Many argue in favor of mortgage payments for one’s entire career. Conversely, against paying off the Mortgage “early.” Once upon a time, in the Old Normal, their underlying assumptions had merit because a rising tide was lifting all boats, and one could “borrow dear, and repay cheap.”
That’s no longer true in the New Normal. The economics for Millennials have changed. Many of those assumptions have therefore changed. Accordingly, you can no longer accept “conventional wisdom”, old rules-of-thumb, without question. Millennials will find many of them are no longer good advice, but quite the opposite.
There’s another reason to question conventional wisdom. Those who make more money off high prices, such as real estate agents, home builders, mortgage lenders, and others are afraid home prices will be depressed when mortgages are paid off by age 50-55. Less money chasing real estate means lower prices, which means lower commissions. (Can’t expect them to see the virtues of the Nest Egg Strategy if their paychecks depend on not seeing it.) Not least, they don’t appreciate how important it is to protect a family’s refuge and sanctuary against the fickle nature of the real estate market.
The following are a listing of the most common Yeah, But arguments against paying down and paying off the mortgage as soon as possible. The aim is to hit the high points of each argument, leaving it to visitors to go deeper on their own, applying it to their personal situation.
Yeah, But … objections include, but not limited to:
But I can’t afford to pay off the mortgage by age 50-55.
But, my 401(k) plan and home appreciation are all I need.
But, I need the tax deduction.
But, I’ll repay with cheaper dollars
But, I plan to move to new house in five years.
But, appreciation will make up for the interest expense.
But, shouldn’t I keep a low 4 % mortgage, for instance.
But, money in the house is idle equity.
But, isn’t the stock market a better investment.
But, rates will never be this cheap again, I should borrow to the Max.
But, stretching it out is only way to afford monthly payment.
But, “gotta buy now” or never.
(The following are summaries, full responses are in book, “the Nest Egg Strategy.”)
“Yeah, but I can’t afford to pay off the mortgage by age 50-55.”
Most people already have a 30-year mortgage that will take them well past the age 50-55 deadline. Most don’t realize the 30-year repayment schedule is nothing but an assumption, a listing of minimum payments and maximum time to pay off the mortgage. Homeowners have the power to change both at any time.
One of those is to refinance and get a shorter a term, a 20-year mortgage for instance. Another work-around is “Strategic Repayment:” Giving back a small yet strategic amount of principal ahead of schedule eliminates all the time that was previously scheduled for that principal. In effect, “buying back” time from the repayment schedule. Strategic Repayment can easily eliminate 10 or more years of payments. That alone would shorten the payoff age from age 65 to 55.
The key word is “strategic.” That’s because there’s so little principal scheduled in the first 10 years of a 30-year mortgage that it takes but a little principal to eliminate most of those payments. Since most people are the first five years of their mortgage, most can recapture all that time by investing far less than they imagine.
“ Yeah, but my 401(k) plan and home appreciation are all I need.
Actually, Millennials need a cash nest egg as an “ensurance policy” against the stock market being in the dumps when it comes time to retire, the account balance less than planned. Or, some investments actually gone bankrupt, a’la Enron. (Most homeowners aren’t professional investors, after all.)
One reason the stock market is more volatile is because significant portion of corporate profits are due to “financial engineering;” no new products or services per se, but swapping “paper.” Which can also create loses, easy come, easy go. Second, computers are playing a bigger role in trading, pushing prices up or down according to algorithms. Globalism is yet another reason. There are other reasons as well. Add them all together and the stock market may go up when the economy is down or go down when the economy is up, for example. Simply put, it’s no longer the slow and steady market it once was.
As for home equity, it may be the best way for people to build wealth. Paying down the mortgage creates hard-dollar equity. Appreciation, paper equity, should be icing on the cake.
Appreciation shouldn’t be taken for granted. It has a split personality, after all; very good when the going is good, disappearing at the slightest hiccup. Overall, the average appreciation rate in most of the country is only about 3.5 percent per year. Compared against the inflation rate, the real increase is minimal. Certainly not worth spending your entire career on mortgage payments.
