Investments vs. Debt-Free Living

Was just listening to a guy named Rick Edelmann on the radio, who’s a staunch opponent of paying down mortgages early, and tosses out the CW on debt-to-income ratios as justification. Here’s the rationale:

Extra payments make the bank rich. Take that extra money (particularly the 13th-month payment of a 15-yr mortgage plan), and put it in annuities. After 20-30 years, you’ll have so much that you can lump-sum any remaining out of your mutuals, and still have lots of money left over. Plus, you’ve got liquidity the whole time.

I wonder how much the money managers are paying him to give that advice.

Let’s do the math. But we’ll leave the math out for now. If I pay a thousand every month, and a large proportion of that is interest rates, then everything I pay down ahead of time as a principal payment cuts those interest rates. This yay-hoo’s strategy is to hope that the yields from the mutual fund outpace the interest paid on the mortgage. Maybe yes, maybe no.  Money managers give advice that’s good for money managers.  They want to play with your hard-earned.  But what if you need your hard-earned?

But if I pay off my house within five years, which can be done if you’ve avoided affluenza and bought within your means (we’ve been in the house for three now, and would be a bit better than 60% paid off if our little castle hadn’t required vast swarms of repairs and updates), then once that’s done, you’re pocketing your paycheck.

So, tell me again, how making small interest rates and being shackled to a monthly payment is better for building wealth than taking home the entirety of your paycheck, and then putting as much of that as desired into investing? Tell me how anything is more liquid than pocketing the entirety of your net paycheck?

Plus, you’re less liquid long-term, because your ability to both make your mortgage payment and put in the mutual fund payment (and remember, if you’re not paying into your mutuals, you’re by definition whacked under his scheme) is dependent upon keeping up your regular income at your job.

Well, what if you turn 50 and get laid off in yet another round of the ubiquitous age discrimination? If you’re debt-free and have a bucket of cash drawing interest and some investments here and there… you’re fine. Take six months, see your kids,drive around the country, and either get rehired in a place that will respect your experience, or take the hobby job you’ve always wanted anyway. If you’re a two-income person, you’ve been living off one and pocketing the other (even with kids) anyway, so by year five of your mortgage-free existence, even a complete schmoe can have their FDIC-insured maximum of a hundred grand in the bank as insurance.

Under the CW, you’re screwed. You’re a serf, shackled to your job in order to make ends meet. Maybe you like your job. GREAT!! But wouldn’t it be nicer to work at a job you like without having to do so come hell or high water, and have the actual freedom to make choices for you, rather than choices that make money managers rich?

Don’t be a peasant.

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19 Comments

  1. Mike

     /  January 14, 2007

    I have heard that arguement before. I never brought into it myself. I was on a “pay more now and cut 5 years of paying off your mortgage” program and while it made things a bit tight on my end, I pay off early and then am good to go. I agree with the moneymanager aspect of this little ditty, they are out for number1.

    Reply
  2. Alex Morgan

     /  January 14, 2007

    As someone who got the very short end of the stick when I sold my home last year, one has to assume that your house will gain in value and you can recoup what you “invest” in your house that you’ve paid off as principal, rather than capital…but…
    1) If you sell your house at a loss, you LOSE all the money you put into it, including any repairs/upgrades, and principal from the mortgage.
    2) The losses are NOT tax deductible.

    Only gains from profits of selling a house are tax free – so by paying off quicker and selling your house BEFORE the mortgage is paid in full you can potentially gain more profit than you may have by investing – since you have to pay taxes on the investing. Or if you decide you have the place of your dreams – take your time and extend out the tax savings. You could gamble and win on the stock market with annuities, but those could tank too. Tax deductions are a tad more stable.

    However, pay off slowly and you can continue to deduct all that interest off your taxes every year. Like all investment strategies, it can be best to take a balanced approach. So I pay on time, rather than accelerated, for my mortgage to get the best in tax savings, but I pay my student loans off faster – because due to my tax bracket I can only deduct so much of that interest. Same thing with cars – I pay them off quickly so the monthly car payment can go to something else, and if heaven forbid I need a loan in an emergency, I have more capital to bring to the table for collateral on a loan (cars fully owned, not so old).

