How to be Setup for Life ?

[MonarchDon]

Hope this is the correct forum to post this question.

I'm in my early 40's and have investments in the stock market (trading account, sep ira, roth ira, etc) but I have not made much money with those accounts. The real money I have made is the equity I have in real estate, I have been lucky to buy at the right time.

What would you do in this situation. I have a house worth $800k and I owe 180k I have the $$$ to pay it off right now, I have 29 years left on a 4.875% fixed rate. I want to pay it off but others have advised me not to.

I have a rental property worth 250k that I owe 75k on at 5.375% fixed. I want ot pay it off also and be totally FREE AND CLEAR. I call that having F.U. Money. What do you think?

[deathtoau]

John Waggoner:Investing - Should you pay off your mortgage? Maybe not (http://story.news.yahoo.com/news?tmpl=story&cid=677&e=15&u=/usatoday/johnwaggonerinvestingshouldyoupayoffyourmortgagema ybenot)

[player24]

[ QUOTE ]
What would you do in this situation. I have a house worth $800k and I owe 180k I have the $$$ to pay it off right now, I have 29 years left on a 4.875% fixed rate. I want to pay it off but others have advised me not to.

...and be totally FREE AND CLEAR. I call that having F.U. Money. What do you think?

[/ QUOTE ]

Compare the after tax cost of your mortgage with the after tax cost of a duration matched risk free investment. Thirty year Treasuries are yielding about 4.55% and you will pay Federal income taxes on this income. Many people will make the critical mistake of comparing a risk-free cash flow stream (your mortgage payments) with the returns on a risky investment. These same people probably believe it is free money when you borrow at low short term rates and lend at higher long term rates (the carry trade). Avoid this mistake.

Obviously, you do not want to liquidate tax deferred retirement accounts to pay off your mortgage. There are penalties and opportunity costs associated with doing so.

Given the low rate of your mortgage and the similarly low rates on duration matched Treasuries, you will probably not be much worse off by prepaying your mortgage, unless you lose the ability to itemize other tax deductions.

So, if it gives you psychic benefits, you are probably justified in paying off the mortgages. I paid off my mortgage when I was forty and have never regretted it. With no mortgage payments, you should be able to to fully fund your retirement accounts and rebuild your financial assets (which is important in terms of diversifying your wealth).

If you decide to pay off your mortgage you should take out a home equity line of credit which has zero cost if untapped. This process usually involves zero closing costs and the line can be used for "emergency" liquidity.

Be careful about thinking you are "FREE AND CLEAR". One million dollars is not enough money to retire on - you are off to a good start but have a long way to go (particularly since alot of your wealth is tied to your principal residence).

[adios]

•Taxes. If you pay off your mortgage, you'll lose the mortgage deduction on your federal income taxes. That lowers your overall return from repaying the mortgage. (Taxes also lower the return from most other investments.) More important, the mortgage interest deduction, either by itself or with other deductions, is typically more than the standard deduction on your federal income taxes. Of all the people who itemized in 2003, 82% claimed mortgage interest as a deduction. Unless you're a real saint, it's probably your mortgage that allows you to itemize deductions and pay less in taxes.


I'd like to point out that the AMT limits how much of a mortgage deduction you can take. On your rental property FWIW I would think that the favorable tax treatment of debt would be a factor in keeping the note on the property.




•Leverage. If you pay off your mortgage, you'll also lose the advantage of using someone else's money to invest. Let's say that your mortgage is paid off, and your home gains 5% in price this year, to $210,000 from $200,000. You've gained $10,000.

But let's say you had $20,000 in equity in your home and a $180,000 mortgage. If you were to sell your home for $210,000, you'd repay the $180,000 loan, keep the $20,000 in equity and pocket $10,000 - without tying up $200,000 of your own money.


Leverage is a two way street, you win and lose more than you would have otherwise. You're not that highly leveraged IMO though.




•Liquidity. If you suddenly need money, you may not be able to sell your house quickly. You'll also have to pay a broker's commission to do so. True, you can tap a home equity line of credit - but then you're back where you started before you paid off your mortgage.


