When To Payoff Mortgage: Housing Myths Part 13

Previous: Payoff Mortgage v. Invest Stocks: Housing Myths Part 12

Do not simply compare nominal interest rates, even tax-adjusted rates (which many people miscalculate). Where you are in the mortgage repayment amortization schedule is only one of the additional factors that determine your cost-benefit analysis.

Tony asked, "I have a current home loan of 50,000 and I have 70,000 in a money market. My current interest per month is 260.00. My gian on my money market is only 53.00 in interested per month [less than %1 APR]. Should I pay off my mortgage or keep paying it and saving in my money market? I also have 100k in a cd that yields 4% at this time."

Where are you in the mortgage repayment amortization schedule?

Mortgages front-load the repayment of interest so paying down extra early in the mortgage saves much more money than does paying down extra late in the mortgage.

Compare two people who owe $50k @ %5 interest:

• Person #1 started a $50k mortgage today and owes almost another $50k in interest, $46,627.89 to be exact, which we will round to $47k. Paying off the $50k mortgage today saves $47k.
• Person #2 has about $50k left on a $500k mortgage, in the last 2 years of a 30-year mortgage. He/she already has paid $466k in interest and the last 20 months contain only about $2k in interest (and only $855 of interest in the last year) so paying off the remaining $50k mortgage today saves $2k.

Two people each owe $50k @ %5 nominal interest rate but one person saves $47k by paying it off today and the other person saves only $2k by paying it off today.

The effective annualized interest rate is lower for Person #2 (in the last year or two of a mortgage) than for Person #1 (in the first year of a mortgage).

What is your tax-filing marital status, top federal/state/local top marginal tax rate, and total itemizable deductions?

Calculate both taxes and tax deductions correctly.

A $100k %4 APY CD yields $4k gross but a 10% top marginal tax rate cuts your effective net interest income to $3.6k after federal income tax while a 35% top marginal tax rate slashes your effective net interest income to only $2.6k after federal income tax--and maybe even less after state/local income taxes.

Parting with $50k savings to payoff a $50k mortgage depends partly on your top marginal tax rate that reduces your income from savings:

4 Percent APY Savings Rate:

• $2.0k gross interest income ($50k at %4 APY)
• $1.8k after 10% tax rate
• $1.3k after 35% tax rate

1 Percent APY Savings Rate:

• $500 gross interest income ($50k at %1 APY)
• $450 after 10% tax rate
• $325 after 35% tax rate

A new $50k %5 30yr mortgage costs $2.5k of interest in the first year so a single person with about another $3.5k of other itemizable deductions (property tax, etc., considering the new IRS property-tax deduction) sees ZERO tax advantage or tax reduction from the mortgage interest costs, when compared to being debt-free with a standard deduction.

New IRS Tax Deductions Worsen Mortgage Debt Deal

The new IRS property tax deductions make mortgage debt an even worse deal than it already was.

2008 and 2009 tax years allow you to take the standard deduction but also deduct $1,000 in property taxes (if married filing jointly, or $500 if single) simply by checking box 39c on Form 1040.

IRS Standard Tax Deductions for 2008 Tax Return
(ie, no "itemized" Schedule A needed)

$ 5,450 (single)
$ 5,950 (single, property tax deduction)
$10,900 (couple, married filing jointly)
$11,900 (couple, married filing jointly, property tax deduction)
$14,000 (senior couple, age 65 or older, married filing jointly, property tax deduction)

Non-senior singles can deduct almost $6k without itemizing and without paying a penny in mortgage interest.

Non-senior couples can deduct almost $12k without itemizing and without paying a penny in mortgage interest.

Senior-citizen couples can deduct $14k without itemizing and without paying a penny in mortgage interest.

These deductions are in addition to the $3.5k per person deductions ("personal exemption") for yourself and dependents.

The IRS tax changes are another reason on top of recent market declines as to why debt does not pay.