    Reply
  3. Don’t forget that you can only deduct so much of that interest payment — all the rest of it is gone. Your argument is sound, though. Part of what makes Russ’s argument work is that they’re in Irving TX, a place that has seen virtually no real-estate appreciation save what the local tax franchise has been able to “revalue” people’s homes to in order to up their revenue. If you have a modest house in a place with very low price volatility, or, if you’re pretty certain you can keep your home forever (thus making the house a purchase, not an investment), it makes a lot of sense.

    Reply
  4. happycrow

     /  January 14, 2007

    A House is not an investment. A house or apartment represents what it costs you to take up space. If you can flip a house in a market that is unstable, great. Otherwise, it’s a drag on your life that should be erased asap…

    Reply
  5. Crow: You are making way too many assumptions here to justify making such blanket statements. The fact of the matter is that in some situations you are correct, in many others Ric Edelman is correct.

    “how making small interest rates and being shackled to a monthly payment is better for building wealth than taking home the entirety of your paycheck, and then putting as much of that as desired into investing? ”

    Assume that someone being evaluated for these options has extra liquid monies to put against their mortgage.. I think that’s a required and safe bet for this topic. Where I feel you are going wrong is that you are assuming in your scenario that if the person does not put the extra monies against their mortgage to pay it off early, that they will spend it frivolously rather than save or invest it.

    Of course if someone squanders the extra monies, they will come out further behind. That is a given. However, punch the numbers into a financial calculator and look at the FV. If someone can obtain a higher return on the extra monies by diverting them to an investment vehicle rather than paying off the mortgage, then they will absolutely be better off under Edelman’s strategy. Your ’50 year old who gets laid off’ scenario fails to take into account that under Edelman’s recommendation, that 50 year old is ALSO sitting on a big wad of cash. In fact, in his scenario, that 50 year old could likely just pay off the house any time they so choose; or at least, pay off the equivalent amount they would have paid down.

    Example: If you have a fixed-rate mortgage at 5%, then it makes little sense to pay off early, particularly nowadays with simple money market accounts paying 4-5%.. Factor in the income tax deduction from the mortgage interest and it should be easily beatable.

    Edelman (I have followed the guy a bit) has never made a blanket statement of “it is always better to pay the minimum on your mortgage”, nor would he.. that would be asinine. Rather, he always advises that people look at their individual scenarios. What he puts forth is a general strategy, one that is pretty solid for most people:

    1. Most people who have fixed-term mortgages locked them in when the rates were at their 20-30 year lows. Thus, its not terribly hard to beat those rates. Obviously, this advice wouldn’t apply to someone in an ARM that is going to balloon on them, but Edelman would be unlikely to suggest it to them in the first place.

    2. Most real estate is not in the appreciation vacuum that you live in. Across the country, real estate has been going up at rates of between 4-7% for the past 50 years.

    3. Real estate absolutely IS an investment, not merely rent as you treat it. Over the past century, real estate was by far the single most value-stable item that someone could own.

    Anyway, I’m not fully disagreeing with you because the reality is that it all depends on the individual scenario. However, your blanket assessment of ‘do this or you’re being a peasant/serf’ is no more accurate than the counter ‘do anything it takes to get a mortgage, ARM or fixed, property property property!’.

    Reply
  6. Zathras

     /  January 15, 2007

    It’s all a question of risk. If you can get a better return on your money elsewhere than the interest rate on your mortgage, than that is the way to go. It’s a simple as that. The difference is that with paying money towards principal on the house, you are certain of the return you get–there is no risk. For most other investments, to get that expected rate of return, there will be some risk involved. The only investments that are essentially risk-free are CD’s and T-bills, which are almost certain to have a lower rate of return than your mortgage interest rate.

    It is a mistake to think that you have to make a choice, and you are locked into that choice. If you want to get out of the mortgage debt later, that’s fine; you just have to transfer your investment money (as long as it’s not in an IRA) to the house. If you have put it in your house, and you want to invest elsewhere, get a home equity loan. It’s all fungible.

    Reply
  7. Zathras

     /  January 15, 2007

    Actually, T-Bills have an expected rate of return of about 5%. Since this return is tax-free, the effective rate of return is over 6%, which might be better than your mortgage.

    Reply
  8. happycrow

     /  January 15, 2007

    Edelmann came out yesterday and said “never do this” in regards to paying down the mortgage early. The “minimum” is my lousy choice of phrasing.

    You’re right: if you’re in an appreciation zone, you’re playing by different rules. And I certainly did not intend to imply that one shouldn’t also save and invest. The initial assumption here, and directly stated in Edelman’s show, is that this is a house you’re going to be in for a long time. If you’re just flipping RE, then you’re just flipping RE. Totally different scenario.

