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What Were Our Parents Thinking?
Paying off mortgage debt isn't always the best tactic
Kevin J. Daum
This article was originally published in the July 2005
edition of Log Homes Illustrated magazine.
Ever since the Great Depression, parents and grandparents
have taught their kids that they should pay off their mortgages.
Seventy-five years later with credit card balances at an all
time high and the economy inconsistent, this still sounds
like sound advice. Surprisingly, paying off your house today
can cost you money and put you at great financial risk.
How can this be? Isn’t a paid off home the essence
of safety and security? As a 22-year real estate industry
veteran and expert, I can answer unequivocally no, not compared
with having money in the bank or diversified investments.
You may find this surprising, considering the number of banks
pushing 15-year loans, not to mention the countless bi-weekly
payment services telling you how much interest you save by
paying off your mortgage early. I am here to tell you that
they are only telling you part of the story.
Most loan officers don’t have the time or knowledge
to teach you the truth about the proper care of your mortgage.
Sadly, the refinance boom of late has made the mortgage market
so price competitive that most loan officers are nothing more
than order takers, trained to take your information and give
you exactly what you asked for – even if it is bad for
you. It’s known as selling you on the path of least
resistance.
The margins in the mortgage business are so slim today that
loan officers are trained to make extra money by selling you
extra services, like the biweekly payment service that do
little more than get you making an extra payment each year
by making 26 half-payments resulting in 13 full payments each
year. You, of course, could do this yourself and knock 7 years
off your loan without paying a fee to anyone else. But, as
I point out, this approach isn’t really benefiting you
anyway.
I am constantly amazed how people are consistently inconsistent
when it comes to their real-estate decisions. They insist
on fully amortized loans that force them to pay off their
mortgages and then turn right around and take money out by
refinancing or in the form of Home Equity Lines Of Credit
(HELOCs). This is all in the name of being conservative.
Ironically, paying off your house is the risky and at times
foolish in the realm of smart money management. Following
are the arguments against paying off the old homestead.
Liquidity reduces risk. Having lots of money
readily available has two conflicting effects on people. First,
it creates fear and anxiety. There is very little consistent
education on managing personal wealth. That means people have
to teach themselves and navigate through all the media and
hype to figure out what is real and what is snake oil.
Everyone has heard overblown horror stories of people squandering,
spending or poorly investing savings, leaving them emotionally
burdened with financial failure. While this can happen, it
is not usually the case with smart, cautious investors. However,
this fear drives many people to put their money in their house
where it is inaccessible.
Once people overcome their irrational fears, the second effect
that lots of cash has is it makes them feel strong and secure
since they can use that money to solve any problem that might
come their way. With a ton of cash, you never have to worry
if you lose your job or a health issue arises. No need to
tap the credit cards or borrow from someone else if you are
piling money every month into CDs and investments. In fact,
the more money you have liquid the more the banks and credit
companies will go out of their way to offer you more.
As a society, we are far more impressed by the person with
$250,000 in the bank then we are by the person with a free
and clear $500,000 house. That is because Mr. Moneybags can
buy his way out of any problem on the spot, whereas Mr. Equity
has to go through a refinance hassle and secure a loan before
he can resolve his issues. If Mr. Equity hasn’t paid
off his house yet and took a 15-year loan, he will have a
much harder time resolving his financial problems than Mr.
Moneybags. Mr. Moneybags can take his time to wait for the
right job or sell the house for full price while Mr. Equity
scrambles to keep from being financially ruined.
Investment diversification protects against losses.
Although real estate is a consistent performing investment,
it can have its volatility like any other investment. If you
have all your money tied up in your real estate and the market
takes a fall, you could find a significant part of your net
worth wiped out. In today’s economy most people have
too many eggs in the real estate basket. Today’s homeowners
typically have more than 80 percent of their net worth in
their house and very little in liquid investments. How nervous
would someone be if all his or her money were in one stock
or mutual fund?
People often think having their money in real estate
equity protects them against high interest rates, but quite
the opposite is true. For example, the highest interest
rates in the modern history of the US were in 1980. Treasury
Bonds were yielding 21 percent. Mortgage rates were pushing
20 percent. If this were to happen in today’s market,
and you were on an Adjustable Rate Mortgage (ARM), you could
see your loan rocket to its 10 percent life cap. However,
if you had liquidity, you could take your cash and buy the
high yielding T-Bonds. If you had done this with $100,000
in 1980, the compounding interest would have given you an
investment today worth more than $13 million.
Investment yield can compensate for interest costs.