Besides, homeowners who “pay off the house” at age 50-55 enjoy the exact same appreciation as those who leveraged their mortgage to the max. In other words, they get the best of both worlds: They enjoy the security of hard-dollar” equity at the same time they’re building their financial statement with appreciation equity.
Why take the chance of putting all your marbles on appreciation when it can be so fickle and also fragile. It comes and goes out of your control, influenced by larger and mysterious economic factors.
No one saw the Housing Crash of 08 coming, for instance, since no one heard anything about Sub-Prime Mortgages or their role in the capital markets. Accordingly, no one could image that prices would drop as much as 50 percent in some markets. Years of appreciation wiped out in a flash. Worse, many homeowners owing more than the house was worth, “underwater.”
This is an extreme example of forces out of your control, and will probably never happen to that extent again, yet it’s best not to assume only the best and put too much faith in paper appreciation.
Simply put, appreciation can be fickle. Enjoy it on your financial statement but don’t bet your retirement on it. You can’t spend appreciation at the grocery store, after all. Make it icing on the cake.
In summary, Millennials need more than a 4101(k) plan and home appreciation to be sure of a comfortable retirement. They need a cash nest egg as an ensurance policy against the real estate and stock markets going sour at the worst time. With their cash egg paying half of living expenses in retirement and Social Security paying the other half, Millennial can be sure of maintaining their standard of living in retirement. It can only get better from there.
“Yeah, but I need the tax deduction.”
Many people think it’s a dollar for dollar reduction in taxes. In fact, that would be a tax credit. A tax “deduction” means that income used to pay mortgage interest is excused from taxation. For example, those in the net 25 percent tax bracket don’t have to pay 25 cents of tax on $1 of income,
In this situation, $1 paid on mortgage interest is excused from 25 cents of taxation. Don’t forget, however, it cost $1 to get that 25 cents. Which means the out of pocket cost was still 75 cents.
That’s why some people, thinking that cash is better than a tax deduction, don’t pay the $1 in mortgage interest but prefer to pay the 25 cents in taxes on other income. They prefer to keep the 75 cents for themselves. (And, place it in tax deferred retirement plan.)
“Yeah, but I’ll Repay with Cheaper Dollars.”
But only if pay raises are higher than Cost of Living increases by a wide margin. If they’re only 1-2 % higher, Standard of Living really isn’t improving, and money spent on interest expense is as dear as ever.
Therefore, the “borrow dear, repay cheap” mantra of the Old Normal, especially in the 1950’s, 60’s, and 70’s, no longer holds water. If it’s “skin off your nose now, it’ll be skin off your nose then.
No indication the situation is going to get any better. Considering how Investors get the lions share of corporate profits, and hold down wages in order accomplish it, Millennials shouldn’t assume that pay raises will be big enough to make mortgage payments look cheap.
That’s not the worst of it. Spending year after year on mortgage payments may be the most expense of all, as time can never be replaced.
“Yeah, but I plan to move in five years. I’ll never pay off this house.”
It’s not the house you’re paying off, but the mortgage! The false assumption or premise is you will get a new 30-year mortgage and start all over again.
Actually, your new mortgage term should start where your old one ended. 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 step.
In other words, take your financial position to the next house. This way, even after three or even four houses, you can hop-scotch down a repayment schedule and still leave the last 15 years of career free of mortgage payments.
“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. And since real estate is scarce, appreciation will always be greater than interest expense.
That may be true in Renaissance cities like San Francisco, Denver, Austin and a few others, but not in most of the country. The appreciation rate averaged only 3.5 percent per year over the past 20 years in most of the country. Good for preserving the value of capital against inflation, but not a real profit.
More to the point, it’s not the interest rate that is the true measuring stick but interest expense. As noted in another response, a 5 percent mortgage might have $10 of interest expense for every $1 of principal during the first 10 years of payment, a true cost of 1,000 percent. Thus, comparing the interest rate against appreciation rate is apples and oranges.