    Reply
  9. I see Real Estate as both a stable homestead and an investment. The ideal scenario for anybody investing in Real Estate is to have a fully paid off homestead and then a house or two or more as investment property — to rent, to flip, to whatever.

    That’s what my aunt in the LA area has done in the past, and as a result she’s the “rich” one on my mom’s side of the family.

    Reply
  10. Wow.. Ok, I’m shocked that he said ‘never do this’.. That’s pretty bad considering the ARMs that some people got themselves into.. Ick..

    Still, you only have to live in a house for two years for any profits to be tax-exempt (up to some limit that far exceeds what 99% of the populace would see).. So you don’t have to be ‘flipping’ RE for a quick profit for it to be effective..

    Whether you’re in the house for 2 years or 30, if you’ve got a 5% mortgage and can earn a risk-free (Zathras’ introduction of risk is a good point) return > 5%, then the answer is simple: don’t pay off the mortgage.

    Me, I’m getting 5.48% from my bank on a short-term note as part of my ‘no risk’ section.. Wouldn’t make any sense to divert that money to a 5% mortgage.

    Reply
  11. Superbiff is posting links and discussing mortgages… therefore the spam filter is freaking out on him. A posting delay with Superbiff’s comments does not necessarily mean he’s dropped the conversation. — ed.

    Here’s something interesting that I can’t quite figure out.. I went to a few mortgage calculation sites and ran the following scenario (Note: the calculators all agree on the #s to within $2k which I attribute to rounding):

    Say you have a $350,000 home loan at 5% interest.

    Your standard 30-year payment is going to be $1,878.88.
    A 20-year payment schedule requires an extra $436.60/mo = $2,315.48.

    Paying your loan off in 20 years will save you $120,680.76 (or $122,995.45 depending which calculator you use).. Nice scratch, right?

    But here’s the really weird thing.. Take that same $436.60/mo for 20 years and pop it into a ‘Future Value of Deposits’ calculator. Even at 5%, the return exceeds the benefit of paying down the mortgage.. Future value of $436.60/mo * 240 mo @ 5% interest = $179,457.30. That means you come out $57,000 ahead by depositing the money instead of paying off the mortgage early.. And that’s before income tax deduction is figured in..

    Anyone know the answer to this? This has to be wrong (I would think that the two should break even other than a difference in when the interest is compounded) but I can’t figure out how.

    http://www.hsh.com/calc-amort.html

    http://www.easysurf.cc/vfpt2.htm#dsdmi

    (Pick whichever you like; those are just example calcs I found).

    Reply
  12. happycrow

     /  January 16, 2007

    Yeah, it was part of a “16 things I’ve said for years” speech, and was presented as a “never.”

    Hrm… if you’re selling short-to-midterm, that depends on appreciation, then.

    But clearly, if you’re NOT intending to sell, then appreciation is only an issue vis-a-vis taxes. In which case, you’re not simply working with your return, but:

    Your Return against Your interest rate + Inflation

    (If you intend to sell, then inflation is totally axed and then some by price appreciation. But he was *specifically* not talking about that scenario, but rather one in which you’re staying in your house long-term.)

    In which case, you’ve got a serious liability against your balance sheet: you’ve built no security in the process, and have to pull really GOOD returns to balance the sheet. Those kind of returns are usually not risk-free.

    Now, if said catastrophe wipes out your house, that’s something else entirely… but at least in that case you’ve hopefully got an insurance company that’s not going to raise the bar on you like some of the Katrina victims in MS.

    Reply
  13. Sure inflation enters into it, but there’s still more to it.. I mean, if we want to get really technical, it’s:

    Interest from investment account – taxes on that interest – inflation + income tax refund on mortgage interest (Note: this can be a big deal, my mortgage interest *changes my tax bracket*, resulting in a 3-4% return on all monies up to that point – this happens for a LOT of people and is more likely the less you make)

    VS

    Interest saved from the mortgage payment


    Go to one of the many calculators online that shows you the effect of paying off your mortgage early.. I put in sample #s of $350,000 at 5%. The 20 year payoff requires an additional $436.60 per month on top of the $1878.88 normal payment. This works out to $104,784. You pay off 10 years early and save yourself $122,995 in interest.

