Heraclitean River

You can never step into the same river twice. . .

Over the past year or so, I’ve explored a number of issues related to mortgage overpayment strategies, particularly issues that should be considered before simply piling excess cash into your mortgage.  Here are links to all the posts in the series, with their topics:

  1. Inflation
  2. Other high-interest debt
  3. Saving for retirement
  4. Emergency funds and insurance
  5. Selling soon
  6. Other investments
  7. When you should pay down your mortgage

This post is part 7 of 7 in a series entitled “When not to pay down your mortgage,” which outlines many scenarios where paying extra on your mortgage isn’t necessarily the best financial strategy.

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This series of posts has attempted to identify reasons why the standard advice that putting extra money into your mortgage may not be the best financial strategy in all circumstances.  Nevertheless, there are also plenty of situations where the standard advice is still relevant.  In this final article, we’ll consider some reasons to pay down your mortgage. continue reading…

This post is part 6 of 7 in a series entitled “When not to pay down your mortgage,” which outlines many scenarios where paying extra on your mortgage isn’t necessarily the best financial strategy.

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In previous installments of this series, we considered your mortgage money as if it were “in a vacuum.”  When inflation or equity payments were considered, we didn’t consider what you might do with your money otherwise.  We just compared the returns on your investment essentially to what you’d have if you just kept the money as cash.

Of course, most people don’t do that.  At a minimum, if you don’t overpay on your mortgage, you might put the money into a money market account or something.  For the past few years, those tend to earn less than 1% interest or so, but that’s still better than 0%.

As mentioned in previous posts, there are some “no-brainer” situations where putting your money elsewhere is a better investment than putting it into your mortgage.  If you have credit card debt or other loans with very high interest rates, definitely pay those off first.  If your employer gives you a “match” for your retirement, be sure to take advantage of that to the greatest degree possible, because getting an immediate 100% or 50% return or whatever is better than any other guaranteed investment out there (including your mortgage).

But let’s say you’re already paid off high-interest loans and credit cards, and you’re getting your employer match.  You have an emergency fund and adequate insurance.  Should you begin pumping money into your mortgage? continue reading…

There seems to be a lot of confusion in the past few days about what exactly will happen if the Boston Marathon suspect isn’t “given his Miranda rights.”  On the one side, you have a lot of liberals and the ACLU claiming that his “rights are being taken away.”  On the other side you have conservatives wanting to treat him as an “enemy combatant” and remove his rights.

Neither of these things have much to do with the “Miranda warning.”  Your rights don’t disappear just because you aren’t read them.  Let me explain. continue reading…

This post is part 5 of 7 in a series entitled “When not to pay down your mortgage,” which outlines many scenarios where paying extra on your mortgage isn’t necessarily the best financial strategy.

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The previous articles in this series have dealt with considerations that should be important to every home buyer: preparing for emergencies, saving responsibly, and making informed decisions about how to prioritize debt payment.

What we haven’t yet considered, though, is the role of real estate as an investment.  For many people, the goal of getting a mortgage is ultimately to own that home.  If that is your goal, this article may not be as relevant to you.  But if you don’t necessarily plan on staying in the same area for the long term, or you plan on upgrading to a larger home at some point, your goal is NOT owning the home you are currently paying a mortgage on.

Instead, you need to consider payments on your mortgage as part of a larger investment strategy.

Seeing the investment return when you sell

If you plan to sell your home before your 30-year or 15-year mortgage (or whatever length) has come to term, your goal should be to maximize the return on your investment.  If you purchase a home with a 30-year mortgage, and you plan to sell in 10 years, it doesn’t really matter if you own 30% or 70% of the house after 10 years.  What matters most from your overall financial picture is whether you come out with a strong return on your investment.

For the moment, let’s consider a very simple case where you have a “magic” loan that requires you to pay no interest.  (This might actually happen in real life: maybe you made a deal with some family members to pay them back within 10 years.)  Also, we’re not going to consider the other costs of owning a home: taxes, home insurance, maintenance costs, etc.  Those will stay the same regardless of your mortgage payment strategy, so they’re not going to change the present analysis.  (However, they do play a role in deciding whether you should even buy a home in the first place.  In cases where you plan to own a home for only a few years, you might be better off renting rather than buying.  That’s a separate issue from what you do once you already have a mortgage, so it’s not particularly relevant here.)

