Myths On Money

This post is written in response to a question that a friend of mine asked. Here is his question:

Question:

When I think about rent VS buying I often think back to those dental students in [Ohio]. They bought condos, lived in them for a few years and then sold them. In most cases they sold them for a lot more than they paid because some of them made improvements to the property. Even the ones that didn’t were able to sell them for about 5-10k more than they paid. Rent would have to pretty low to make it better than buying from limited perspective.

Please show me where my thinking is wrong on that. I’m going to be in a position to make the choice between buying and renting quite soon. I always thought buying was the answer, but now I’m confused.

Before reading on, you may want to reread the post that illicited this comment. It may also be useful to consider all the cash flows.

Answer:

• Don’t Rush
• Consider All the Costs
• An Example
• The Nutshell

Don’t Rush

First off, do not think that I am trying to convince people not to buy a home. That’s not my point at all. Buying a home is a great way to build your wealth, and over the long term will almost certainly be better than renting. The point I am shooting for here is that people should not RUSH into buying a home just because REALTORs are advertising that renting is a waste of money. Rushing into any decision is a great way to make the wrong one. If you buy a home without considering every cost associated with buying a home, then you may find yourself overextended.

Homeownership is a great financial decision. But, it also happens to be the single biggest financial decision you will ever make. The reason that my posts seems in favor of renting is because there is no end to the people who are willing to promote homeownership, regardless of the cost to you. I think that buying a home is the best decision for most people. But it must be done under the right circumstances and at the right time, with a careful eye for the terms of the loan. More on the terms of the loan in a later post.

The problem with most people’s financial decision making process is that they limit their perspective. If you only look at the gain at the time of sale of the home, and ignore all other expenses and gains, then you will make a poor financial decision.

Consider all the costs

So what are the extra costs that people do not usually think about? First, closing costs. Closing costs typically will cost the buyer 3-7% of the amount of the loan. Next, selling costs. Selling costs vary a lot, and sometimes do not even exist, but if they do exist, then they will cut into your gains when you sell the home. Finally you have expenses that you incur while owning the home. These include property taxes, cost of maintenance and repairs, homeowner association fees, mortgage insurance, property and liability insurance, etc. Most experts agree that these costs usually amount to about 40% of mortgage payment.

An example

A hard, numbers-oriented example. Suppose a dental student buys a $150,000 condo, and lives in it for 5 years. He pays 9% interest on his mortgage. His condo appreciates at a rate of 6% per year. His monthly payment is $1,200, so his property taxes, condo fees, insurance premiums, and other expenses total $480 (40% * $1,200) each month. He has no selling costs. So, after 5 years, what did he gain? His condo’s appreciated value is $200,000, so he has gained $50,000 in only 5 years! If you ignore the costs, then you think, “Wow, he just got $50,000. I’m never renting again!” But what did he pay? He has paid $67,000 in interest, $29,000 in monthly expenses, and $4,500 in closing costs. So his total cost of owning the condo is $100,500 for those 5 years. So, did he make $50,000? Nope. He LOST $50,000.

But wait, we’re not done. You think, “$50,000 lost? I’m never buying a home!” But that’s not true. What would you have lost if you had rented? Suppose the student could have rented a comparable apartment for $1,200/month. So what did he gain? Nothing. No income. What did he spend? $72,000 ($1,200/month * 60 months). So the renter LOST $72,000.

So the student should buy, right? Well, if you limit your perspective to just that, then yeah, he would want to buy the condo. But there is a problem with this analysis. The problem is that the condo buyer has spent $1,680 a month (mortgage payment plus other expenses), while the renter has only spent $1,200 a month. Making a financial decision based upon different expenses like that is like comparing a motorcycle to a car on the basis of horsepower. A motorcycle will have less horsepower but be faster, right? The difference is in the weight of the vehicle.