I warned about such issues before the market crash:

Prepay Mortgage V. Invest in Stock Market
Myth of Mortgage-Interest Income-Tax Deduction
Myth of the Stock Market (Leveraged Borrow-To-Invest Dangers)

Save Money on Your Winter Home-Heating Costs

Some people muse idly about the coming winter's fuel costs as if it were a storm over which they have no control. However, you do control your heat costs. Moreover, if everyone did these smart actions, lower demand would put downward pressure on fuel prices.

• Insulate: What would you think if someone left his/her front door wide open all winter and then complained about his/her heating costs? Lax insulation is like leaving your front door open in winter. First, inspect your current insulation. You can upgrade from minimum to average or from average to super-insulated. The roof is the most important because heat rises. Control air infiltration/leaks with caulk, etc. When it comes to heat retention, windows are only the next best thing to a hole in the wall, so use the best combination of storm windows, shutters, plastic films, thermal drapes, etc.
• Use Free Heat: Manage your windows to use free solar heat gain (insolation) through the glazed surfaces (eg, glass). Make a solar space to trap solar-heated air against your building (eg, cover the interior of a screen porch in black, fill it with thermal masses (water jugs, lawn mowers), and cover the exterior screens with clear plastic). Manage your yard to landscape for best solar gain on the whole house in winter. Basically, do the opposite of summer home-cooling techniques. Basements are free passive geothermal heat sources, when even their typical geothermal-heat 40-50F degrees are better than zero-degree (0F) outside air temperature (check radon gas if necessary). Earth-sheltered homes maximize free, passive, geothermal heat.
• Reduce Usage/Lower Demand: Conservation (not burning fuel) is the cheapest and easiest method to keep heating costs low. Insulation helps after you already have heated a space, but consider all the heating and fuel-burning that you do not need to do in the first place. Size/service/clean your furnace to peak efficiency, which is like raising the MPG on your car (otherwise, you are burning gallons without any heat benefit, simply burning money). Get a programmable thermostat that lowers heat while you are at work or sleeping under blankets. Lower your "standard" temperature a few degrees and wear a sweater (yes, the cliche actually works extremely well). Make "winter rooms," the old-fashioned method to keep the key part of the house at standard temperature (keep water-pipes above freezing or shut-off/drain the pipes from, say, an upstairs bathroom) and close-off unnecessary square footage (adjust heat registers/vents, close/add doors between rooms, etc.), such as the "exercise room" that is more of a junk room anyway. Winter rooms simulate the efficiency of studios, tiny homes, or other low-cost, efficient, simple-living lifestyles.

Let me know if I forgot anything.

Good luck.

Crossposted from Inexpensive Home Building

Avoid Holiday Travel Costs with Virtual Visits

Look Who's Coming to 21st-Century Dinner

National Public Radio (NPR) yesterday interviewed a woman who could not afford airfare to visit family. High fuel prices raise the cost of air and road travel.

Better than a card or phone call:

Use a webcam to virtually visit for almost free.

You might already own the computer, internet connection, and webcam needed to virtually visit distant family (and webcams are cheap now).

You can park the monitor like another seat at the dinner table (fun gimmick).

A large TV display beside the table might feel like another table.

Virtual visiting also can help when little Billy might be bored at Grandma's house but can play with his cousin across the country.

Payoff Mortgage v. Invest Stocks: Housing Myths Part 12

Previous: Home Decorating Costs: Housing Myths Part 11

Hock Your House?
Beware Over-Hyped Benefits of Leveraged Stock-Market Investments

Free Money Finance (FMF) responded to a pro-debt, pro-leverage Ben Stein article. Stein and some FMF commenters unfortunately repeated a number of false assumptions about stock market returns and dubious expectations about arbitrage net returns.

Sustained real returns near double-digit rates prove elusive.

People trick themselves into believing that low inflation (officially) under 3% is normal, that mortgage interest rates under 6% are normal, and that long-term, indexed stock market annual returns on investment (ROI) of 9-12% are normal. None of that is true.