But to really make the decision, you have to compare your return with another investment. Over long periods of time, you could probably beat 5.91% by investing in stocks. The stock market has averaged a 10.4% gain since 1926, according to Ibbotson Associates, a Chicago research firm.


And there's the rub. Investing in this kidney stone of a market would make most people balk. When people talk about paying off their mortgage, they're often considering investing the money they save in real estate. Stocks have gone nowhere since 1999, but home prices are going wild in many parts of the country. "I talk to one or two people a week who ask about buying another house and just flipping it," says Malcolm Makin, a financial planner in Westerly, R.I.


That's not the time to load up on real estate. Although the word "bubble" is batted around too frequently - true bubbles are rare - you can make a strong argument that housing gains will ease:

The liquidity you feel comfortable with is a personal decision of course. What you might consider is paying off your house and establishing an equity line of credit if you had liquidity concerns. I would think that you drive a hard bargain and get some really good rates since you have all your equity if you paid it off.


•Rising rates. Every quarter-point increase in mortgage rates eliminates potential buyers from the market. The Mortgage Bankers Association thinks the rate on 30-year fixed-rate mortgages will rise to 6.6% by the end of 2005, and 7.3% by the start of 2007.

Could be a concern.


•Cooling prices. Home prices, like stock prices, don't normally double in a year or two. Typically, home prices rise 1 or 2 percentage points above inflation, currently running at 3.1%.

If this was a big concern just sell your property.


•Soaring expectations. In 1999, people would talk about how much they made from their tech stocks. These days, the topic is usually how much they have made from their houses. That's not a good sign. People who buy now are "doing the same thing they did with tech stocks," says Tim McIntosh, a financial planner in St. Petersburg, Fla. Should home prices actually fall, the magic of leverage will work in reverse. If you buy a $200,000 house with $20,000, you'll be in trouble if your home price falls 10% to $180,000.

Again if you thought prices were going to fall sell. I don't think this has much to do with paying of your loans given the amount of equity you do have.


One thing I'd consider is limiting my liability in your rental property. Perhaps set yourself up as an LLC such that the LLC runs the rental business such that your personal assets are protected like the equity in the property you live in. FWIW I'd tend to pay off the note on the property where I lived and tend to keep the note on my rental property.

My wife and I are debating the merits of selling our property. I look at real estate prices in other markets, compare them to prices in the market I live in, see how fast prices are rising in the market I live in and I'm inclined not to sell at this point. Her opinion is that if we can get a certain price we should sell. I agree but my price target is about 25% higher.

[adios]

Dang you responded while I was writing mine as again you stated this better than I did. Nice post.

[player24]

Thanks adios. Some people will try to overcomplicate the analysis, but you appropriately point out that some of the issues which Waggoner raises in his newspaper column are irrelevant to the decision at hand.

Certainly, it is nice to have been long real estate over the past few years (much better than stocks). I live on the East Coast, in one of the hotter markets. Hopefully your market will make up for lost ground (so to speak).

[MonarchDon]

So, if it gives you psychic benefits, you are probably justified in paying off the mortgages. I paid off my mortgage when I was forty and have never regretted it. With no mortgage payments, you should be able to to fully fund your retirement accounts and rebuild your financial assets (which is important in terms of diversifying your wealth).

If you decide to pay off your mortgage you should take out a home equity line of credit which has zero cost if untapped. This process usually involves zero closing costs and the line can be used for "emergency" liquidity.

Be careful about thinking you are "FREE AND CLEAR". One million dollars is not enough money to retire on - you are off to a good start but have a long way to go (particularly since alot of your wealth is tied to your principal residence).

[/ QUOTE ]

Thank you for what seems like logical, sound advise. I like the equity line idea that way I wouldn't have to look for a first mtg. which may be dificult? I was thinking about buying more investment property and obtaining tax write offs through mortgages on rental properties?