Same thing here. So, what if the renter also spent $1,680? $1,200 in rent, and $480 to be saved. Even if his saved money earns no interest, he would have $29,000 in the bank. So, the renter would have lost $75,000 in rent, and gained $29,000 in savings, so his total loss would be $44,000. So, in this case, the renter would be better off than the condo owner.

But that only applies to THIS EXACT SITUATION. What if the appreciation of the condo were higher? Then buying is the better decision. What if the renter can earn a good interest rate on his savings? Then the renter wins. What if the monthly expenses of ownership are lower than 40% ? Then the buyer might be better off. This is why finance is a 4-year degree. This is why they offer masters and PHds in finance. Every situation is different. Every situation needs to be carefully analyzed. And it can get very complex, very quickly.

The Nutshell

You probably should buy if:

1. Real estate prices are appreciating at a high rate.
2. You can afford to pay more than the mortgage payment on the house (40% more).
3. You plan to be in the home at least 5 years.

You should probably rent if:

1. The mortgage payment is barely affordable.
2. You have the opportunity to save your money at a decent interest rate.
3. Local real estate prices have historically risen slowly.

If your situation falls somewhere in between these two categories, then a more thorough analysis is needed to give an accurate decision. If you can do this yourself, then great. If you can’t, you could find someone trained in finance to help, or you could just eyeball it. Just remember to include all of the relevant benefits and costs and you should come out fairly close. Remember that 5 years is a typical time frame for buying to be profitable. If you don’t know anyone who can run the numbers, just let me know and I would be glad to help.

Lastly, remember a financial loss is sometimes worth the satisfaction of home ownership!

A Shocking Discovery

I was recently watching a financial self-help video from a very popular finance guru, and I was shocked to hear this person say that buying a home was a great investment because it would yield a very high return in the first year that it was owned, and that it would continue to give high investment returns throughout the life of the home. This is surprising, because any one well grounded in finance would be able to tell you that a home is a very very bad investment for the first 3-5 years. It is not until after that time range that the home’s appreciation will begin to actually give a positive investment return.

How Could They Miss?

If the point of the high cost of a mortgage and the need for longevity in a mortgage are such a fundamental principles, then how could the guru have possibly missed it? The answer lies in the cash flows the guru used for the analysis. See, from a certain perspective, the guru was right. But it’s not the whole story. It’s kind of like in Star Wars, when Luke accuses Obi-wan of lying about his father’s death. Obi-wan tells Luke that what Obi-wan’s statement that Luke’s father had died was true, from a certain point of view. And it was. But did Luke realize that he was not hearing what he thought he was hearing? No. He thought that his father was physically dead, while Obi-wan meant that he was dead in a less literal sense. So, while what Obi-wan had said was true from a certain perspective, it certainly succeeded in deceiving Luke. Such is often the case in finance. What you hear may be true from a certain perspective, but it is still deceptive and does not tell the whole story of what is happening to your wealth.

So What Is Happening?

Before I can answer the question of what is really happening and what return you are getting from your investment in your home that first year, I first need to explain a financial tool called a cash-flow diagram. The diagram is fairly simple: it consists of a horizontal line with vertical hash marks all along it. Each hash mark corresponds to a specific time period (ie a month, a year, etc). The diagram must be consistent in that each hash mark must represent the exact same amount of time that each other hash mark represents. On each hash mark, the relative cash flows for that period of time are listed. A cash-flow diagram helps us visualize where the money is flowing, when it is flowing, and which way it is flowing (in to your pocketbook or out of your pocketbook).

With that brief introduction, let’s take a look at the two cash-flow diagrams below. Here’s the scenario: you make a $10,000 down payment on a $160,000 house, meaning that you must borrow the remaining $150,000. Closing costs (typically ranging from 3-5 percent of the balance of the loan) come out to $6,000, a conservative 3% of the loan amount. The home appreciates 4% the first year that it is owned. The top diagram shows the full, actual reality of what the calculation of mortgage returns would look like; the bottom one illustrates a diagram like the one the guru was using for their analysis.

