Debt reduction/payoff.

[TrevorS]

Originally Posted By: JHZR2
Again, nobody is denying or arguing the power of compounding.

And this isn't about taking on another mortgage for an investment property, which most people cannot afford.

This is about paying down debt and generate free cash flow at a marginal level, then identify what is the best process to deal with that cash flow.



If you have cashflow to pay down a mortgage but you also have access to stocks paying 8%-10%, then the cashflow from investing is greater than the cashflow from paying down the mortgage.

 

[JHZR2]

And a note on that - the op has a primary residence. All the talk about depreciating it is moot.

 

[TrevorS]

That point was only in response to you asking why I had losses on my investment property (and extrapolating that what I was advocating had failed).

 

[JHZR2]

Originally Posted By: TrevorS
Originally Posted By: JHZR2
Again, nobody is denying or arguing the power of compounding.

And this isn't about taking on another mortgage for an investment property, which most people cannot afford.

This is about paying down debt and generate free cash flow at a marginal level, then identify what is the best process to deal with that cash flow.



If you have cashflow to pay down a mortgage but you also have access to stocks paying 8%-10%, then the cashflow from investing is greater than the cashflow from paying down the mortgage.


Again, you're making the horrid assumption that there is a mass of principal to amass 8-10% on. I might agree if, for example, someone inherits $100 k and can invest or pay off the mortgage. Because the marhginal gain after taxes and all, assuming no principal risk, is a few percent.

But typically were talking about a few hundred dollars free cash flow for individual families, and the return on that at any point in time upfront is small. Compounding is beneficial, but the benefit upfront is minor, and the greater risk to most is sustaining mortgage payments. Paying off the mortgage thus provides better security and is a better choice.

Again, everyone should have some reasonable baseline investing, otherwise they can't afford to purchase property anyway... And so we're talking about marginal dollars afterwards.

 

[TrevorS]

I started a reply saying you need to look at real numbers but thought I better provide an example.

So let's start with the marginal household with a 20% marginal tax rate (probably lower than yours), $100k 25 year mortgage at a gross rate of 4.5% (higher than your 3%) and a decision with what to do with $100 gross income.

Option 1: Pay $80 ($100 minus tax) a month extra into mortgage. With an effective rate of 3.6% this means the total mortgage cost goes from $151.8k over 25 years down to $140.3k over 20 years. Saves $11.5k.

Note there is no extra cashflow for 20 years!!!!! You are cashflow negative for 20 years so quite when you can free up large amounts of cash to invest for a marginal saving household is interesting.

This is the way it is because rates are so low.

Option 2: Marginal saving household puts the $100 a month into 401k and gets 4.5% compounded.

In 20 years they will have $38.8k, 3.4 times more than from using that $100 against the mortgage. They get to $11.5k ie the same as the mortgage savings option in 8 years not 20 and then the compounding takes it out of sight!

Option 3: They have maxed out 401k like you but are savvy enough to get 8% on their investments.

$80 monthly at 8% gets them $47.1k in year 20, 4.1 times more than before. They get to $11.5k between year 8 and 9.

Note these numbers are even more stark with your interest rate of 3%: Assuming a marginal tax rate of 20%, $100 of monthly gross income towards the mortgage only saves $7k and takes 20 years before you can enjoy no mortgage to begin investing.

With your 8% return you can get $7k in 6 years and grow to $47k in 20 years. You would be $40k better off in 20 years for just $100 a month investing rather than putting that towards your cheap mortgage.

 

[JHZR2]

Great discussion.

So let's look at it from a slightly different angle, which is related to the marginal rates of free cash when orginating a mortgage.

Let's say a $250k mortgage (sorry should have used $100k to be in alignment with your example, but I had already ran the nummbers... And $250k is probably more realistic for average home prices across the USA), current rates are at 4.33% for 30 year and 3.33% for 15 year. I ran some numbers using online calculators for ease of use.

For the 30 year mortgage, one would pay $196971 in interest, with each month's payment being $1241.