I think the psycological part is right on, I'm from old school upbringing and have been taught that " stop paying intrest and start collecting intrest"

I'm a long way from being "setup" however, if my income changes in the near future at least I'll have a roof over my head, (as long as I can afford the property taxes)

[HDPM]

There were good posts above. I lean towards paying the mortgage for a few reasons. And I am assuming you can pay it off and still have other things working. Anyway, however you cut it, having a house paid for gives you a lot of comfort. Psychological yes, but you need less to live on all of a sudden. That means you might be able to invest in a few riskier things. Or decide to work for less money. And of course, it takes a little less cash to live on if you decide to live on investments. And isn't that why we invest? To be able to live the way you want? Having a paid for house is a massive step in the right direction. Not foolproof. Not a guarantee of course, but it is big. Let's say your mortgage is 1500/mo. How much do you need invested to guarantee a return that gives you 1500/mo after tax, month in, month out. Paying off the house not so bad IMO.

[inishowen]

Since I'm in the same boat heres my two cents assuming that you don't want to sell your home for a long while: My guess is that your rental income covers the nut on the rental property plus a little extra, but the extra is not enough to change your lifestyle at all (meaning you wouldn't miss it if it wasn't there). You have $255k in debt. I'd put the rental into an LLC, refinance both properties shifting as much of that debt as possible onto the income-producing rental (every $60 in positive rental cash flow qualifies you for an add'l $10k in mortgage debt). You'll probably be left with a little more than $100k in debt on your non-income producing home. Set up a separate account. Into that separate account deposit what your currently paying in mortgage payments on your home less what your new mortgate payment will be. This way you are not giving up any tax benefits and are paying yourself every month as long as you keep the unit/s rented. 10-15 years from now you'll have very little debt left on your home, a solid number in your separate account if you haven't invested it elsewhere, and a rental that has equity build up with little $ input from you.

Or, sell your home, capture approx $600k in equity after expenses. You'll pay less in cap gains taxes by using the $500k primary residence exemption, buy a cheaper home (which probably isn't an option in SoCal) and invest the difference.

I wouldn't buy another rental property in this market unless it was a complete steal. Just my two cents

[midas]

If you're in OC then your real estate values are probably safe. Don't pay off the mortgage, where else can you get that cheap of a loan that's deductable? Use the excess cash to invest in another business, more real estate or gradually enter the market over time. If you want the peace of mind, pay off the loans then reinvest the prior mortgage payments in the market over time to build value.

[GeorgeF]

As your investments are concentrated in one local real estate market you should make sure it is not dependent on a single employer, and that there are no plans to allow developers to overbuild the market.

As to the loans

I would suggest that you borrow more on the rental, I think 60%-80% of value. The only reason own rental properties is that the rate or return on property is much higher than that of the loan. If that is not the case sell the rental.

The loan on the house does not seem out of line.

[gvibes]

I don't think that 1M = f-u money. Not even close. I have nothing further to add.

[Misfire]

[ QUOTE ]
I don't think that 1M = f-u money. Not even close. I have nothing further to add.

[/ QUOTE ]

1M is plenty FU money for just about anyone who doesn't need luxury to feel good about themselves. You can live comfortably off the interest 1M generates in a bad CD, let alone a sound investment.

[Misfire]

If I'm not mistaken, the tax benefits of having a mortgage only apply to the amount of interest paid. Why would you pay $X in interest to avoid paying only a percentage of $X in taxes. Sounds -EV to me. Pay off the mortgage.

[eastbay]

[ QUOTE ]
If I'm not mistaken, the tax benefits of having a mortgage only apply to the amount of interest paid. Why would you pay $X in interest to avoid paying only a percentage of $X in taxes. Sounds -EV to me. Pay off the mortgage.

[/ QUOTE ]

If you can invest the money elsewhere for a better return than your interest minus tax breaks, it's a net win not to pay it.

eastbay

[RunDownHouse]

You have a seriously flawed understanding of finance.

[Misfire]

[ QUOTE ]
If you can invest the money elsewhere for a better return than your interest minus tax breaks, it's a net win not to pay it.

[/ QUOTE ]

Adjusted for its beta, you're going to be hard pressed to find an investment that yields enough to justify borrowing against your home in order to invest.

[eastbay]

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If you can invest the money elsewhere for a better return than your interest minus tax breaks, it's a net win not to pay it.

[/ QUOTE ]

Adjusted for its beta, you're going to be hard pressed to find an investment that yields enough to justify borrowing against your home in order to invest.