In addition, appreciation is not real until you sell and cash out. (They don’t take appreciation dollars at the grocery store.) And, that presumes it doesn’t evaporate in the meantime, as happened in the Crash of 2008.
Finally, comparing one rate against another is moot, because the house will appreciate the same amount as all the other houses in the neighborhood. It’s a function of the market, not a mathematical ratio. Doesn’t matter whether you owe 10 percent on the mortgage or 90 percent, the value of your house will go up the exact same amount as your neighbors.
Therefore, you don’t enjoy 3 percent more appreciation (5 percent vs 8 percent) for being in debt. It may look like it on paper, but not in real dollars and cents.
“Yeah, but shouldn’t I keep a low 4% mortgage for as long as possible?”
Similar to the previous rebuttal, it’s not the stated interest rate that matters but actual interest expense. This is controlled by the length of the repayment period, not the interest rate.
As noted on the Home Page, when homeowners push the monthly payment to the lowest possible amount, they unwittingly reduce the principal to such a tiny amount in the first decade that the balance remains virtually unchanged, year after year. This means interest continues to pile up on virtually the same balance, until it’s not uncommon for interest to be $10 for every $1 of principal. On a cash basis, not an annual one, the true cost is 1,000 percent!
Indeed, keeping the first 15 years of a “cheap” 4 percent, 30-year mortgage, is actually very expensive. Better those years be eliminated, the time and money recaptured for saving and investment accounts, putting the time-value of money to work for you.
Indeed, it’s not the annual interest rate but the length of the repayment period that adds the greatest cost to a mortgage.
“Yeah, but money in the house is idle equity.”
Actually, every dollar that eliminates that much interest in the front of a 30-year mortgage is working harder than any other investment.
Once again it’s a confusion between the annual rate and actual interest expense. The naysayers think you’re saving 5 cents of interest on a 5 percent mortgage when it can easily be $10. Saving $10 of interest for every $1 of principal repayment is hardly idle equity.
Furthermore, an investment that recaptures 15 years of your career is priceless. You’ve only got 30-40 years in a career, saving 40 percent of it to for saving and investment accounts is one of the best investments you can make.
“Yeah, but isn’t it better to put money in stock market.”
It’s good to invest money in the stock market, but only after you’ve first eliminated exorbitant interest expense in the first half of a 30-year mortgage. Otherwise, you’re starting too far behind in the foot race.
And that doesn’t even account for the uncertain nature of the stock market. The market can crash for reasons beyond your control, understanding, and never saw it coming. Like most crashes, no one saw it coming, a “black swan” event that no one had seen before.
On top of that, those with self-directed 401(k) plans may not have much experience in analyzing the market and thus put too much faith and money in companies they work for, or in the favorite darling of the media. Employees lost their entire retirement with Enron, for example.
Thus, by all means, do put money in the stock market. But not before eliminating exorbitant interest expense on a debt that also consumes 40 percent of your career.
“Yeah, but I should borrow as much as I can while money is cheap.”
Yes, you should take advantage while interest rates are low. Better than borrowing more money, however, is using it to afford a shorter term! Instead of a 30-year mortgage, for example, the lower interest rate can be used to get a 15-year term. Saving 15 years of your career is pure gold!
Same with refinancing: Instead of lowering the payment, keep your current payment the same and use the lower rate to reduce the term. Perhaps not 15 years, but saving 10 years of your career would be a boon.
There’s also a Catch 22 to maximizing the amount you can borrow at lower rates – if and when rates go back up to normal, several things can go wrong. (1) the market value of the house will surely go down. (2) Next buyer won’t be able to borrow as much, forcing you to make up the difference. (3) Lender will force you to reduce the loan balance in order to maintain their loan to value ratio. (4). Lender may foreclose if you can’t pay down the loan. Moral of story: Look before your leap.
