Yeah, But …

                                         

                                                         Yeah, But ….

 

Conventional wisdom produces rules-of-thumb that sound good. Even though most have gone out of date, they still hang around. One reason is they’re easy to remember.

Another is financial advisors, tax accountants, real estate agents, mortgage brokers, money magazines, and parents all tell Millennials to get the biggest mortgage, smallest monthly payment, and the longest repayment period. They shouldn’t worry, it will all work out in the end.  

Conventional wisdom protests against the idea of paying off the mortgage by age 50-55, and being free of mortgage payments, with nifty sounding “Yeah, But  …” arguments. It’ll take independent Bloggers and other advisors, who don’t have a stake in maximizing borrowing power, to provide Millennials with the other side of the argument.

Providing that other side is also the purpose of the following section. It will test the assumptions behind many of these Yeah, But … arguments. Whatever their grain of truth, it’s far smaller than the compelling reasons to switch to the equity strategy in the New Normal. 

(The following are summaries of the answers to these arguments. Full responses are in book, “the Nest Egg Strategy.”) 

 

 

Yeah, but I need the tax deduction.”
A tax deduction is not a tax credit.  A tax credit is a dollar for dollar reduction in taxes. A tax “deduction” means that income used to pay mortgage interest is excused from taxation.

Since most people are in the net 20-25 percent tax bracket, it means they save actually 20-25 cents in taxes for every $1 paid in mortgage interest. Out of pocket to pay that interest expense is still 75-80 cents. Some think it’s better to pay the 20-25 cents in taxes and keep the 75-80 cents. (And, place the savings in tax deferred retirement plan.)

 

Yeah, but payments that seem expensive today will look cheap tomorrow.” 
That was true in the Old Normal when steady pay raises were improving everyone’s standard of living. However, if raises are no better than cost of living, mortgage payments will be just as expensive tomorrow as they are today. “Borrow dear, repay cheap” was part of the Old Normal, not part of the New Normal.

 

“Yeah, but I plan to move in five years. I’ll never pay off this house.”
You take your financial position with you to the next house. In other words, the time you’ve knocked off the old mortgage can be incorporated into the new mortgage. For example, if there’s 15 years left on an original 20-year mortgage, simply get a new 15-year mortgage on the new house. In effect, you pick up where you left off, never losing a penny.

 

“Yeah, but appreciation will make up for all the interest expense.”
Theory is if interest rate is 5% and appreciation is 8%, you make 3% for being in debt. Three fallacies: One is interest is paid in cash while appreciation is a paper gain. Appreciation is not real until you sell and cash out, presuming it doesn’t evaporate in the meantime, as happened in 2008.

Two: It fails to account for the money you might have earned if that interest expense was used as investment capital instead.

Three: The house will appreciate the same as all the other houses in the neighborhood, regardless of “leverage.” It’s calculated on market value, not debt level.

 

“Yeah, but shouldn’t I keep a low 4% mortgage for as long as possible?”
Don’t be fooled by an interest rate. It only represents the annual cost of keeping the debt afloat. Which is okay when the aim is to leverage debt to the maximum. But, i
t doesn’t speak to the cost of buying real equity, which is the reduction of debt. 

The true cost to build equity is the amount of cash needed to repay $1 of debt. In other words, how much of the payment goes to interest and how much to principal loan reduction? Which changes dramatically according to the section of the repayment schedule.

During the first years of a 5% 30-year mortgage, for example, for every $1 of principal reduction the homeowner is scheduled to pay $10 of interest expense. A 10 to 1 ratio is a true cost of 1,000 percent! (The lender didn’t stack it there, but that’s another story.) 

In point of fact, it’s the length of the repayment period, and not the interest rate, that adds the greatest cost to a mortgage. Thus, the first 15 years of a 30-year mortgage are very expensive, no matter the interest rate.

 

“Yeah, but money in the house is idle equity.”
Actually, every dollar that eliminates heavy interest expense in the front of a 30-year mortgage is working harder than any other investment.