We’re also going to assume, as we have in previous posts, that you have enough equity in your home so you don’t have to pay PMI (generally at least 20%).  PMI is an additional complication that can really cut into your rate of return, so often it’s best to try to achieve that level of equity as quickly as is reasonable.

Okay, so let’s take some extreme cases.  Say you buy a house that’s worth $100,000.  You put a 20% down payment on the house, i.e., $20,000.  You owe some “magic bank” or family member $80,000.  Again, we’re going to first take a really simple case where you don’t have to pay interest and don’t even make payments.  (We’ll get into the details later.)

Let’s say that over 10 years, the value of your house increases to $150,000.  You sell the home.  $80,000 of that $150,000 goes to pay off the loan.  You’re left with $70,000.

If you wanted to think of this as a return on an investment, you put in $20,000 at the beginning of the 10 years, and you walked away with $70,000 at the end.  Your money effectively was increased 3.5 times, or an overall return of 250%.  That’s an effective annual return of 13.3% on your investment for 10 years — a rather high number.

Now, let’s say that instead of making a 20% down payment, say you made a 50% down payment.  After 10 years, the home is worth $150,000.  You sell it and pay off the other $50,000 remaining on the loan.  You walk away with $100,000.

At first this may sound better: you walk away with more money.  But you also put more money into the house to begin with.  For a $50,000 initial investment, you came away with $100,000.  You doubled your money, so your overall return is 100%, or about 7.2% annually.  That’s still a good return, but it’s significantly less than you had with a smaller initial investment.

The lower investment in your home can (under some circumstances) result in a higher effective return.  Note that in both cases the amount of money that goes in and comes out is exactly the same overall: in both cases, you eventually pay the $100,000 purchase price, and you eventually sell the house for $150,000.  Your net profit in both cases is thus $50,000.

The difference is that you put in varying amounts to get that profit.  If someone gave you a choice: (1) invest $20,000 and net $50,000 profit in 10 years or (2) invest $50,000 and net $50,000 profit in 10 years, which would you choose (assuming there was equal risk)?  You’d obviously go for the first case.

And that’s an important consideration for short-term owners.  Your goal is not to have a high percentage of equity at the end of 10 years: it’s to get away with the best return with the smallest amount of investment.

Now, of course, we made a lot of assumptions here.  In many cases, what I’ve just described may not be a great strategy.  Let’s think about some other scenarios.

Depreciating home value

The most important assumption we made above is that your house actually went up in value after 10 years.  For a well-maintained property in a desirable area to live, property values generally do gradually trend upward.  How much upward is highly variable, but I’ve seen averages over the past 50-60 years fall in the 4% annual return per year for residential property on average.  In desirable areas, it might be more like 5-8%, while in many areas it will be lower than 4%.  Only in the cases of real estate bubbles, speculation (often in previously undeveloped areas), or property neglect, do you tend to see significant decreases in value for the long term.

Nevertheless, many people have seen home values drop significantly since around 2006, so it’s important to consider the case of a depreciating home value in our calculations.

Let’s again take an extreme scenario.  Before we had a home that gained $50,000 in value; now let’s consider a loss of that magnitude.

Suppose again you buy a home that costs $100,000.  Suppose you make the $20,000 down payment.  And now suppose that after 10 years, the home has lost $50,000 in value, so it is only worth half of what it was before.

When you go to sell the home, you only get $50,000 back, but you need to pay off an $80,000 loan.  So you need to come up with $30,000 just to sell your home.  In common language these days, you were “under water” in your home loan.

Your return on your investment isn’t just zero.  It isn’t even negative 100%, because you clearly lost more than your $20,000 investment.  In this case, it’s as if you doubled-down at a casino and need to cough up even more money just to get out of the game.

Instead, suppose you initially put down a $50,000 payment, as we considered before.  In that case, when you sell the home, you get $50,000 from the sale, which you need to immediately use to pay off the remainder of the loan.  You walk away with exactly $0.