The areas highlighted in yellow are cash-flows which the guru neglected to account for. Notice that in the top analysis, we have taken into consideration EVERY expense and EVERY income associated with the mortgage. In both cases, the final amount of equity in the home that you get when you sell the home is the same, but the amount of the expense is different. The difference in the “investment return” is 138%!

Okay, time to break out the ol’ thinking cap. A negative investment return means that you are losing money at that particular rate. In order to get an idea of the implications of this loan, think of the cash-flows above as a savings account. If you put $16,000 (the $10,000 down payment plus the closing costs) in a savings account today, and deposited $997.95 into that account every month and you only had $17,923.71 in that bank account at the end of the year, what would you think? You deposited almost $38,000 between the initial deposit and the monthly deposits. And at the end of a year, you have less than half of what you deposited in the first place. Wouldn’t that make you mad? I know I would be calling the bank and giving them an earful if my savings account exhibited such behavior!

This is why it is so very very important to consider all cash-flows associated with a purchase/investment. I am not trying to say that buying a home is a bad thing to do. I am only trying to show the importance of understanding and applying the effects of all relevant cash-flows when considering an investment. Suppose you had gone in to the bank and your mortgage officer had told you that you could earn a 79% return on your home in one year. Before you read this post, you would probably have believed him, wouldn’t you? But that fact remains that, while the equity growth from $10,000 to $18,000 is indeed 79%, it does not really tell the whole truth. What about the expense of closing costs? What about the interest expense? Shouldn’t that be considered? Isn’t that important? Doesn’t that strongly affect the investment returns your home is providing? Absolutely. So before you jump into a financial decision, stop and ask yourself the following questions: (1) What will it cost me, both now and in the future? and (2) What will I get (income) from it, both now and in the future? If you do that, you will find yourself making much better financial decisions. And if you can’t figure it out, or what a specific calculation in regards to your decision, then ask a (unbiased!) financial professional for help.

The Word on the Street:

The latest financial fad has financial planners advocating plans wherein the client (you) takes home equity loans or refinances their house to take out the equity in it, and then invests these funds (preferably in a cash value life insurance policy). These pros contend that this is the best route to riches.

The Truth:

Although this plan has academic merits, and can look very appealing on paper, it is also highly risky, not to mention being completely out of the financial capabilities of the large majority of American households.

Doubt Me? Let’s take a long look at the pros and cons of this strategy.

Mortgage Leveraging, What is it?

First of all, let me define what I mean by “leveraging”. Leveraging is when you borrow money to invest it. It has the phenomenal ability to multiply your investment returns. But beware, this multiplicative power works two ways; since your gains are huge, your losses are also huge, should the market turn the wrong way.

The mortgage leveraging plan runs like this: say you have a home on which you owe $200,000, but has recently been appraised for $350,000. This means that you have $150,000 in home equity built up. According to the leveraging plan, you would be well advised to refinance your home, taking out a fresh mortgage of $280,000 and paying off your old loan balance of $200,000. This would leave you with $80,000 of cold hard cash to invest, which you do. Your new loan has an interest rate of 7%, but, after you take your tax deduction, it really only winds up costing you 5.25% (at a 25% tax bracket). This is a low number that is easily beaten by the market, especially if you invest on a tax-deferred basis, such as in an IRA or life insurance policy. Since $80,000 is well beyond the allowable annual contribution allowed for retirement plans, the best remaining option for your home equity money is in a cash value life insurance policy. You invest your money, and, over the long run and on the average, you earn 8% per year. The difference between what you earned and what you paid in interest is called your marginal rate of return, and, in this case, equals a 2.75% gain on your home equity that otherwise would have had none.

The Nutshell

This is an extremely complex financial issue, and the post that fully analyzes it is quite long. Here is the quick-and-dirty breakdown of the ups and downs.