[/ QUOTE ]

Maybe you can comment on this example:

http://www.fool.com/foolu/askfoolu/2001/askfoolu010307.htm

eastbay

[Misfire]

1. They're still not considering risk. Yes, index funds do very good long term, but they are still riskier than real estate. Not everybody holds onto their home 10+ years anyway. It would really suck to sell after, say, 3 years of this while your index fund is down AND you have less equity in your house than if you had just knocked out the principle. "Fred" averages what, less than $8.5k/yr more than "Phil" over 30 years. Adjusted for risk, his edge isn't even that much.

2. There is security in owning your home (and everything else of yours) free and clear. I have paid off every single debt I owe. This gives me plenty of extra money to invest (like "Phil"), but it also gives me the opportunity (or rather, the security) not to HAVE to generate that extra income I used to have to pay on my debts. They're gone. I'm no longer running with ankle weights. I could literally fold up my business tomorrow and go work part time at McDonald's and maintain my same standard of living (sans investing). More importantly, if my business ever does go sour, I won't have creditors hanging over my head.

[eastbay]

I think your points are valid, and it comes down to an individual's goals and proclivities.

FWIW, I also choose to pay down my mortgage at the fastest pace I can, rather than try to invest that money elsewhere, and pretty much for the same reasons you mentioned.

eastbay

[inishowen]

I don't see the upside to paying down a fixed rate mortgage a little at a time. Beyond the psychological comfort of seeing your principal number decline monthly there is no decrease in monthly payment and you are losing some of your inflation hedge. I think a better way to do it is to set up a separate account to receive these extra payments, that way the cash is available to you in case of emergency. If you never need it and the balance grows to a solid number, then you could pay down the principal and refinance for a lower monthly payment.

[eastbay]

[ QUOTE ]
I don't see the upside to paying down a fixed rate mortgage a little at a time. Beyond the psychological comfort of seeing your principal number decline monthly there is no decrease in monthly payment and you are losing some of your inflation hedge. I think a better way to do it is to set up a separate account to receive these extra payments, that way the cash is available to you in case of emergency. If you never need it and the balance grows to a solid number, then you could pay down the principal and refinance for a lower monthly payment.

[/ QUOTE ]

I don't know of any liquid account that pays at a rate to match what I am paying in interest on unpaid principle. I think it's not possible to find one, either.

Why isn't that savings the upside?

eastbay

[inishowen]

Because any pre payments on a fixed note are applied to the back end of the note and do not better your situation today. What you are doing is using todays dollars to pay a debt not due for 5,10,15 maybe 20 years out when the inflation adjusted buying power of that same money will be considerably less. Even at savings account interest you are doing better than pre paying monthly. Either you earn the interest or give the money to the bank for them to profit on.

[NoTalent]

Has anyone ever heard someone say "Damn, I sure wish I didn't pay off that house", or "Man I wish I had a mortgage" ?

[Misfire]

Your mortgage interest eats away most of this advantage.

[Misfire]

[ QUOTE ]
Has anyone ever heard someone say "Damn, I sure wish I didn't pay off that house", or "Man I wish I had a mortgage" ?

[/ QUOTE ]

[TN_POKER_MAN]

yes

That's why they created reverse mortgages. I'm not saying its wise, but there are folks out there with paid for houses and no nest eggs.

[BradleyT]

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Has anyone ever heard someone say "Damn, I sure wish I didn't pay off that house", or "Man I wish I had a mortgage" ?

[/ QUOTE ]

nh sir.

[Dan Mezick]

I'd focus on buying more real estate-- you are good at it.

Why not repeat what works for you?

Why not take the cash you have to pay off the 2 houses and look for another "special situation" real estate purchase.

Then as soon as you can leverage that one 100% by taking out your equity to pay off the other 2.

Then all the debt is on one (income) property (use a LLC to isolate it) and you own the other 2 outright.

You have real estate knowledge why not leverage it. You already know what you are doing-- repeat the pattern.

[ScottTheFish]

[ QUOTE ]
I think your points are valid, and it comes down to an individual's goals and proclivities.