The confusion lay in thinking the savings rate is the same as the interest rate, 5 cents on a 5 percent mortgage for instance. Not so! It’s tied to the amount of interest scheduled for the payments eliminated.

Since the average interest scheduled during the first five years of a 30-year repayment schedule is about $10 of interest to every $1 of principal, it means your return on investment is 1,000 percent!

The equity is hardly idle!

 

“Yeah, but isn’t it better to put money in stock market.”
This is another example of comparing an interest rate against the earning rate of an alternative investment, comparing apples and pears.

During the first five years of a 5 percent 30-year mortgage the true relationship is $10 of interest to every $1 of principal, a true cost of 1,000%. Yet, Financial Planners will advise clients to continue paying 1,000% in order to earn 10% elsewhere, the stock market for example. 

And that doesn’t even account for the uncertain nature of the stock market. especially for those who have little experience yet asked to pick stocks for their 401(k) plans. On top of that, there are the Crashes of 2008 and 2020 to consider. 

Moral of the story is that it’s unwise to continue paying the exorbitant cost of the debt strategy in exchange for uncertain gains in the stock market. 

In a nutshell, it’s the certainty of saving $10 of interest against the uncertainty of a return of perhaps 10 percent by investing $1 in the stock market. Even those who don’t believe in pure economics can see the merits of eliminating the interest expense first and then investing in the stock market.

 

“Yeah, but I should borrow as much as I can while money is cheap.”
Borrowing as much as you can is a trap! Homeowners will be left high and dry when rates go back up, which they surely will. Since the next buyer won’t be able to afford the monthly payment of higher rates, homeowners might be lucky to just break even. More likely that they’ll lose money.

“It’s different this time,” is the refrain of those who don’t respect the laws of economics, and hope that rates won’t return to their historical levels. If history is any guide, it’s not a question of “if” but “when?”

“Once in a lifetime chance” to get the house of your dreams is another temptation. Especially for those who always wanted to build their dream house.

The “smart money” doesn’t use the lower rates to get a bigger mortgage but a shorter repayment term. Instead of a 30-year mortgage they use the lower interest rate to get a 15-year term with the same monthly payment. Saving 15 years of your career is pure gold!

 

“Yeah, but I have no choice but take the lowest monthly payment.” 
There are times when it’s better to buy a home, even with a lazy mortgage, than not to own a home at all. That doesn’t mean they have to live with it forever. 

They can start to buy-back time by giving back the principal ahead of schedule, beginning the very next month. In a matter of five years, they can eliminate an extra 15 years of payments, leaving only 10 years of normal payments to pay off the mortgage by age 50-55.

 

“Yeah, but it’s Now or Never”
“Prices are getting out of reach.” Even a lazy mortgage will look like a good investment.

The more prices go up, the more its taken as proof that prices will continue to go up. Seems like a sign of scarcity. Buy now or never. Actually. it’s the amount of money chasing real estate (earnings and borrowing power) in an area that pushes the price up.

Opposite is also true – prices decrease when the money decreases, i.e. recessions, higher interest rates, natural disasters, pandemics, etc.

Thinking its scarcity, and not realizing it’s money, people often buy at top of the market. They’re taken by surprise when prices drop. Worse, they’re left holding the bag, forced to sell low.  

Be wary of “now or never,” it’s often a tipoff that high is too high.

 

A Last Word …:
Many people make decisions according to what they believe. Facts are secondary. Hence, their attraction to conventional wisdom. 

Most would like to believe these old rules-of-thumb are still true, especially since they seem to posses a grain of truth. And, since traditional advisors still tout them. They don’t stop to notice that many of these advisors have a financial interest in not upsetting the apple cart.

The income of those in real estate, including Realtors, Builders, Mortgage Brokers, consultants, tax accountants, media people, and a host of others are often tied to you paying the highest price and borrowing the most. The facts behind conventional wisdom may be out of date, but they’ll be the last to admit it.

It’s up to independent advisors, Bloggers, and others not tied to financial incentives of the real estate industry to recommend that Millennials investigate the merits of the equity strategy in general and Nest Egg Strategy in particular.