The logic of this strategy is undeniable, and it seems, on the surface, as though it really is as great as they make it out to be. These are the conditions under which a mortgage leveraging strategy might work:

1. Your investment vehicle must be able to consistently outperform the market as a whole over the long run.
2. Your mortgage payment is currently a relatively small portion of your income.
3. In order to get a good rate, you must have good credit. Poor credit leads to higher interest costs on the mortgage and raises the required return on the investment.

Here’s a few of the pitfalls to be aware of:

1. Inability to make larger mortgage payments on equity loans. If it takes too much of your income to make payments on the equity, then you will place yourself under undue stress.
2. Tax-sheltered retirement plans have contribution limits. These limits may prohibit you from getting tax breaks on your investment growth, which will make it harder to make a profit on your equity. In 2007, this limit was $5,000/yr for most retirement vehicles.
   (source: http://www.irs.gov/formspubs/article/0,,id=117542,00.html)
3. If you use a life insurance policy as your investment vehicle, be aware that the cost of the life insurance policy may be quite high. Be sure to check into the costs and evaluate what effect they will have on your investment’s ability to outperform your mortgage interest.
4. Be aware that your investment advisor probably stands to make a huge comission if you choose to invest your home equity, especially if you choose life insurance as the vehicle. If possible, try to get an unbiased second opinion.

That’s the very very short of it. For a more in-depth analysis, keep reading!

Sign Me Up!

Here are some of the arguments used to promote such an investment strategy:

1. Your home’s value continues to appreciate regardless of how much equity you have in it, so you might as well invest the equity and double the growth.
2. By pulling out your equity, you provide yourself with some liquidity (ability to convert assets into cash at need). If you should become unable to make your mortgage payment, you can simply pull funds out of the investment account to make your mortgage payment and thus keep your home in hard times.
3. Since the interest on your mortgage is tax deductible, this can help you pay fewer taxes.
4. What if interest rates are high? Not to fear, market rates of return tend to run parallel to interest rates, so your investment will always outpace your loan.
5. Since you do get a tax break on mortgage interest, this lowers the effective rate of interest that you pay.
6. Life insurance policies grow tax-free, and a lump deposit will buy insurance for life!
7. You qualify for a loan based not upon your equity, but on your income. Therefore, you should pull out your equity while you are employed so that it can be used when you are unemployed.

Let’s take a look at these arguments.

Argument 1

Very true. Your home will appreciate regardless of how much is owed on it. Since your home equity represents gobs of your of money that is essentially doing nothing, it would seem logical to invest those funds so that they can grow.

Argument 2

My favorite of these arguments. If you have $70k in the bank when you lose your job, you can continue to make all of your critical payments without being foreclosed on. This is definitely a plus of this plan.

Argument 3

Also valid. Tax savings lower your effective interest rate on your mortgage, and put cash back in your pocket. But you still wind up paying more than you save (for a detailed discussion of tax benefits of home ownership, see this post).

Argument 4

Really only vaguely true-ish. What is true, and the source of this “misunderstanding” is that when the Federal Reserve Board meets and establishes a high base interest rate for the economy, this is generally a sign of good economic health. When interest rates are lowered, it is (again, generally) a sign of deteriorating economic conditions. Thus, when rates are low, the stock market performs poorly, and vice-versa.

At least, this is the argument maintained by advocates of mortgage leveraging. But just take a look at the recent economic conditions; interest rates are at all time lows, and the stock market is performing poorly. But the stock market performance is in no way correlated to the actual costs of a mortgage today. If you are paying 6% for your mortgage, you would be disappointed if you expected to see the stock market give you 8% or 10% this year, as some mortgage leveraging proponents would tell you. You would find that you are taking a loss this year, in some cases, a substantial loss. The graph below shows historic mortgage rates superimposed upon historic annual rates of return for the S&P 500 (generally considered by financial professionals to be a fair representation of “the market” as a whole). Do you see strong correlation here? I don’t. There is a general tendency for interest rates to drop when the stock market drops, but it certainly is not a 1:1 correlation, and the market rates are always lower than the mortgage rate.