FWIW, I also choose to pay down my mortgage at the fastest pace I can, rather than try to invest that money elsewhere, and pretty much for the same reasons you mentioned.

eastbay

[/ QUOTE ]

Agreed. I'm a big proponent of paying the mortgage off. I always look at it like this...if you had a house paid for free and clear, would you borrow against it at 5% to invest in the stock market? I wouldn't, and I doubt most people would. But that's in effect what you're doing if you keep a mortgage.

And Tax break, Shmax break. Why do I want to pay 10K in interest to save 3K in taxes? I'll let Uncle Same have his 3K and I'll pocket the other 7K. Thanks.

[MonarchDon]

Just thought I would post an update. I paid the mortgage off, to many people that may not be the best move but for me it works. Now I own property free and clear (except for property taxes)in Southern Cali. Now I am going to start investing in other areas with the money I was paying towards my mortgage. I have traded some commodities in the past but I am going to just concentrate on 1 market and work that up and down, Wheat is the market of choice for me.

Although I'm surely not wealthy by any means I feel pretty good right now and at 42 I feel confident to go out and make some smart financial decisions that well help to get me "Set Up For Life"

[NoTalent]

Remember don't count the money in your house as cash until you actually sell it. The prices can go up and down. How much have your homes appreciated in the last 5 years? If they have more than doubled, I'd try to hedge myself in case the prices fall (only you know how much they would fall to give you a loss).

Good luck and hope for a correction, not a pop.

[MonarchDon]

No Talent, sounds like sage advise. The house being paid off is for peace of mind with the benefit of freeing up cash each month to do what ever I want to with it. My house first and foremost is my home and secondly a very good investment.

[imported_bingobazza]

[ QUOTE ]
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Has anyone ever heard someone say "Damn, I sure wish I didn't pay off that house", or "Man I wish I had a mortgage" ?

[/ QUOTE ]

nh sir.

[/ QUOTE ]

Actually, its quite common in the UK. There are plenty of older people who want to mortgage their house to invest the capital into a trust and get income from it, whilst moving the capital outside their estate for tax purposes when they die. When the tax man tallys the estate on death, the kids get more as the trust isnt taxed, and the settlor, while alive, gets income fronm the trust that he wouldnt have otherwise enjoyed. In some cases, the interest is rolled up and further reduces the estate value and the tax bill on death. Ironic that most people spend most of their lives with a mortgage they want to get rid off, and wish they had one on their death bed.

Bingo

PS - estate and trust law is prob different in the US.

[DesertCat]

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Has anyone ever heard someone say "Damn, I sure wish I didn't pay off that house", or "Man I wish I had a mortgage" ?

[/ QUOTE ]

That's because they usually never do the math on how much it cost them. Or if they did, they're too depressed to talk about it.

I have a 5.875% mortgage. I have more than enough to pay off the mortgage sitting in my brokerage account, where it has earned far in excess of 10% a year for the last five years. If I had paid off my mortgage, I'd be very much poorer. But I might be a special case, I actually work as an investor full time.

It's not a simple decision for most people. You need to be confident that your long term return (risk adjusted) on your investment will be in excess of your mortgage rate. Some people (Buffett) think that index funds (the market) will be returning around 8% for the next 20 years, so it's not a huge win, esp. if you are borrowing at 7%.

And when I say risk, I'm not talking about "beta", a little number tha signifies how much variance an investment's price has (and is mostly useless for investors other than in option trading). Real risk is the likelyhood of permanent impairment in the value of your investment.

The risk of index funds is overpaying, i.e. you buy them at a market top and have to deal with bad returns for a few years until you catch up. Since an index fund is a claim on the net worth and income of a huge number of companies, there is little risk of permanent impairment. You buy a single stock (let's say, "enron") with all your money, you have a high risk of permanent impairment. A "risk adjusted" return is you r estimate of the +EV of an investment, incorporating the percentage likelyhood of a permanent impairment and how big that impairment might be.

The other side of risk is liquidity. You can't play games where you invest long term if you borrow short term. I.e. index funds aren't one or two year investments, you have to be committed to them for at least 5-10 years, if you are forced to sell at inopportune times, you're returns will be horrible. So any money you put in them you shouldn't require for living expenses or mortgage payments.