For the 15 year, one would pay $67953 in interest, with each month's payment being $1766.

OK, so 15 year vs 30 year yields roughly $130k more of YOUR cash in your pocket. Even if 30% came back as a tax refund, its still a TON of your own cash going out.

Now, let's play the game of if one had enough to pay the 15 year but wanted the 30 year for "flexibility", and saved the delta...

$500/month at 6% (used before) invested over 30 years is $180k principal, and $502810 total value of the account.

If instead one paid their mortgage off in 15 years, and then invested the $1766/month for the next 15 years at 6%, the $317880 principal would yield $522860 total value of the account.

BUT, one must also consider that the person saved $130k cash outflow because of paying FAR less interest. Its all saved in the first fifteen years when the mortgage is active, but for reasonable results, let's say then that it averages $722/month in the SECOND 15 years. If one invested that savings, it would be an additional $213k. If you realize that the savings are over the first 15 years and are evaluated at the 30 year point, then the additional sum is $512k.

So for the person who went with the 30 year note, at the end of 30 years, they have a $250k property (plus appreciation), and $503 in cash.

The person who went with the 15 year note (or who paid their 30 off on a 15 year timeframe roughly) end up in 30 years with a $250k property, $523k in cash, plus a ton of saved interest which because of that much less cash outflow, could yield an additional $213k or more.

So $753k for the 30 year note with investing, vs $986k (or $1285k) for the 15 year note.

Of course the issue is that most who write the 30 year note will not save the $500 extra per month... In fact, most go with a 30 year note because they can NOT afford to buy on a 15 year note. All this sets up people for long term failure.

Now let's say that youre already maxing the 401k and HSA to minimize tax burden. Then the marginal dollars are not available to have any benefit from an immediate tax-based equivalent return.

One could argue that investing would yield more like 10-12% on average... But what if it does not? What if you bought in 2000 and are holding today?

All in all, could be a $500k error.

We can run scenarios all day, and argue all day, every day. Im not sure one will ever get to the bottom because everybody's situation is different. But saying to hold on to "good" debt is clearly not always the best approach.

Again also, if one was sitting on a windfall of capital, it may be different, because then compounding on a large amount of principal from day 1 factors in... versus compounding on a tiny sum. As I showed, if you look at constant dollars budgeted and put out in a disciplined way over 30 years, one still would be better off NOT having this "good" debt, be it the $130k less interest, or the more total capital at the end of year 30.

 

[TrevorS]

Originally Posted By: JHZR2
Great discussion.

So let's look at it from a slightly different angle, which is related to the marginal rates of free cash when orginating a mortgage.

Let's say a $250k mortgage (sorry should have used $100k to be in alignment with your example, but I had already ran the nummbers... And $250k is probably more realistic for average home prices across the USA), current rates are at 4.33% for 30 year and 3.33% for 15 year. I ran some numbers using online calculators for ease of use.

For the 30 year mortgage, one would pay $196971 in interest, with each month's payment being $1241.

For the 15 year, one would pay $67953 in interest, with each month's payment being $1766.

OK, so 15 year vs 30 year yields roughly $130k more of YOUR cash in your pocket. Even if 30% came back as a tax refund, its still a TON of your own cash going out.

Now, let's play the game of if one had enough to pay the 15 year but wanted the 30 year for "flexibility", and saved the delta...

$500/month at 6% (used before) invested over 30 years is $180k principal, and $502810 total value of the account.

If instead one paid their mortgage off in 15 years, and then invested the $1766/month for the next 15 years at 6%, the $317880 principal would yield $522860 total value of the account.


Ok so two things in your post, one of which I will answer separately

The above is somewhat a logical comparison. What you posted afterwards is invalid as you began to double count.

Even in the above you've changed the parameters. Most strikingly you've reduced the interest rate by introducing a 15 year mortgage. You've also assumed a 6% return when you said you could achieve 8%-10%.

For the 4.33% rate you need to factor in the tax deduction which for many people can be significant.