Argument 5

Also technically true, but deceptive. The tax break does reduce your EFFECTIVE interest rate, but not your ACTUAL interest (the one which determines your payment). The only way the tax break would affect your payment would be if you used it to reduce the amount you must pay out-of-pocket each month. The tax break could be added to your investment portfolio (as I did in my spreadsheet analysis) to increase the effective rate of return there.

Regardless, any returns you get from your investment will be automatically reduced by the amount you pay in interest to the bank. In the example above, the loan was issued at 7%. This means that any return your investment gives automatically gets a -7% tacked onto it. Here is where we get into the dangers of leveraging. In years of moderate growth or small downturns in the market, your equity account can lose a great deal of money. Very high returns are required to overcome the costs of the mortgage (and insurance costs, if you choose an insurance vehicle). This leads us to….

Argument 6

Technically true, but misleading. Even though you are not making regular payments into the fund, you are still paying the cost of insurance every month. These costs are necessary to any life insurance policy and most people do need life insurance. So if you gotta pay for it, why not get some benefit? It’s a good point. The problem, however, is that in their much-touted calculations, the pros fail to account for the draining effect of the cost of insurance on the value of your invested equity. For deposits of the size we are talking about with mortgages, the life insurance policy would have to have a very large death benefit in order to be able to legally accept funds of such magnitude. And a large death benefit naturally incurs a large cost to the investor. Plus, you could get a term insurance policy, which is much cheaper (often 80-90% cheaper) than a cash value policy of any kind, and invest the difference, thus giving your funds a positive boost, rather than a negative drain. To do so, however, you must place your equity investment into a taxable vehicle, and the drains on that are likely to exceed the drains of the life insurance. To sum up; the cost of insurance and the cost of the mortgage both add negative growth to your invested equity, and make it that much harder for you to get ahead.

Argument 7

The twin brother of argument 2. If you do need to access your equity for some emergency, but have lost your source of income, you will find it impossible to obtain your equity because your income has dried up. This is a valid point, and one I agree with. If you are going to pull out your equity, you need to do so while you can, because when you need it, it will not be available to you.

Argument 8

What? You thought there were only 7 arguments? Well, this is an argument in favor of lmortgage leveraging, but not in the way you might think. It’s an important point for any person considering this strategy to consider, but they will never hear it. Why won’t the client hear this argument? Let me tell you the argument, and leave it to you to answer that question.

Financial planners make huge commissions selling cash value life insurance policies, and the bigger the death benefit, the better.

I think it might surprise you to learn where I first heard of the “mortgage leveraging strategy”. As a financial professional, I am obligated to attend continuing education classes to keep my licenses current. I was a little surprised to attend a LIFE INSURANCE continuing education class and have the entire time dedicated to the virtues of mortgage leveraging. Why was this concept taught at a life insurance class? Because the advisers and life insurance companies make tons and tons of money selling high death benefit policies. The commission a planner gets for writing a cash value life insurance policy will give him/her a commission that can be up to 5x greater than the commission for a mutual fund representing an equivalent cash investment.

Let me just add that I am not mentioning this point to frighten you away from using financial advisors. I think a goodly many financial planners and advisers are in the business to help people, but you should be wary because there are planners out there who are somewhat predatory, and will not be afraid to put their interests ahead of yours. I am also not saying that I am opposed to using cash value life insurance policies (in fact, I think the only way I would ever consider mortgage leveraging is within one specific type of cash value life insurance policy). They can be very useful to certain people. But I think it is important for you, the client, to be aware of the potential conflict of interest.

Pit Stop

You may want to pause and get a drink or stretch your legs before you continue. I know this post is very long, but there is a good reason for that. This is an extremely complicated financial issue, affecting almost every single aspect of a personal financial plan. If you are ready, let’s keep going.

The Downside

Let’s take a look now at some of the more problematic areas of the strategy.

