Paying down house vs Saving for retirement

I thought this was an interesting video from Fox Business debating whether to pay off your house or saving for retirement. The argument for saving for retirement was:
1) Lots of expenses when you are retired.
2) Housing is one of the few fixed expenses
3) You can make more after tax on your house.

The argument for paying down your house:
1) Emotional security of having the house paid off.
2) Expenses are down significantly with the mortgage paid off.

The guy arguing for paying down the house, Craig Carnick, did a poor job. His whole argument was emotional security. Ignoring that a bad couple of years in market like we might be seeing now could kill you in retirement if you are planning on that money to pay your mortgage. Not to mention the fact that when you are in retirement, you reduce he risk of some of your portfolio which makes beating the after tax mortgage payment with your after tax investments more difficult. Plus, a person making this decision probably has gotten their mortgage to the point they are paying a lot more principal rather than interest, meaning that "free" money from interest is probably not that much.

Ohh well, I do agree with Craig Carnick in that the paying off your mortgage reduces your expenses and allows you to have much more flexibility to maneuver around and meet your needs in retirement.

"One size fits all when its the truth"

Listening to a recent Dave Ramsey podcast, he said "One size fits all when its the truth." I think that is a great statement. As I stated in a recent blog post, I believe that a lot of Dave Ramsey's advice is general. Make no mistake what I mean about this is that a couple of the things he teaches are his opinions and some are based on truth. For example, the truth is borrower is slave to the lender and debt is bad. Therefore, he urges people to get out of debt, avoid debt no matter whether its considered "secured" or not. Ask anyone who has a lot of debt and most of the time they will be frustrated that they so much of their hard work goes to paying debt. If your mortgage is 25% of your income, do you like that every day 25% of your time working is to pay someone else? Probably not. "But I get property out of that." If you have a 30 year mortgage, you haven't even paid off half of the mortgage until 20 years into paying that debt!

When its the truth, like North is North, the temperature, or how much money you have in your bank account...the truth is not relative. However, some of Dave's advice is opinion and not truth. "You must put 15% of your gross in retirement savings." I am not sure what truth that is based on. You must save for retirement, no doubt. If you don't know what you will need, 15% will be a great start. But, I am not sure the 15% should be taken as truth. I will tell you one thing though, if you are just out of college and do 15%, you will live a great life in retirement and thats the truth...

The advice is general, not specific

I Googled recently for Dave Ramsey's credit card study information and found lots of blogs spreading anti-Dave Ramseyisms and I realized that people just don't get it. Dave Ramsey provides general advice which can be applied to everyone. That doesn't mean every piece of advice is the best for everyone, but its good for everyone. For example, someone called in to his show a couple month's ago and asked about 529s. He admitted on the show that not all 529s are bad, but some of them are so its easy to just say avoid them all. Looking into it, I found that some states limit investment choices and charge high fees for their 529s. If you are in a state where you can invest in a mutual fund with a long track record (10-15 years) that has low fees and get a tax deduction for doing so, I believe he would say that is a good choice. But, since not all states and 529 plans are like that, its easier to suggest other investment methods when they exist and also are tax advantaged.

Other areas where I think he gives general advice are the amount to save on retirement and never to use credit cards. The amount to save for retirement he suggests is 15% (once consumer debt is paid off) of your gross income. Advice can't possibly be global like that and perfect for everyone no matter their age, salary, and family situation. So, he gives the best rule of thumb, 15%. You can calculate how much you will need for your particular lifestyle, salary, and age and probably come up with a better figure for yourself. But, if you can't figure it out, 15% of gross will probably work.

Another example is credit cards. Dave says the following:

You’re also paying more. A study by Dunn and Bradstreet showed that the credit card user spends 12 to 18% more when using credit instead of cash. After McDonald’s began taking credit cards, they found that people spent $5 to $7 more per sale.

If someone was disciplined and got a credit card purely for gas purchases making 5% cash back (instead of rewards they will never use)...I doubt they would buy 12-18% more gas just because they are using the credit card or they will buy gas from places with 12-18% higher prices than they would have with using cash or a debit card. The fact is most Americans are not this disciplined. So, a better general rule is to avoid the credit card altogether.

Would Dave agree with that? Not sure, but I believe it :-)

Investment or Mortgage

I had a conversation with a friend this morning about how poorly our 401ks have faired this year. Although they are almost breaking even for the year, the market volatility had me thinking...

One of the popular questions people ask is whether it is better to push money into investments or on to your mortgage. Some financial advisers will tell you to put it into investments which will get you 8-10% while you only pay 6% on your mortgage. Others will point out the tax advantages of the interest on your mortgage, while ignoring the tax implications on your investments. Either way, working out the numbers you can make more if you assume an 8-10% return than you spend would on a 6% mortgage.

Other financial advisers, like popular anti-debt talk show host Dave Ramsey, will tell you to fully fund your 401k and Roth IRAs before paying off your mortgage. Fully funding, according to Dave Ramsey, means 15% of your gross income towards Roth IRAs and your pre-tax retirement accounts like IRAs and 401ks. At that point, he would tell you to put it towards your house debt because you wouldn't take equity out of your home to put it in the stock market, would you? The answer is, you especially wouldn't do so now.

The key is that the 8-10% return on investment is projected and you will not find guaranteed interest higher than your mortgage. The market has proven its volatility this year and you would have struggled to get over 5% back on stocks, mutual funds, through money market/savings accounts, or through CDs/bonds this year so far. Yet, most of us with mortgages have primary mortgages somewhere between 5-7% with some secondary mortgages from 7-10%. So far this year, paying off your mortgage would have been the better financial decision. In the end, paying down your house also brings more financial stability to your family and more freedom overall.