Note that if you get a lower rate on a 15 year mortgage then thats a different comparison to what we were talking about ie what to do with extra savings.

So to get back to a true like for like decision, let me ask you this question. If you have that 15 year mortgage, would you pay extra savings towards the capital and pay it even earlier or would that be better earning 6%?

Indeed you've made my point. The lower and lower your borrowing rate (and tax deductions make it even lower than face value), the better it is to invest excess cashflow in other investments rather than into the mortgage.

Btw, want something even better than the 15 year mortgage? Try an ARM. 5 year fixed is available as low as 2.7%, 10 year fixed is as low as 3.2%. Both of these default to a 30 year term. This frees up even more cashflow for investing. Again what would you so, put extra money into the mortgage or invest it.

Remember, the decision we were comparing is what to do with extra money, not whether a lower interest rate mortgage is cheaper than a higher interest rate mortgage.

As the rate goes lower, the risk reward picture for investing improves. I would go for that ARM over the 15 year so that I could invest more.

 

[JHZR2]

Originally Posted By: TrevorS
Ok so two things in your post, one of which I will answer separately

The above is a logical comparison. What you posted afterwards is invalid as you began to double count.

Even in the above you've changed the parameters. Most strikingly you've reduced the interest rate by introducing a 15 year mortgage. You've also assumed a 6% return when you said you could achieve 8%-10%.

For the 4.33% rate you need to factor in the tax deduction which for many people can be significant.

And of course if you get a great rate on a 15 year mortgage then that's something to consider, but let me ask you this question. If you have that 15 year mortgage, would you pay extra towards the capital and pay it even earlier or would that be better earning 6%?

Indeed you've made my point. The lower and lower your borrowing rate (and tax deductions make it even lower than face value), the better it is to invest excess cashflow in other investments rather than into the mortgage.

Btw, want something even better than the 15 year mortgage? Try an ARM. 5 year fixed is available as low as 2.7%, 10 year fixed is as low as 3.2%. Both of these default to a 30 year term.


No, on earlier pages we (you?) mentioned 6% so I used that for consistency. The fact that I have some stocks that yield 8-10%, or that the last year or two have returned quite well does not mean that it is a valid assessment. It may or may not be. It depends upon what glimpse in time youre existing in. Obviously your return based upon 2008 values is different than 2010 or 2014.

The mortgage rates were TODAYS rates from Bankrate.com. Of course a 15 year will be lower. The tax bit is consistent across the loans, you will get the benefit, but it does not change the fact that youre paying $1 in interest to get $35c back.

And of course Id pay my mortgage. Why? Because the principal is also in there. So on top of the hundred thousand or thousands in interest paid out (which count against any returns), then youre stuck paying principal for so many more years.

Its not a tough concept - mortages are the largest monthly outflow of cash for most people. Get rid of the mortgage and there is FAR more cash to invest and apply as one desires. So absolutely Ill pay my mortgage to have those thousands of dollars freed up each month to be able to do more real stuff to get it working for me.

The numbers are what they are. Im not sure how you can deny that you pay FAR less interest on a 15 year than a 30 year. The tax benefit is the same on a basis of dollars paid, but that is money that remains in YOUR pocket over the long run. Reducing the effective rate on the mortgage by tax breaks is great, but it does not change the fact that hundreds of thousands are being paid in interest - money that youll never see again. My calculations were pretty straightforward - for the same money outflow per month, the 15 yr mortgage returns better. You can play all sorts of what ifs, but you must account for risk and investment losses, not rose colored glasses. And remember, one should always be investing for retirement or better before ever buying a home, so even more of your point is IMO moot.

 

[TrevorS]

The 6% was only the increase in property value and excludes profit generated. So that particular investment for me has generated more than 6% and my other investments have annual returns in the double digits.

What you did with the 15 year example was reduce the interest rate and compare it to a higher rate 30 year mortgage. Of course a lower interest rate saves you more! I made the same choice on a car loan offered at 2% for 36 months vs 4% for longer periods. I went for the 2%.