1. It is expensive. One of the troubles of this approach is the massive mortgages that have to be taken out to support it. You may be able to afford a $300,000 mortgage now, but when that has ballooned to $520,000 in ten years and its time to refinance, can you afford a near doubling of your mortgage payment? You can’t take the money out of your investment earnings to make the payment without sacrificing your compound interest, and thus, destroying the whole system. So, who can afford such a system? Only people whose income already vastly outstrips their mortgage payment. How many people do you know who can afford to double their mortgage? Sure, many people’s incomes will increase. But will it be enough? And what about those people who are already at the peak of their careers?
2. Refinancing restrictions. Generally, a bank will not allow you to withdraw more than about 80% of the equity in your home through a refinance or home equity loan. This means that the amount that you will be able to pull out of your home will be substantially reduced, which reduces the amount you have to invest and the subsequent interest you may earn.
3. Closing costs. Ah, closing costs. The great money maker of the mortgage lending machine. I will do another post that goes into detail on what these beauties do to your mortgage. All you need to know now is that you can expect to pay anywhere from 3%-5% of the principal of your loan in closing costs whenever you take out a mortgage. This includes refinances. So, each time you refinance to pull out more equity to invest, you will pay dearly for the right to borrow your own money. It doesn’t seem particularly fair when you think about it that way, but it’s the truth. These closing costs are yet another factor that cuts deeply into the equity investments long-run results.
4. Increased risk. While having some cash in savings from your equity on hand to make your mortgage payment is a good idea and reduces your risk, the overall risk of leveraging your equity is quite high. First of all, if you should experience a drop in value in your equity account at the wrong time, then you may not have the funds you need and you can lose your home easily. Secondly, if you refinance periodically, you run the risk that interest rates will rise. As we have seen earlier, higher interest rates does not promise, in any way, that your investment will return higher yields than your mortgage charges.

But my adviser showed me the numbers and it works, big time!

Have you ever heard the expression “you can prove anything with statistics”? Everybody knows that stats can be tweaked and tortured until they beg for mercy and willingly confess whatever the statistician wishes them to confess. Well, financial calculations can be like that a bit as well. The reason for this is because financial calculations can quickly become extremely complex when you try to incorporate every applicable factor (that’s why financial analysts are so well paid). So, whenever someone wants to try to convince someone of a certain financial “fact”, all they have to do is omit, for the sake of “simplicity”, certain details. Often, long-term averages for market growth are shown, rather than actual results. While the market will PROBABLY tend towards the average, the specific timing of market drops can be crucial, and the regularity of those drops can also be crucial. You will ALWAYS get different results in reality than is shown in projections.

I have seen a number of calculations involving leveraged mortgages, and they all show that the person who pays off their home is stupid and broke, while the savvy, hip, young financial guru is sipping martinis in the Bahamas with their multi-million dollar retirement. In these calculations, all you are shown is the final dollar value of the investment vehicle. You are not shown any costs, losses, or remaining equity (because there presumably is no equity in the home, or very little). But what matters at the end of the day is not just what is in your retirement account.

Perhaps the biggest factor contributing to the deceptive nature of these calculations is their simple incompatibility with each other. In finance, it is very important to put everything into the same terms. In other words, you must compare apples to apples. When the pros show you a calculation that shows $1 million more in the leveraged equity account than in the paid off home, what they are not showing you is the cash flows behind the strategies.

Here is a quick example:

Jill is considering purchasing a $250k home in an area where homes are appreciating at 5% per year, on average. If she gets a 30 year traditional fixed rate mortgage, her payment will be $1,555 each month (at 6.35%). Now consider the alternative. Bill can get a 30 year mortgage that is interest-only for 10 years, and will refinance his home every 10 years. This would give him a payment of $1,322 (at 6.35%). Ten years later, he refinances. His home has appreciated such that his new loan has a principal of $325k, and a payment of $1,723 (at 6.35%). Ten years after that, he refinances again, this time taking a loan of $530k, with a payment of $2,808(at 6.35%). At this point, Bill’s advisor will tell us that the Jill has no savings, while the Bill has $1.2 million in savings.