An executive who I reported to around 2004-2005 when hearing I was purchasing a house made the comment that he hopes it was a big mortgage, cause "thats how we lock in our employees." Was he joking? He said it jokingly, but there was some truth behind that joke. Many people rely on their salaries to pay their mortgages and couldn't take a pay cut. If you had your house paid off, you might be able to support your family while working a lower paying job. That helps financial stability. Also, you might be able to choose to do something you love rather than what you put up with. :-)

Finally, imagine what you can do with an extra mortgage payment in your pocket every month. Let's say you have a low mortgage payment of $1000 per month. If you could invest that over the next 10 years instead of use it to pay off your mortgage, in 10 years at 10% annual return your would have over $205,000. Try it with your mortgage numbers using this Investment Calculator.

As my friend concluded our conversation today, "That guaranteed 8% by paying down my [second] mortgage is sounding pretty good about now."

Amortization schedules show the real problem

Financial Advisors love to flaunt the power of compound interest, that is the amount of interest money can earn over time when you earn interest on the principal and interest that exists. If you look at an amortization schedule, you will see the opposite, almost a negative compound interest thing happening.

First, an example. Using an Amortization calculator and Freddie Mac's current weekly average mortgage rate of 5.85% on a 30 yr loan starting in April of let's say $150k, you will find I would pay off the first half of principal in February of 2029 making the minimum monthly payment. Thats almost 21 years to pay off $75,000 at almost $900 per month! By the end of 30 years, the total interest paid is over $168k!

While changing the principal doesn't change when you pay off half, your interest rate does. If you have a higher mortgage rate, lets say 7%...you pay off half in December of 2029. So, when you pay off your first half of your mortgage varies from about 20-22 years based on the current interest rates.

Now, in the past people have paid little to no attention to these schedules. Its because paying off principal wasn't an issue when houses were growing at 4% compounded annually. But, with the recent housing market growth slowdown, I hope that more people pay attention to it. If someone gets a 100% financed $150k house now and prices only go up 1% per year for the next 3 years and then they try to sell it, they will have paid off roughly $6.5k in principal and gained about $4.5k in value on their home. So, if they sell it at that $154,500 with a standard Realtor fee of 6%, they will pay $9,270 in Realtor fees. This will leave them with a whopping $1,730 check for paying $32,400 in mortgage payments not including PMI, homeowners, and taxes. Sure, they will also have got a small tax deduction during that time...but I think they might have been able to rent and save more money.

Just as a matter of opinion, look at your amortization schedule and consider dropping some more money into your mortgage monthly. Maybe you can pay off the first half a bit quicker than in 20 years then :-)

Savings on cars is a great investment vehicle

In Fidelity Investment's quarterly magazine this month, they had an article entitled Rev up Your Retirement Savings. In this article, they declared that the average car loan is $479/mo and lasts 48 months based on information they had gotten from Edmunds. If people kept their car an extra year and invested that $479/mo with a 7% annual return, they would have $199,190 in 35 years. If they kept it two extra years, they would have $331,823 in 35 years. I set out to look closer at these numbers...

First, the data for their average expense of a vehicle comes from this article at msn.com called ABCs for a great car loan. That article says:

In the United States, the average down payment for a car is $2,400, the average amount financed is $24,864 and the average monthly payment is $479, according to Edmunds.com. The most popular loan term is now a payment-stretching six years. If you're "upside down" on your old car loan (you still owe money on it after the trade-in), it's no longer a deal breaker. In these days of easy credit, lenders will roll the old balance into the new. Nor are down payments de rigueur; you can finance up to 100% of the manufacturer's suggested retail price, plus taxes, tags and fees.

So, according to that the average car costs $27,264...but is 6 years and not the 4 years Fidelity uses. So, they already have a hole in their logic. Regardless, I think $27,264 is a bit high and I will use their numbers, $479 for 4 years making the total spent on the car $23,000 including interest.

By my calculations, at 4.8% this $479 payment for 48 months would let you buy $20,485 worth of a car. If I take that as your initial savings when you have a car loan and as not your initial savings when you don't have a car loan, than I can run some different numbers. SO, if you had $20,485 and got this 4 year loan at 4.8% interest but in the fifth year put all $479/mo ($5,748) towards your savings and got a 7% return, then you roughly would have $342,500 after 35 years. If you keep the car an extra year and put another $5,748 towards your savings with 7% return, you would have $430,500 roughly. If you paid off the car with your initial savings and bought a new car every 5 years, saving the rest, you would have $228,200 at the end of 35 years. That initial lump sum grows more quickly with compound interest than you can keep up. With buying a new car every 6 years debt free, you end up with $322,600 and every 7 years you end up with $390,000. All of this can be seen on the chart above.

Does this mean going debt free does not make sense when you run the numbers? Absolutely not. Because what is not shown, is the risk. Would you take a loan out at 4.8% per year to put it in mutual funds? Probably not...but thats essentially what you are doing. Because I had the spreadsheet made, I was able to play around in numerous what if sort of scenarios. What if interest rates on car loans go up or what if we hit a bad point in the economy where stocks go flat? That can't happen, could it? Of course it could and it is happening right now. In these cases, the no debt models win every time.

Feel free to email me if you want the spreadsheet to play around for it yourself...