But that comparison was not the same as the decision on whether to pay more into your mortgage. You added another variable.

And the fact that the rate has gone down means that your decision on what to do with any extra savings should be even more biased towards investing because the differential is higher.

As I said, hold the term at 30 years, get a 5 or 10 year ARM and that's better than either fixed option. Why? Because you increase the interest rate differential and you increase cashflow for investing.

How about another question? Borrow zero and save up to pay the house in cash. That's got to be even cheaper right? After all you pay no interest that way.

The concept for me is really simple. The closer you get to zero, the better it is to invest spare cash than pay balances down. I'm guessing your actual mortgage rate after tax is 2%. Almost every solid company out there pays more than that in dividends. If you're paying down balances effectively borrowed at less than 3%, I don't get it because its so low risk to earn more than that.

(This is different from what you are now saying about getting a 15 year mortgage at a lower rate than a 30 year mortgage. If were talking about choosing mortgages then go for the 5 or 10 year ARM ensuring you save enough to be able to pay it down should it adjust unexpectedly high)

 

[TrevorS]

Originally Posted By: JHZR2
BUT, one must also consider that the person saved $130k cash outflow because of paying FAR less interest. Its all saved in the first fifteen years when the mortgage is active, but for reasonable results, let's say then that it averages $722/month in the SECOND 15 years. If one invested that savings, it would be an additional $213k. If you realize that the savings are over the first 15 years and are evaluated at the 30 year point, then the additional sum is $512k.

So for the person who went with the 30 year note, at the end of 30 years, they have a $250k property (plus appreciation), and $503 in cash.

The person who went with the 15 year note (or who paid their 30 off on a 15 year timeframe roughly) end up in 30 years with a $250k property, $523k in cash, plus a ton of saved interest which because of that much less cash outflow, could yield an additional $213k or more.

So $753k for the 30 year note with investing, vs $986k (or $1285k) for the 15 year note.

All in all, could be a $500k error.


I wanted to reply to this part after reading it through more.

Unfortunately you have double counted this interest saving. Your prior comparison that had both a 30 year mortgage at a higher rate and a 15 year mortgage at a lower rate generate the same return from the investing of the total payment difference at 6% captured everything you needed to make the comparison.

Ironically there is a $500k error but it is in your math.

What you've shown is that a 15 year mortgage needs to be cheaper than a 30 year mortgage by about 1% to offset investment return differences arising from cashflow timings at a return rate of 6%. This just goes to show that markets work and equilibrium is reached. The rate difference truly reflects expected returns for the periods in question.

I hope you weren't banking on an extra $0.5million for yourself when choosing your own mortgage strategy as I don't think it is there.

I do agree that who knows what will happen in the future but borrowing at 2% is not risky if you save rather than spend!

 

[JHZR2]

You're right, originated mortgages are slightly different than the full run numbers I put out. But one certainly can pay their 30 year as a 15; I have multiple friends doing just that, at least one that I know is truly doing it in a disciplined way.

I don't see a $500k error. I took numbers straight from amortization tables and investment calculators assuming $x per month invested at a certain rate for some duration. You may disagree on my assessment of the future value of the dollars saved in interest, but they were dollars that were real and were paid from one's account to the bank. Reducing total cash outlay does have some future value as that cash goes someplace.

But the 15 vs 30 bit was for two reasons - first, because so many use the discussion of taking a 30 over a 15 for flexibility... So they can see what it costs, and second, because if instead of the $100 you used, it was a more reasonable amount of money, like $500, then one could indeed pay their 30 off like a 15. In the end, the savings from that point on in terms of returns add up the same no matter what.

I agree that making more is better than less, and that compounding is great. But all I'm saying is that a big return on a little money is not that much, while a little interest on a big principal is a lot of money going the wrong direction. The best way to combat that is get the mortgage gone so that the thousands spent on it monthly can be diverted to doing real and lucrative things. Joe public isn't going to obtain investment real property or do big things with $100 or $500 a month, but if he can free up thousands a month by having the mortgage gone, then that free cash can be converted into doing real and big things, and that's where real wealth will be built.