Seems like a no brainer, right? Well, not really. Consider this: Bill spent/invested $850k while Jill has spent/invested only $560k. That is a huge difference, especially if those funds are placed into interest-bearing accounts. In this scenario, also think about this: since Jill has a significantly smaller payment, why can’t she be investing some each month? Equity leveraging advocates will show you success by using uneven cash flows. How could Jill possibly have as much money in the bottom line if she spent half of what Bill did? If you balance out the cash flows (ie let Jill invest the same amount of money that Bill spends on his mortgages), you will see that Jill comes out with the same funds, or maybe even more. It depends on a large number of variables, but basically, leveraging the home increases your risk, while giving you lukewarm results.

Taking all these factors into consideration, I have tried to incorporate the following principles into my analysis:

1. Inclusion of ALL costs associated with each approach. I have been equally brutal towards the 30 yr and 15 yr traditional mortgage payoff approaches as I have towards the refinancing approach. I have included closing costs, refinancing restrictions, tax costs (investments are considered to grow in taxable vehicles because life insurance policies may not be the best place for those funds and because taxes are easier to estimate than life insurance premiums).
2. I have used the actual S&P 500 returns for the past 30 years in my analysis. The reason for this is simple. Often, long-term averages for market growth are shown, rather than actual results. While the market will PROBABLY tend towards the average, the specific timing of market drops can be crucial, and the regularity of those drops can also be crucial. You will ALWAYS get different results in reality than is shown in projections. By using the actual results, I hope to get a more accurate reflection of the market’s tendencies.
3. Equivalent cash flows. The monthly cash outflow, whether to the investment or to the mortgage, is the same for each mortgage type. This makes it so that each plan spends the same amount of money so that the ending net worth can be profitably compared.
4. Tax benefits. In my spreadsheet, I have taken account of the advantages of mortgage interest tax deductions for all types of mortgages. In this case, I have taken each year’s tax returns due to the mortgage interest tax-deduction and placed them into the investment account.

Let’s look at the numbers

Use this spreadsheet to run your own numbers, in a way that makes sense to you. I have found that, in general, it takes an exceptional combination of good fortune for the mortgage leveraging to really pay off. Have you noticed that the 30 year fixed rate loan actually returns the highest net worth to the investor? It actually beat the 15 year loan, and I’ll tell you why. I used the actual rates of return for the past 30 years as the interest rate that the invested funds grow at. Because the 15 year loan got a late start, it was more adversely affected by the giant market drops of 2002 and 2003. Notice that if the long-run market average rate of return is used as the growth rate, then the 15 year loan returns jump significantly, and surpass es the 30 year loan (see the sheet for the year-by-year breakdown of the 15 year loan for this comparison). It just goes to show that market volatility never quite mirrors the results you see when an average rate is used for every year.

Equity Leveraging Spreadsheet

Conclusion

While there is a chance that using this strategy will put you on top, the amount by which you come out on top is usually relatively small, and the risk level associated with a leveraging strategy is quite high.

In order for this strategy to work, high investment returns are required. While there are many people in this world who are convinced that they can get very high returns every year over the market rate of return, but as Burton G Malkiel, in his time honored book A Random Walk Down Wall Street, explains, no money manager in the recorded history of the stock market has ever beaten the stock market returns for more than a few years at a time. If you are convinced that you can beat the market by significant amounts, then this approach should definitely bring great wealth. But, if you are wrong, then you could be in serious danger.