Perhaps the biggest temptation is “once in a lifetime chance” to get the house of your dreams. Better you should get the retirement account of your dreams.
“Yeah, but I had no choice but take the lowest monthly payment.”
Most homeowners needed the low monthly payment of a 30-year mortgage in order to qualify for the loan. That doesn’t mean they have to live with it for 30 years, however.
They can buy-back time by giving back the principal ahead of schedule. Since there’s so little principal reduction in the first 10 years of schedule payments it takes very little principal to buy back those 10 years of payments. Simple!
In other words, do what you must do now but don’t suffer the consequences forever. Figure out how much principal is scheduled in the first 10-15 years of the repayment schedule and establish a budget to repay it over the next five years. That’ll eliminate 90 percent of the penalty for taking the lazy mortgage.
“Yeah, but,. Buy Now or Never”
The fallacy is real state is a scarce asset, and therefore prices will continue to go up, “if I don’t buy now, I’ll never get the chance again.” Actually, the price of homes goes up and down according to the amount of money in an area; income and borrowing power.
This explains why median price in Renaissance cites, such as San Francisco, are many times higher than Birmingham Alabama. Median price in Birmingham is $182 K, it’s $1.34 M in San Fran. Otherwise, it’s the same house; same size, same appliances, same flooring, same building materials, same everything. Difference is income level, and thus borrowing power.
Which also explains why prices fall when there’s an economic setback, i.e. recessions, stock market crash, higher interest rates, natural disasters, pandemics, high unemployment, etc. When that happens, the amount of money available to chase real estate falls, and prices fall. (The Fed aims to offset these regressions with lower interest rates, which tend to work for a while.)
Considering that it’s income and borrowing power that determines whether prices are going up or down, prospective home buyers should examine what’s happening in their area.
If income is the same but borrowing power has increased because of artificial low interest rates, for example, the debate is how long these low interest rates will last? Prices will fall if they go back to traditional levels, leaving people high and dry who bought at the high water mark.
Alternatively, if income is rising at a steady pace over a long period, the price of real estate will likewise increase at a steady pace. Then it’s a good idea to buy into that rising market, even if it’s tight in the beginning.
All of which means that prospective homeowners must consider the income trends in their area to determine whether prices will be going up, staying the same, or perhaps falling. Ignore the old bromides, such as “they’re not making any more land.”
To be sure, be wary of “buy now or never.” Except for Renaissance cities, it’s usually a scare tactic, which is a tipoff that prices are higher than economics can justify.
A Last Word …
All of these “yeah, but …” arguments have a grain of truth but the merits of leaving the last 15 years of career to build cash nest egg far surpasses them. They sound so logical it’s easy to accept them as gospel truth. Especially when they’re repeated by respected people for so long.
It takes a strong independent streak to go against the crowd, to go against what everyone else believes, and seemed to be true for so long. Those who do are known as “Early Adopters.”
Hallmark of Early Adopters is their reliance on statistical evidence, not on gut reaction. Gut reactions usually reflect the past, statistical evidence predicts the future. It’s especially important to rely on statistical evidence when it comes to your biggest investment. The price for assuming the future will be like the past is enormous.
Ultimately, “life is like a clipper and only you can be the skipper.”
Yeah, But . . .
Millennials will surely have questions about the Nest Egg Strategy, especially since conventional wisdom advises the opposite, i.e. get the biggest mortgage, smallest monthly payment, and stretch it out for as long as possible.
It’s true the government and financial industry have attempted to mitigate the cost of all that interest expense with tax deductions, and such, but they don’t propose that leveraging debt will be a better way to create a retirement account. The implication is there’s a greater good for being in debt.
Of particular challenge are axioms that have been packaged into tidy little statements, especially when many of them were true in the Old Normal. They can such a stumbling block that a separate tab, “Yeah, But …” has been created to address each one. Listed below are the headlines for some of the biggest ones:
“Yeah, but home appreciation is my nest egg, my retirement account.”
“Money will never be this cheap again, borrow as much as you can.”