The grandest part of paying off your mortgage is that it's a "risk free" investment. You save what ever the current mortgage rates are each year, guaranteed, so any alternative "risk adjusted" investment returns have to beat that. Note: There is some liquidity risk, i.e. if you don't have a job it might be hard to get a bank to loan you the money back.

[DesertCat]

[ QUOTE ]
1. They're still not considering risk. Yes, index funds do very good long term, but they are still riskier than real estate. Not everybody holds onto their home 10+ years anyway. It would really suck to sell after, say, 3 years of this while your index fund is down AND you have less equity in your house than if you had just knocked out the principle.

[/ QUOTE ]

You misunderstand risk. If you sell your home after three years where are you going to live? For 90%+ of us, it's another house with another mortgage, while you continue to put extra money into your index fund.

If you aren't forced to sell the index fund for liquidity reasons, having it decline in price is actually great. It's because in the example you would be "dollar cost averaging", buying more shares at lower prices, which over time gives you an average purchase price much closer to the fund's lows, than it's high's.

That really increases your net worth thirty years from now when you retire. And it doesn't appear to me that the fixed rate example the motley fool ran incorporated this benefit, so their results understate the historical benefit of indexed funds.

This another example of why is why beta isn't risk.

[DesertCat]

[ QUOTE ]


•Cooling prices. Home prices, like stock prices, don't normally double in a year or two. Typically, home prices rise 1 or 2 percentage points above inflation, currently running at 3.1%.

If this was a big concern just sell your property.


[/ QUOTE ]

Good advice. There are two things to consider, maximizing the value of your properties and how you finance them.

Paying off your mortgage really is a financing decision that has little to do with their value (in most cases). Property goes up, down, doesn't matter. What matters is whether you want to tie up X amount of money financing it at a Y interest rate, or put that money in an alternative investment at what you think is a better return.

[player24]

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The grandest part of paying off your mortgage is that it's a "risk free" investment. You save what ever the current mortgage rates are each year, guaranteed, so any alternative "risk adjusted" investment returns have to beat that.

[/ QUOTE ]


You have stated this concept correctly, but you have misapplied this concept in the rest of your analysis and stated an improper conclusion (i.e. it is not 'costly' or 'depressing' to prepay a mortgage).

Yes, you need to compare the cost of mortgage financing (after tax) with the (after tax) return available on risk-free investments.

But: 1) 20 years is not the appropriate horizon (unless you are certain that you will own the property for 20 years, unlikely), 2) 10 percent is not an appropriate investment return assumption (even skilled-professional investors should not resort to the conclusion that they can achieve 10 percent returns without risk).

To properly perform this analysis, you should use an investment rate of return is based on investment which has zero price volatility measured over the period during which your loan will remain outstanding. For a loan which you 'know' will remain outstanding for 10+ years, you should use a 10 year Treasury. Given that ten-year Treasuries are yielding about 4.1%, you will probably be better off prepaying a loan with a pre-tax cost of 5.875%.

When you make more optimistic regarding the return you can earn on your cash, you are inappropriately applying the principle that you must match the riskiness of your liability (the mortgage loan) to the riskiness of your investment. If you were to attempt to invest in stocks for a 10-year horizon, you might actually return more than 4% after tax...but you might not. (that is 'risk')

So, is it irrational for someone to have a mortgage loan outstanding and an investment portfolio which is sufficient to prepay the loan? No, it is not irrational - just risky. And prepaying the loan, especially in the current yield environment, is probably the better course of action.

[DesertCat]

[ QUOTE ]

But: 1) 20 years is not the appropriate horizon (unless you are certain that you will own the property for 20 years, unlikely),



[/ QUOTE ]

You make an assumption on investment duration which is incorrect, and renders all of your conclusions wrong. Typically you will own property for much longer than 20 years. Not the SAME property, but most people will own a series of home for the bulk of their lives.

When you sell one home and buy another, you aren't forced to liquidate the index funds you built up while having a mortgage. You may choose to tap long term savings to buy a bigger house, but you typically won't. And when you buy the new home with a mortgage, you can continue to add to your savings same as if you remained in your previous house with your previous mortgage. So effectively your time horizon is 30 years plus.