Again, in both cases, you lost $50,000.  That was your net loss.  But the lower down payment magnifies the effect of that loss, requiring you to come up with more money just to get out of your investment (obviously the least desirable situation).

What we know so far

When a home value goes up, you get a greater return per amount invested by having lower equity.  What a home value goes down, you get a greater loss per amount invested by having lower equity.

Having lower equity will, in some sense, magnify the effects on your investment.  Therefore, it generally only makes sense to deliberately keep your equity down to reap a higher investment if you’re fairly confident of an increase of property value.

This may sound a bit like gambling, and all investments are gambling to some extent.  But do remember that in these simplified cases, the NET gain or loss is the same in all cases.  You’re still gaining $50,000 at the end or losing $50,000 at the end OVERALL, regardless of the strategy.  It comes down to a question of where the best place is to put your money.  So, if your home value is going up, and if you haven’t achieved some of the goals discussed in previous posts like having an emergency fund, insurance, and retirement savings, it’s perhaps a better bet to invest more in those things before worrying about an increase in equity.

Of course, that’s not the whole story.  We haven’t factored in the interest yet.

Returns in real mortgages

When we consider the amount paid in interest to hold a mortgage, most of the returns we saw previously don’t look so good.  Nevertheless, under normal circumstances (i.e., not in a real estate bubble) with low interest rates (as we have now), lower equity still may not be a bad thing for investments.

Suppose, for example, that you have a 4% rate on a 30-year mortgage.  Suppose that you get a reasonably good (but not stellar) 5% increase in property value annually.  Suppose that you start out with a 20% down payment (to avoid PMI).

The calculations now are rather complex, but in the end, you would still see a higher effective return for a short-term sale by making the standard mortgage payments each month, rather than by overpaying.

Suppose you plan to sell your home after 10 years.

If you pay your standard payment, you would end up with a 51.7% return on the money invested over 10 years (about 4.25% annual return).

Now, suppose you overpaid your mortgage by increasing your payments by 20%.  (For example, if you had a $500 standard payment, you paid $600 every month instead.)  In that case, your effective return on your money when you sell after 10 years would be 48.2% (or about a 4.01% annual return).

If you increased your payments even further to build equity and paid double your standard mortgage payment, in this scenario you’d end up with a 39.8% return over 10 years (about 3.41% annual return).

It’s important to note again that this advice applies only to short-term ownership.  If you overpay your mortgage each month, you will eventually pay it off early.  And once you’ve paid off your mortgage, the interest no longer cuts into your returns, while your home value may continue to appreciate.  That means that eventually the overall return will in fact be better when you overpay, since you end up paying less interest overall.

For the scenarios discussed here, your return for a 20% overpayment will surpass your return for a normal payment around 24 years into your mortgage.  If you double your mortgage payment every month, the break-even point is about 15 years: after 15 years of ownership, your overall return on investment will be greater with the doubled payment versus the standard one.

This is confirmation that this the strategy we’re discussing here is only relevant when you plan to sell early.  The longer you own your home, the less relevant these ideas are.

Also, let’s emphasize the assumptions here: this was for a 4% rate on a 30-year mortgage, with a 5% gain in property value.  The returns will obviously be quite different depending on individual circumstances.  As a rule of thumb, this strategy is strongest when your expected gain in property value is at least the percentage of interest you’re paying on your loan.  You’ll still get higher effective returns on your money invested by not overpaying with your 4% interest rate if your property only gains 4% every year in value, instead of 5%.  You’ll still barely get it if your home only gains 3.75% annually.  This should be common sense, but if your house is gaining value at significantly less than your interest rate, the additional interest you’re paying in will trump any additional returns by keeping equity lower.

A final practical concern about selling your home and liquidity

So far, the trade-offs with low equity seem to be hedging your investment return.  But do keep in mind that having cash on hand (rather than stuck in a mortgage) can be critical during a home sale.  From a practical perspective, many people end up in a situation where they are trying to sell their home at the same time as they are buying a new one, often within a small time window (because of a move for a job or something).