I'm happy with the approach I'm taking, and I am able to invest, and get rid of my biggest cash outflow ASAP so that I can devote my cash to other things that will have real return and yield for me (besides stock investments). I'm not concerned, I have a very low risk and realistic plan that will have everything paid for and us as millionaires (real, not with some portfolio of bank-owned real estate) far younger than most achieve it. If by some magical stretch I miss out on the compounding of some thousands of dollars today and in the next couple years, I'll not miss it based upon realistic and conservative targets I've evaluated. Feel free to go be mr savvy investor. If it's working out for you, perfect. I know my plan is getting us to the point where we desire and with low risk and great return, so I'm not concerned in the slightest. Good discussion and good luck.

 

[Win]

Originally Posted By: TrevorS
Originally Posted By: TrevorS
So by keeping a mortgage and not instead almost paying it down with two investments, I am paying the interest on the mortgage and getting 6% capital gain on top.


What's even more compelling in this example is the following:

When I purchased the investment property, it was worth about 25% of my current home mortgage.

Based on the historic growth rates, at the 25 year mark, it will be worth 100% of my original home mortgage amount.

So in 25 years, that investment generates enough profit to pay off its own mortgage and enough capital growth to pay off my home mortgage.

As I said, in that city, I could have done even better. On the other hand, its a nice property in an expensive location and I currently have a great tenant.


Maybe.

The S & L crisis and the last Wall Street meltdown were less than twenty years apart. Extrapolating real estate values and rental income over long terms like you are planning on is dicey.

I would pay my debt down. That plan works every time.

 

[TrevorS]

Yes good discussion and thanks for participating.

I have no doubt you'll make it to become a millionaire. I've always felt that this country makes it possible for anyone who really wants it. Indeed it isn't about making it big, it's just about being sensible, realizing that what you earn is a lot and like you've done, making a plan. Problem is that a million is not really enough. I would say about $2-3million net worth is where you need to be depending on where you want to live and what you want to do in your spare time but from what I understand you are young so have plenty of time to get there too!

To clarify where I disagree with your math. You suggested that paying over 15 years with an interest rate of 1% lower than a mortgage over 30 years could generate $986 or $1285k of assets compared to $753k. So it seems you are assuming paying your mortgage in 15 years generates up to $0.5million extra.

I ran the numbers and the difference will be about $115k in favor of the 15 year mortgage. You took the $130k interest savings and compounded them again when you had already compounded the overall payment differential (ie capital and interest) which in years 0-15 is in favor of the 30 year mortgage and in years 15-30 swings in favor of the 15 year mortgage.

The $130k interest savings (a result of the reduction of mortgage rate and term) are the only savings that you can claim from the change to a 15 year mortgage because the 6% investment return from cashflow differences actually favors the 30 year mortgage returning $527k vs $514k.

My last words on this as I hope to try and explain it better.

Firstly of course a 15 year mortgage is going to cost less than a 30 year mortgage due to both term and rate. But the ARM is even better as the rate is lower and with the 15 your repayment is higher so you have to borrow less. So the 15 works because you are forced to borrow less. You borrow less, you spend less. But if you were to borrow the same amount, the ARM will be even cheaper.

Secondly when you have money and you decide to pay more than your mortgage payment, it is an investment decision. You are deciding to invest in something that will return you 3% before tax deduction and 2.x% after tax deduction. You are making that decision vs another investment decision that will almost certainly pay higher.

If at any point in time you can simply transfer money to pay off a debt, the idea that any secured asset you have belongs to the bank is an emotional illusion. My NET worth is my net worth. I choose not to pay off the small balance on my investment property because I would then pay tax on the incremental profit.

As to risk, I have to say that I have only lost money when I trusted a third party to do something speculative. You take some losses on the way and learn from them. Apart from that incident I would consider myself a risk averse investor. In fact I'm kicking myself for not having taken more risks since the financial crisis. On the other hand there are some things I have done reasonably well such as timing and longer term core stock and fund selections. I don't play the stock market, if anything I aim to be a value investor.