A common argument for keeping money in equity I hear is the
minimal yield banks are returning these days. People will
argue that there is no point in borrowing at 5 percent if
a CD will only yield 2.5 percent. This is mainly an argument
against financial education. CDs are not the only safe investments
out there today.
According to Andrew West and Leslie Pincombe at Merrill Lynch,
considered to be conservative advisors, a reasonable investor
over time can, with reasonable diversification, expect to
see an average 8 percent in the marketplace. That means no
day trading and junk-bond buying.
But even the S & P 500 has resulted in better than 12
percent over any five-year period in the last 50 years, including
during the Internet bubble. This means that you could borrow
$100,000 on a 5.5 percent fixed-rate loan and make a profit
after covering your interest costs of $2,500 to $4,500 annually
with minimal risk. Or put another way, those of you with $250,000
in equity are throwing away between $6,000 and $10,000 in
free money every year.
Even if you don’t like the investment climate, you
can always choose to pay off the loan at that time if you
have the cash on hand. But it is better to analyze the return
on your investment instead of forcing mandatory investment
at low mortgage rates through amortization.
Mortgage interest is your biggest tax deduction.
Regardless of whether you live in a red or blue state, we
all generally agree we would like to pay less to support the
government. Income taxes can eat up anywhere from 15 to 45
percent of your income, depending upon where you live and
how much income you report every year to the IRS. Now, you
Depression-minded people get ready because this next benefit
didn’t exist until the 1950s.
The largest single deduction for almost everyone is home
mortgage interest. There are limits on the interest based
upon the size of the loan and how much cash you have taken
out of your property, but on a new purchase you can write
off interest on a loan of up to $1,000,000. At 5.5 percent,
that is $55,000 in tax deduction. Not only will that save
you as much as $24,000 in a state like California, but it
might even be enough deduction to drop you into a lower tax
bracket, saving you even more. This is truly one of the great
government subsidies, and since most members of congress are
homeowners, it is not likely to go away soon.
Unfortunately, if you pay down the mortgage on your home
you do double damage. Not only do you remove today’s
deduction, but also you reduce the amount of deductible loan
amount for the future. The IRS allows you to deduct interest
on your lowest loan balance plus the cost of any capital improvements
plus $100,000. So, if you paid down your loan from $500,000
to $100,000 and decide to take the money out again, you can
only deduct the interest on $200,000, assuming you make no
improvements to the house. On a 5.5 percent loan, you unknowingly
cheated yourself out of $16,500 in tax deduction or as much
as $7,000 in free government money.
These and others are strong reasons particularly for you
retirees keeping your money in your pocket rather than paying
down your mortgage. With people living longer, the odds of
living out the rest of your life in your house are getting
slimmer. Most elderly people will end up living in assisted-living
facilities at a cost of thousands of dollars a month, and
many will have to sell their homes in a hurry to pay for it.
Additionally, many people now are finding their fixed income
to be insufficient to cover their monthly expenses and are
taking risky expensive reverse mortgages that eat away at
the equity with most of the benefit going to the banks.
Here is the truth regarding the fallacy of saving interest
by paying off your mortgage early. If paying an extra $300
would shorten your loan by, say, five years, you could invest
the same $300 at an equal interest rate and have the same
amount of money available to pay off the loan five years early
if you so choose.
So, next time you are sitting with extra cash in your hand
at the end of the month and are thinking about paying down
that mortgage stop, count to 10 and consider the previous
arguments. Do yourself a favor and seek out financial advice
from investment advisors and your CPA before recklessly investing
your money in a place where it can cost you greatly.
Kevin Daum is the Founder and CEO of Stratford Financial
Services, a Real Estate finance and education company, founded
in 1989. Stratford specializes in Purchase loans, Refinance
loans and Custom Home Construction finance and has successfully
financed thousands of clients. He is the author of "Building
Your Own Home for Dummies" (Wiley), as well as "What
the Banks Won’t Tell You." Mr. Daum was an Underwriter
for Plaza Savings and Loan and Key Bank of New York. He is
an INC 500 CEO and has been listed as one the 40 Most Influential
People Under 40 in the San Francisco Bay Area. He is the Global
Chair for the Edison Innovation Program with the Young Entrepreneurs'
Organization (YEO) and is a founding Board member of the Bay
Area Chapter of YEO.
Mr. Daum is a frequent contributor to numerous business
publications on the subjects of Real Estate and Small Business
leadership and speaks regularly on both subjects. He can be
contacted at kevin@stratfordfinancial.com.
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