In a scenario like that, you would generally be much better off with cash available.  You might be able to make a substantial down payment on a new home, even before you sell the old one.  You might be able to have a cash reserve allowing you to continue easily making payments on your mortgage for a few months or even a year until you get a good offer on your old home.  Sometimes being able to wait for a good buyer can earn you thousands or tens of thousands of dollars extra in your sale, so having that flexibility can be a huge advantage.  (In many cases, it vastly outweighs the depreciating interest you’re generally saving on your loan by overpayments.)  If all of your excess cash was thrown into your old mortgage, however, you may have little cash around to navigate a high-pressure sale situation.

So beyond any investment advantage, keeping money in a liquid state when you’re gearing up to sell your home in the next few years is a really good idea.

Conclusion

If you plan to sell your house in the short term (5 to 10 years), building up equity is often not that beneficial just for the sake of equity.  If you are fairly confident that your home value is rising annually, there may also be good investment reasons why lower equity can actually help your overall portfolio.  Whether this is a good decision in your particular case will depend on the rising value of your real estate investment when balanced against the losses in interest that you pay on the loan.

With all of that said, keep in mind that inflation already can make the long-term difference in interest payments between payment strategies less relevant, as discussed in the first post of this series.  In the end, it comes down to a comparison among three different rates: your mortgage interest rate, the inflation rate, and the rate at which you house gains (or loses) value.  If your interest rate is below or around the inflation rate, overpayment may not be a good strategy.  As discussed here, if your interest rate is below or around your home’s appreciation rate — and you plan to sell soon — overpayment may not be a good strategy.  Making the exact call for a particular situation is difficult and requires some more complex mathematical analysis, but these overall trends are important.

Ultimately, what matters when considering an overpayment strategy is what you do with the money if you don’t use it to pay down the mortgage.  The previous posts in this series discussed some critical financial needs that may need to be addressed before paying down a mortgage.  If you have all those needs covered, though, you still need to figure out what to do with the rest of the money if you don’t put it into your mortgage.  A comprehensive investment strategy needs to take that into account, and this topic will be considered in the next post of the series.

Go to part 6: Other investments

Disclaimer: This is not intended to be professional financial advice, nor does it apply to all people in all situations.  It’s a good idea to consult a professional financial advisor before making any major changes in your finance management, because individual circumstances will often affect the choice of strategy.

In case you haven’t heard, there’s a doctor named Kermit Gosnell on trial in Philadelphia for murdering seven infants after botched abortions, along with various other crimes.  Aside from the local Philadelphia press and various pro-life blogs, little has been said about this story nationally until a few days ago, despite the fact that the trial has been going on for weeks.  A particularly damning photograph shows an almost empty reserved press section at the trial.

The mainstream press has not reacted well to those asking why the story hasn’t been covered.  As the story spread over Twitter, there have been plenty of voices trying to excuse the situation, strenuously arguing against a “coverup.”   Of course, open letters from conservative sources asking the mainstream media to cover the story went unheeded for almost a week, as stories like the Rutgers basketball fiasco got significant coverage as a literal baby-killer went unnoticed. continue reading…

In common everyday language, the word agnostic has come to mean “I’m not sure about the whole religion thing.”  Many people who don’t really believe in a deity prefer it to the term atheist, which can sound harsh to some.

While agnostic is often used today, it has a precise technical meaning that is somewhat different from the common definition.  It allows a certain kind of distinction to be made about our knowledge and beliefs that are difficult to make with other terms, so it’s useful to review the actual definitions.  Also, as we’ll see, it’s actually possible to be an agnostic atheist or even an agnostic theist. continue reading…

This post is part 4 of 7 in a series entitled “When not to pay down your mortgage,” which outlines many scenarios where paying extra on your mortgage isn’t necessarily the best financial strategy.

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In previous articles, we identified two of the highest priorities in financial planning that should generally be addressed before making extra payments on a mortgage — high-interest debt and employer matches to retirement funds.  There is one further high priority that should take precedence over most other investments: preparing for disaster.

