com/dshort/charts/markets/SPX-Dow-Nasdaq-since-2000-nominal.gif

Of course the DJIA isn't really a valid comparison over time. Shittybank, The Notorious AIG, and Government Motors are no longer in the DJIA, for instance.

Alica Jack said...

This is the toughest part, paying off your mortgages. Mortgage calculator is the best source to manage the mortgage payments.