    So, after 20 years, you don’t have anything in your savings account (beyond what is counted outside of this comparison), but you have paid off your home in full. Total Paid: $555,715.20.

    Now here’s where it gets strange.. Go to a “Future Value of Deposits” calculator and put in the same scenario.. That $436.06 each month for 20 years at 5% annual return. In the end you have $179,235.34. Now, obviously you haven’t paid off your mortgage. Back on the same 5% scenario as above, at the 20 year mark, you still owe $177,142.94 on your mortgage.

    In other words, you can pay off the mortgage in full and still have $2,092.40 left in your pocket.

    I can’t figure out WHY this is though even though I’ve checked the #s repeatedly; all the calculators come out the same.. I would think that a 5% mortgage vs a 5% investment should cancel each other out.. The only thing I can think of is that it is some quirk of how compound interest works but I am baffled as to exactly how.

    Yeah, one can say “ah but you had to pay taxes on that interest” but I’m ignoring that for now due to the fact that you get a tax deduction on the mortgage interest paid as noted above.. And in this case, that’s pretty significant, to the tune of $278,672.04 at that 20-year point in the loan. At even a 20% income tax rate, you’re talking about at least another $55,734.41. That’s enough of a difference that I am starting to find Edelman’s scenario to be very believable.. Factoring in the tax deduction, at even a 3% rate of return, you STILL come out ahead..

    It may be skewed based on the numbers I put in but given its all multiplicative math and the same compound interest patterns, it should hold true no matter what the principals and respective rates.

    Reply
  14. The figure is suspiciously close to a mortgage payment. Did said calculator adjust for inflation losses? It may have, but one of the reasons I consistently hear T-bills getting dissed is that they only barely beat interest rate inflation. Granted, we’ve got some pretty historically low levels of inflation going on, since the Feds are doing it on the sly with our exchange rates, but even at 3-4% a year, that counts.

    Reply
  15. I’m not sure what/why you mean by ‘suspiciously close’.. I encourage you to take a look for yourself.. There’s tons of mortgage calculators online where you can put in your principal, mortgage limit and then tell it ‘Show me the normal 30 year scenario, along with 15 and 20 year options’.. Then compare it to a Future Value financial calculator based upon monthly deposits at a particular interest level.. That’s where I obtained the numbers..

    Financial calculators don’t adjust for inflation; that would be impossible since inflation is not a constant or derived from a formula.. So, yeah, its not going to be quite as good as what I put above in terms of real dollars, but the #s are striking enough that I don’t think the scenario can be dismissed.

    Reply
  16. Or a math error? I got, as a total payment at 20 yrs, of 554,160, vs 676,396.80 at 30 yrs. Maybe I left off a decimal somewhere…

    I think part of this goes into the hyper-aggressiveness of the LQ and myself, as well. I couldn’t pay off a house in your area in five years — period. That’s 6k per month — more than my household gross. But at house prices here, we’re well on our way. And that regional variation, maybe even more than appreciation, may be what’s causing the disconnect. Five years’ accumulated compound interest is nice, but it’s not a big difference, compared to cutting out 15-25 years’ interest.

    Reply
  17. “suspicious in this case” is just the number involved, even though without that variable, I think the scenario’s in trouble…

    hrm. Gotta get to bed. catch you tomorrow.

    Reply
  18. And in this morning’s early radio spot, Edelman said that you should only invest in stock mutuals and not diversify (and that last is a direct quote), because if you keep investing steadily, you’re diversified in time, which is just as good as being diversified in investments. wtf? That’s the kind of boom-time thinking that lost people their shirts in the Dot-Bomb…

    Reply
  19. Chris — as regards the FV calculator, it’s generally not possible to invest with a return at the true cost of money; even money-market accounts chisel you there. The differential between money-cost and your return is the life-blood of deposit organizations. Same way as it’s almost impossible to borrow at the cost of money (unless you’re a bank).

    The general inclination is sound though. I suspect the real issue is, as Russ was trying to point out, what the rest of the equation is. If you live in an area where housing is dirt-cheap and your mortgage poses very little risk to you, then perhaps it’s better to invest it instead as per the rest of the thread.

    With the FV-thing, though, to do that right you need to do a monte-carlo analysis of different long-run interest-rate scenarios. The one thing we DO know is that the long-run cost of money will not remain constant over the life of the mortgage. With a fixed-rate mortgage, this’s largely in one’s favor, since rates have been so low. With an adjustable, not necessarily so.

    Reply

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