The best argument of this theory is the liquidity provided by pulling your home equity while times are good. If you choose to pull your home’s equity, I recommend using an Equity Indexed Universal Life insurance policy for your funds. These are great funds because the insurance company will guarantee that your account will never decrease in value; in exchange, they place a cap (usually around 10% or 11%) on how much your account can grow each year. By using an account like this, you can avoid costly taxes and mitigate much of the risk of losing your equity to a market slump. But be aware of the costs of such a life insurance policy. While you may still wind up losing money, it is likely to be a small loss. This is, in essence, like purchasing mortgage insurance for yourself, just in case times get hard, and and loss you may take should be considered a “cost of insurance”. Of course, you could also make a profit, in which case you may want to buy some champagne and pat yoursel fon the back.

Alternatively, instead of pulling out most of your equity in a lump, you can establish a home equity line of credit to accomplish much of the same purpose. With a line a credit, you can basically use your house as an EMERGENCY credit card, and pull out only as much equity as you need to keep making your payments long enough to get back up on your feet. Be very very careful of the temptation to use your home equity credit line when the need is not terribly dire. Such a casual burning of your equity will put you in grave risk of losing your home.

For more information and ideas on this topic, check out this article.

The Word on the Street:

This is one of the big myths of our day. The myth holds that keeping a mortgage to its full term, rather then paying it down early, is wise because the homeowner can deduct the interest payments from his/her federal taxes.

The Truth:

Keeping a mortgage (or any other loan for that matter) for a longer period of time will always end up making the homeowner pay more in interest than can be saved in taxes.

Doubt me? Let’s run the numbers on three different size mortgages and see if I am right.

A Simple Truth

It always amazes me to think that there are professors and other people with PhD’s who cannot decide if this myth is true or not. I have crunched the numbers on dozens of different mortgages with a range of interest rates and tax brackets, and I have never found a mortgage for which this theory holds true.

In fact, when you look at it a different way, you can see that it is impossible for the tax savings on a mortgage to save you money while the mortgage is in force. It really boils down to a very simple truth about taxes.

Depending on your income, the government takes a percentage of your income as taxes. The higher your income, the higher the percentage they take in taxes. The idea behind the tax deduction is that you reduce how much of your income that the government taxes. So, if you pay 40% in taxes and you make $100,000 in a year, the government will take 40,000 in taxes. If, however, you have a mortgage and you deduct $10,000 worth of interest, then the government only takes 40% of $90,000, which is $36,000, a tax savings of $4,000.

But think with me now. In order to get the deduction you must pay interest. In the example above, the person paid $10,000 in interest, but only save $4,000 in taxes! This is the simple truth: in order to save $.40 on taxes, you must spend $1.00 in interest. The interest will always exceed the tax saving! To put it mathematically:

Tax Savings = Tax percentage * Interest Paid

And since the tax percentage is always less than 1, the tax savings is always less than the interest paid.

An Example

The following tables analyze a $200,000, a $300,000, and a $400,000 mortgage at 6% interest kept for the full 30 years, and for a shorter term if an additional $200 is paid towards the mortgage each month. The homeowner is in a 40% tax bracket.

You can see that the interest payment dwarfs the tax savings in every case.

Now let’s take the same graphs and combine the results. The yellow area in the graph below represents the positive cost difference between early repayment (ER) and paying to full term (FT).

As you can see, paying the mortgage down early will save you more money that you can save in taxes. This is the simple truth, no games or hidden tricks.

Another Perk

Another perk of early repayment of a mortgage is that you have saved time for investment. In the case of the $300,000 mortgage, a $200 extra monthly payment would chop about 7 years off the repayment time. That is 7 years that you get to enjoy your home payment free. That is also 7 years in which your income is freed up for investment. This is when you do your heavy hitting investing. With the mortgage gone, it is not unreasonable to invest the entire mortgage payment (a total of over $20,000/year). Investments like that add up fast!

It can’t be so simple, can it?

Well, when you boil it down to just the taxes and interest, it is that simple. However, many people endorse a philosophy of investing your extra money instead of paying down your mortgage. This philosophy has its merits, but is beyond the scope of this particular post. If you want to see reasons to keep your mortgage, then keep coming back, because this myth is next on our list!

To Be Continued…