“Keep a cheap mortgage, e.g. 3.5 percent for as long as you can.”
“I need the tax deduction.”
“Money in the house is idle equity.”
“I can’t afford to pay off the mortgage by age 50-55.”
“I’ll never pay off this house; I‘m going to move in a few years.“
“Yeah, but home appreciation is my nest egg, my retirement account.”
Many count on home appreciation as their “ace in the hole.” Which it is, until it isn’t! Appreciation is fickle. Especially when financial engineering on Wall Street is responsible for increases well beyond that justified by real pay raises. If it can increase dramatically for mysterious reasons, it can disappear for mysterious reasons too.
Furthermore, appreciation only exists on paper, Monopoly money, unless and until the house is sold and turned into cash. That’s a matter of timing and luck, not the result of a detailed plan. The sad but repeating fact is the financial markets can change dramatically, as they is in 2008. Home values fell by half, leaving many homeowners “underwater.” Simply put, home appreciation is too fragile to put all your eggs in that basket.
Many also believe their appreciation “profit” is tied to how much or how little equity they’ve invested in the house. In other words, the less equity the higher profit margin. (Divide equity into appreciation = bingo!) Except, appreciation is actually a multiple on the market value of the house, not its “leverage.” For example, a $250 K house will appreciate $12,500 if the appreciation rate is 5 percent, no matter whether it’s 80 percent equity or 80 percent debt. Everyone in the neighborhood enjoys the same rate of appreciation. Therefore, appreciation is a moot consideration in whether to adopt the Nest Egg Strategy.
Not least, appreciation is more of a “gamble” than most realize, because homeowners don’t know all the factors affecting it and have little control control over any of them. In contrast, a calculated “risk” is when all of the factors are known, and homeowners have control over most of them. The Nest Egg Strategy is a calculated risk. With something as important as retirement, Millennials can’t afford to gamble!
“Money will never be this cheap again, borrow as much as you can.” Two problems, (1) Interest rate has little to do with “expensive or cheap.” (2) Interest rate for the next buyer is more important than your interest rate, how you got into a mortgage.
(1) Everyone touts the interest rate, implying a low rate means low interest expense. It doesn’t! The interest rate is an annual percentage. Interest expense is the amount of cash spent on interest expense, which is controlled by length of the repayment period.
For instance, average interest expense during first five years on a 6 percent, 30-year mortgage is $4.22 for every $1 of principal loan reduction. Which means the true cost of buying ownership is actually 422 percent! It falls dramatically every five years thereafter, $4.22, (2) $2.83, (3) $1.86, (4) $1.11, (5) $0.57, (6) $.086. This means there’s no such thing as a cheap 30-year mortgage!
Given that a 20-year repayment term starts at $1.86, fifty five percent less than a 30-year mortgage, a 20-year should be the new standard. It also saves time – precious 10 years of a limited career.
(2) When interest rates go up, the resale value of houses go down. Buy the most expensive house possible with a “cheap” mortgage and its resale value may be less when it’s time to sell. Some claim, “it’s different this time,” rates won’t go back to their traditional 7-8 percent range. History asserts otherwise. It says they will, because they always have.
Simply put, borrowing to the max when rates are cheap can easily backfire!
“Keep a cheap mortgage, e.g. 3.5 percent for as long as you can.” This objection relates to the former one, it’s not the interest rate that matters but interest expense!
It’s the length of the repayment period that adds the greatest cost, not the rate. As you saw in previous objection, actual interest expense is $4.22, (2) $2.83, (3) $1.86, (4) $1.11, (5) $0.57, (6) $.086 on a 6 percent, 30-year mortgage. Simply put, the first 10 years of payments are extremely expensive, especially if you move and start over again on a new repayment schedule. Might use 20 years of your career on the first two periods of two mortgages, barely touching the balance.
You want to leap frog these two periods as quickly as possible. That’s the function of Strategic Repayment. Over five calendar years, including regular payments, it aims to eliminate an extra 10 years of payments, landing on payment #180 or year 15. Not only do you eliminate all that interest expense, you’ve liberated 10 years for your retirement account!
