How to be Setup for Life ?

[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]

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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" ?

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nh sir.

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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" ?

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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]

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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.

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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]

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•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.


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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.

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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]

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



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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.

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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).


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

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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%.


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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]

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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.


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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'.