[ QUOTE ]

2) 10 percent is not an appropriate investment return assumption (even skilled-professional investors should not resort to the conclusion that they can achieve 10 percent returns without risk).


[/ QUOTE ]

10 percent is roughly the long term return from stock market index funds, no professional needed.

[ QUOTE ]

To properly perform this analysis, you should use an investment rate of return is based on investment which has zero price volatility measured over the period during which your loan will remain outstanding. For a loan which you 'know' will remain outstanding for 10+ years, you should use a 10 year Treasury. Given that ten-year Treasuries are yielding about 4.1%, you will probably be better off prepaying a loan with a pre-tax cost of 5.875%.


[/ QUOTE ]

I'd guess that the stock market indexes have never failed to trounce 5.875% over 20 year periods+. So you can ignore volatility over very long periods of time.

And over shorter periods, you are ignoring the effects of dollar cost averaging, which benefits from higher volatility to increase average returns.

Example: If the stock market drops by 50% tomorrow, and takes one year just to return to it's former level. The dollar cost averager won't be breaking even, he'll have a substantial gain since he was buying more shares than usual while the market was in the dumps.

[player24]

[ QUOTE ]
You make an assumption on investment duration which is incorrect, and renders all of your conclusions wrong. Typically you will own property for much longer than 20 years. Not the SAME property, but most people will own a series of home for the bulk of their lives.


[/ QUOTE ]

Nope. When you sell one property and buy another property you cannot roll your mortgage. You must apply for a new mortgage loan and accept the market interest rate. Your analysis depends on you having the SAME mortgage rate for a 20+ year period, which is not assured. (i.e. subject to risk)

If you sell your property and move after 10 years, you will be forced to payoff your 5.875% mortgage. If your risk-free investment has not returned 5.875% (remember, it hasn't matured yet and is, therefore, subject to principal volatility) the total return of your risk-free asset may be less than the principal buildup of your mortgage liability. This possibility constitutes 'risk'.

When you buy a new property you will enter a new mortgage at a rate other than 5.875% (because you cannot roll your existing mortgage). So you are subject to the risk that the new mortgage rate will be higher than the rate of return you have locked in with the 20 year risk free investment (which you locked in by buying a 20 year treasury 10 years earlier). If the new mortgage rate is higher than your investment rate, you will have negative carry (and would have been better off having prepaid the mortgage rather than buying a risk-free asset with your money.)

Given that you do not know your horizon, and your horizon is likely (for most people) to be less than 20 years, it is not appropriate to view stock index funds as a risk-free asset. But, even if this point were incorrect, you would remain subject to "tail risk". No one can say with certainty that stocks will return more than 5.875% over the next 20 years (despite historical results in which stocks have generally returned more than 5.875% over 20 year horizons). This lack of certainty constitutes 'risk'.

[DesertCat]

[ QUOTE ]

Nope. When you sell one property and buy another property you cannot roll your mortgage. You must apply for a new mortgage loan and accept the market interest rate. Your analysis depends on you having the SAME mortgage rate for a 20+ year period, which is not assured. (i.e. subject to risk)


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When you buy the new home, you get a new mortgage, without using any of the index funds you've built up by having the mortgage. So if the return on your savings is lower than the return you would have gotten on your mortgage, it only "appears" that you've momentarily lost money.

You actually have to sell to lose money. You haven't lost because you've built up a low cost basis in index funds that you aren't going to sell (certainly not at a market low). Volatility is only risk if you are forced to sell, otherwise it's actually opportunity.

You'll get a new house and new mortgage and continue to save in the higher return index funds. Even if temporary dips drop your returns below the mortgage rate, you can be confident that over long periods of time your returns will exceed it. And you always have the option of paying off your mortgage if it gets too high.

Example: S&P Returns by Decade (http://biz.yahoo.com/funds/b3.html)

This info is from Bogle's book and ends in 1993, but will serve our purpose. S&P 500 has averaged 10.3% a year since 1926. 49 out of 58 ten year periods produced higher than 5% returns.

And once again, this understates "real world" returns if they buyer is using dollar cost averaging to make their index fund investments.