Indeed, buying back time is more important than keeping a low interest rate. The real objective is to get rid of the first two periods as quickly as possible.
“I need the tax deduction.” If you’re in the 25 percent tax bracket, you save 25 cents for each $1 of interest expense. You lose the other 75 cents.
It’s not a tax “credit,” in other words. A “credit” is a dollar for dollar reduction in taxes. A “deduction” means income spent on mortgage interest is excused from taxation. If you’re in the 25 percent tax bracket, for instance, it means you’ll save 25 cents in taxes.
Some homeowners prefer to pay the 25 cents in taxes, and keep the other 75 cents for themselves.
“Money in the house is idle equity.” If equity in the house eliminates the need for $4.22 of interest expense it means it’s working harder than any other investment. You might earn 10 percent in the stock market, for instance, but that’s not nearly the return on investment for knocking off the first 10 years of a 30-year mortgage.
That’s doesn’t even count what 10 years of investment capital are worth, especially when compound earnings are added to the equation. It’s a complete reversal in your fortunes.
“I can’t afford to pay off the mortgage by age 50-55.” You can easily eliminate 10 years of payments via Strategic Repayment, which targets the “lazy” portion of a 30-year repayment schedule. It’s “lazy” because you get credit for only $1 of every $5.22 in principal and interest payment on a 6 percent 30-year mortgage. Eliminating this 10-year portion automatically shortens the pay off age to 55. (See Strategic Repayment section.)
Happily it takes far less principal than most imagine. Since there’s only 7 percent of the original balance scheduled to be repaid in first five years on a 6 percent 30-year repayment schedule, for instance, it takes early repayment of only 7 percent principal to eliminate those five years of payment. If you don’t repay that principal early, you’re forced to pay all the scheduled interest expense. There’s no third choice.
In an attempt to make sense of getting credit for only $1 of every $5.22 in payments, people believe the urban myth the lender stacked all the interest in the front of the schedule. How else could a 6 percent mortgage be so expensive!
Actually, it’s because the monthly payment was made so small there was almost nothing left for principal after interest was paid first. Thus, the outstanding balance remained virtually unchanged month after month, year after year, interest expense piling up.
Breaking up this loop, reducing the balance early on, is the key to paying off the mortgage by age 50-55. (Good use of Christmas Bonus.)
“I’ll never pay off this house; I‘m going to move in a few years.” The assumption is you’ll get a new 30-year mortgage and start all over again. Any progress on the current mortgage will be lost. Unless you …
Take your current mortgage “position” with you to the new house by getting a new mortgage that matches the time left on the old one. If there’s 20 years left on the old mortgage (after eliminating an extra 7 years of payments for instance), get a new 20-year mortgage and the benefits of Strategic Repayment carry over to the new house.
It’s a mis-take get a new 30-year mortgage every time you move. (Temptation is to get that more expensive house.) Getting a new 30-year mortgage is how people wake up at age 45 with 30 years to go on a new mortgage. Sadly, once those years are gone, they’re gone forever.
A Last Word about “Yeah, But …” The underlying premise of most objections is there’s a “greater good” for staying in debt. They don’t go so far as to say that managing debt is better than building equity. Nor do they mention how leveraging debt can build a retirement account. But they do imply it’s better, referring to its track record in the Old Normal
Another temptation is many of these objections have a grain of truth, even if not the “whole” truth. Temptation is to take them at face value because they come from people you trust, such as parents and grandparents, real estate professionals, as well as friends and neighbors. Hence, another reason they must be weighed carefully, determining which might apply to you and to what degree.
Human Nature also comes into play, the temptation to wait to see if the situation improves, if the Old Normal returns. By the time they find out, however, it may be too late, too much of their career may be gone.
Even though all the evidence favors the Nest Egg Strategy it still takes a strong personality to take the road less traveled.