Build up an emergency fund

Everyone should have at least 3 to 6 months (and preferably 12 months) of income saved up somewhere in case of some sudden financial need: job loss, major home repair, uncovered medical expenses, whatever.  At least 3 months of income should be kept in a relatively liquid state (such as a savings or money market account), so you can access them without a huge amount of trouble when a sudden need arises.  The rest of the emergency fund can be put into low-risk investments with guaranteed returns, if you like.  A CD may have an early withdrawal penalty, and it may not be a high return, but it gives a little growth in your funds while still guaranteed not to lose value when the market crashes and you just happen to be out of a job and need the money the most.

If you pay down your mortgage before building up your emergency fund, you may find yourself in greater trouble when disaster strikes.  You may think the extra equity you have in your home will help you, but it’s not going to be easy to get a home equity loan when you don’t have a job or you have sudden huge expenses that the bank can see which may prevent you from even making regular payments on your original mortgage.

With the emergency money in a savings or investment account, you are free to do with it as you wish, including, for example, continuing to make payments on your mortgage for a year or more when you’re out of work.  If all of that money has already gone into your house, and you have no cash reserve, you may end up in a default instead.

That’s not to say that you shouldn’t work toward equity in your home, but after paying down very high interest rate debt (like credit cards), the next priority should usually be establishing a emergency fund in reserve.  That will allow much more flexibility in down times than any equity locked up in your house.

Have adequate insurance

Emergency funds are great for dealing with minor disasters, but for serious situations that will cost you more than about 6 months’ worth of income to deal with, you probably need insurance.  People with mortgages will already have homeowners insurance, but they may not be adequately insured for other major catastrophes.  Life insurance, disability insurance, and long-term care insurance will be incredibly important for covering financial gaps when a spouse or parent dies or is unable to work.

Particularly for parents, a life insurance policy for a few thousand or even a hundred thousand dollars is usually not enough.  Be sure that your life insurance and disability insurance are sufficient to keep the household running until children are grown.  Most people never need to use term life insurance, and that’s the best-case scenario: you get to be with your kids as they grow up.  But what happens if you don’t?  It may seem expensive, depending on your age, sex, and health, but it will do a lot more to help your family in the event of a true disaster than just about any other investment.

One important money-saving note about insurance with deductibles: go for a high deductible in most cases.  That’s what your emergency fund is for.  And that’s why emergency funds and insurance go hand-in-hand.  It’s ridiculous to pay to have a $250 deductible for your car insurance instead of a $1,000 or $2,000 deductible when you have tens of thousands in an emergency fund.  You can afford better insurance with higher deductibles, and you can afford to have higher deductibles if you have a strong emergency fund.  In this case, saving your emergency money will actually help you to afford better insurance at a cheaper rate.

Conclusion

We’ve now identified the three main items you MUST do before even considering paying down your mortgage: (1) pay down higher-interest debt, (2) take advantage of major retirement opportunities like employer matches and significant tax-advantaged accounts, and (3) be prepared for disaster with emergency money and insurance.

If you’ve paid off those high-interest credit cards, you’ve got at least 6 months of emergency money in the bank, and you’re doing at least the full employer match for retirement, it may be time to consider whether overpayment is a good option.  However, as we’ll explore in the next couple of posts, there are still other factors to consider.

Go to part 5: Selling soon

Disclaimer: This is not intended to be professional financial advice, nor does it apply to all people in all situations.  It’s a good idea to consult a professional financial advisor before making any major changes in your finance management, because individual circumstances will often affect the choice of strategy.

This post is part 3 of 7 in a series entitled “When not to pay down your mortgage,” which outlines many scenarios where paying extra on your mortgage isn’t necessarily the best financial strategy.

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As detailed in the previous post of this series, excess savings in your budget should not automatically be used to pay down principal on a mortgage loan.  Aside from paying off higher interest loans first, another better option is often investment in retirement accounts.

The employer match: Always the best option

Many employers offer some sort of matched funds for investment in a retirement account, whether that takes the form of a 401(k), a 403(b), or some other type of account.