As to where low risk investing and leveraging with financial analysis have gotten me, I was wondering what a good way of expressing it might be and calculated that my net worth is equal to the net salary I have earned in just over 20 years of working. An annual return of 5% together with a continued good savings rate will maintain that.

 

[Mykl]

A 30 year fixed rate is somewhere in the area of 4.5% right now

Adjusted for inflation the average annual return from an S&P 500 index fund is 7.2%

If you're investing in a tax advantaged account you absolutely should prioritize investing above mortgage repayment if your goal is to maximize your net worth. But after the tax man takes his cut as well as other fees from a non-IRA/401k account, you may not be giving up as much as you think by going after your mortgage first.

 

[hattaresguy]

You guys are over thinking this, pay down the debt but don't starve your other investments to do it.

When I finance my townhouse projects I pay extra on the principle so I can kill the note in under 10 years.

For a primary residence IMHO 10-15 years is a great time frame to pay it off.

The vast majority of people are fairly lousy with their money, but a large percentage are not so one size fits all advice doesn't always work.

 

[hattaresguy]

Originally Posted By: JHZR2
Originally Posted By: hattaresguy

I don't agree with paying cash for everything and he doesn't teach the difference between good debt and bad debt.

My Amex and Visa pay me a fair amount of money every year to use them. I'm getting $1k worth of fuel cards from Amex in May for my boat. Thanks Amex!

Right now I'm sitting on $600 worth of airline tickets from my Visa...


Youre kind of mixing terms here. Do you carry a balance, accruing 10+% per month on the debt? That's an expensive way to get "free" airline tickets.

I use credit cards for more or less everything I buy. But I pay them off per month so never truly accrue revolving, interest pearing debt. Big difference.


Sorry I was trying to make two points with one post and it got muddled.

I only acquire debt for investment purposes, ie good debt. CC rewards programs I make use of, I never carry a balance, ie bad debt.

 

[Vikas]

I agree with the points made by JH that for most (almost all?) people, paying mortgage becomes extremely disciplined financial transaction apart from the 401-K contribution. Few might talk about investing extra in the market but unless one sets up automatic deduction, it is hard for a normal individual to contribute to it all the time.

There is psychological impetus behind getting rid of mortgage especially for people who have no other debt even though the real A/B comparison may not hold true (especially if the mortgage rate is around 3%) For example, if my ARM is coming for rate change in 2020, I would probably like to get the whole thing paid off before that time frame. If I were to put the extra in the market, the chances are I would have more in 2020 to pay off the balance but the illogical side of the brain wants to take no chances.

 

[TrevorS]

Each time I've taken a mortgage, I've asked for the maximum I could get and used a lower introductory rate to achieve that.

I've also put down at least 30% downpayment to reduce the rate and reduce my own risk.

I always create an analysis of what I am getting into for the next 5 years. Its a conservative projection. I ensure I set aside enough to spend what I need to and to save what I need to. So if I have a 5 year ARM, I plan to have enough savings in 5 years to knock off a large chunk of the mortgage to cope with any increase in the interest rate.

Believe me, I absolutely hate the feeling that compared to what I owe the bank, I have very little. I can't imagine what it must be like to start a career with 6 figure student loans. And I've pretty much never been in that position because I've ensured I have savings, have always planned to continue to save, and put my own equity into property rather than try to finance a large part of it.

My overall setup is actually conservative and that allows me to take advantage of the very low after tax mortgage rates and focus on the investment side. If mortgages became more expensive than investment returns, I would take savings and pay them down.

 

[rjundi]

The missing part in the equation is your salary and future worth. $22k in debt is a drop in the bucket or staggering dependent on your family income and fixed costs.

Good luck with the payoff.

My only regret with debt is not getting a 15 year mortage years ago and sticking to it instead of a 30yr>30yr>15 year currently. At least I have 60% equity but looking at age 55 for home payoff.