If you are lucky enough to be in that situation, you should generally take advantage of that as much as your financial situation allows.  Sometimes employers will even have a 1:1 match up to a certain amount: be sure to take that.  Can you think of a single other investment where you are guaranteed an instant 100% return on your money?

Even if your employer only matches a portion of your retirement investment, you should contribute the maximum that you can to take advantage of that match.  Retirement may seem a long time away, but a 50% return or whatever on your money instantly should not be dismissed.  The value of a real estate investment or a stock portfolio may go up or down — as may your retirement account — but starting out with 50% or 100% more in it is a huge financial gain.  And generally it requires little more than a bit of paperwork.

Other retirement accounts

Once you get beyond the matched funds, further investment in IRAs (Roth or traditional) or in 401(k) or 403(b) accounts is a riskier proposition.  Here you have to balance the guaranteed return on your mortgage versus variable returns on retirement investments.  This is a difficult question and will be considered in more detail in a future post.

For now, I would say that the situation depends on your overall financial condition.  If you have enough money in an emergency fund and no high interest debt (like credit cards), you can start to consider these options.  If you’re younger, all things being equal, you might lean toward retirement investments, since you have time to take some bigger risks rather than depending on the guaranteed return of the mortgage.  If you’re older, it may depend on how much retirement money you already have put away.

The other factor to consider is that annual investment in some of these types of accounts is capped.  For example, the Roth IRA provides tax-free growth, but annual contributions are capped.  This creates difficulties for investment strategy.

Suppose you have a 4% fixed-rate mortgage.  Assuming you have a large mortgage or other deductions, you might have an effective after-tax interest rate of slightly less.  But right now, there are few options (such as CDs) that could give you a guaranteed return on a retirement investment that is 3-4%.  So, it seems that paying the mortgage is clearly the winner, if you’re risk-averse.

But wait a minute.  Let’s say that the interest rate situation changes in a couple years, and now there are CDs or bonds or other guaranteed investments with a higher rate of return.  If you had socked away a few thousand each year in your Roth IRA, you could now take advantage of those tax-free returns with a large balance in your IRA, but if you don’t have that money in the Roth IRA to begin with, you are limited to the annual caps in getting your money into the account in the first place.

There’s no clear answer here.  The best choice will depend on the details of your finances, the economic conditions, various tax advantages, your risk tolerance, and how lucky you might be about predicting the future.  Nevertheless, saving for retirement is not necessarily a lesser goal than paying your mortgage, so keep options open.

In general, taking advantage of tax-free retirement growth (e.g., Roth IRA) and tax-deferred retirement plans (many other retirement accounts) is a better option for long-term financial gain.  Paying down the mortgage should only be a priority in particular situations where that equity or guaranteed return are necessary for your specific portfolio.

Summary

If your employer offers a match for retirement contributions, definitely take advantage of that over just about any other possible investment opportunity.

For retirement savings beyond the employer match, there are a lot of variables, but a balanced investment strategy should generally consider retirement as a priority at least on par with mortgage investment.  That means that a tax-advantaged retirement plan with a possible high rate of return will usually be better than worrying about tax-deductible mortgage interest.  However, this is a general statement that may not apply to every situation.

Go to part 4: Emergency funds and insurance

Disclaimer: This is not intended to be professional financial advice, nor does it apply to all people in all situations.  It’s a good idea to consult a professional financial advisor before making any major changes in your finance management, because individual circumstances will often affect the choice of strategy.

This post is part 2 of 7 in a series entitled “When not to pay down your mortgage,” which outlines many scenarios where paying extra on your mortgage isn’t necessarily the best financial strategy.

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For many years, making extra payments on your mortgage was generally viewed as an excellent investment.  If you want to own your home “free and clear,” there’s no better feeling than seeing that principal number go down on your loan.

However, with mortgage rates at historical lows, it may be time to reconsider the value of making early payments or extra payments on your mortgage.  If you have extra cash that you can do something with, mortgage payments are just one of many options.  At a minimum, there are generally other financial steps you should consider before putting the money into a mortgage.

In a previous post, I considered the need to evaluate long-term inflation effects when evaluating payment strategies.  But before you even worry about complexities like that, there are other more basic issues to consider. continue reading…