Real (inflation/price-adjusted) stock/mutual fund ROI can be flat or negative over most of a decade. (Update 6/25/08: Remember that you are bleeding your mortgage interest even if your stock is "flat" and remember what a flat or negative first decade means for the long run in the world of compound interest.)

Hyped nominal stock returns near double digits often include periods of high inflation such as when consumer prices rose over 13% in 1979 (little real stock growth). (Update 6/25/08:...and the real growth can become real LOSSES when you remember your borrowing costs (see next paragraph).)

The periods of high nominal stock returns often coincide with high nominal debt costs (little arbitrage room): One measure records average mortgage rates of over 9% in most of 1991 and over 15% for about a year 1981-1982 (US Federal Housing Finance Board’s Monthly Interest Rate Survey (MIRS) National Average Contract Rate for purchase of previously occupied non-farm single-family homes, by combined lenders). The common apples-oranges mistake is comparing a recent short-term snapshot of low mortgage rates to past long-term inflation-contaminated stock returns, which is just as misleading as comparing a short-term stock-market crash returns to high long-term mortgage rates. The pro-leverage cheerleaders parrot the past 30-year S&P500 historical average but rarely mention the concurrently high 30-year fixed-rate mortgage average that leveraged people paid--because the 2nd half of the reality undermines their "easy money" sales pitch. (Update 6/25/08: Note the hypocrisy of people who drone on about decades-old "historical performance" until you remind them that they are leaving out the historical performance of COSTS, at which point they insist that old data is irrelevant because "that was then, this is now": Fine, then never mention past performance again, start with a clean slate on BOTH gains and costs, and we are left with a future, guaranteed mortgage loss compensated by nothing guaranteed on the plus side, and even a 5% mortgage could result in a double loss, as described later.)

Those hyped stock returns are sometimes intentionally inflated using a misleading method (arithmetic average annual return) in another improper apples-oranges comparison to mortgage rates: Use the proper annualized return (geometric mean) to compare directly to compounded mortgage-interest negative returns.

The popular major-market indicator Vanguard 500 S&P500 index fund (VFINX) cost about $30 in 1987 (20 years ago) and $140 today (late 2007), which is an annualized return of not 9-12% but only 8.01%--before taxes (Update 11/12/07: A VFINX $30 purchase and current $133 price puts the 20-year annualized return at 7.73%) (Update 7/13/08: A VFINX $30 purchase in 1987 and the current $114 price puts the 20-year annualized return at 6.90%. There are many other pluses and minuses such as dividends which might add 1.6% to the 6.90% for 8.50% BEFORE COSTS but a 0.15% expense ratio reduces that to 8.35% and a possible 0.5% mortgage PMI (often overlooked on the leveraged cost side) reduces that to 7.85%, plus possible mortgage points, dividend taxes, etc., before we even get to subtracting the main "mortgage rate").

The S&P500 20-year average performed about the same as an 8.xx% bond (before tax differences), and the US 30-year Treasury bond's yield was about 8% for most of the first decade after 1987 and peaked over 10% in 1987.

Borrow at 11% to earn 8%?

Anyone who in 1987 had cash to buy a house in full but decided instead to take an average 30-year fixed-rate mortgage (FRM) to invest the cash in an S&P500 index fund might have crucified him/herself on a (July) 10.5% mortgage interest rate to earn 8% in stocks/mutual funds, for a clear loss.

The poor sap could pay more in additional fees to refinance when mortgage rates decreased but average rates fluctuated near 8% for most of the 2 decades (finally breaking below 6.5% about 2002). Even a small negative arbitrage percentage can cost you tens of thousands of dollars. (Update 6/27/08: You could get a 5.xx% mortgage in 2005 but VFINX price since 2005 performed about 3.2% (5% with dividends) so your 2005-2008 leveraged investment gave about a 0% net return. VFINX price since 1998 performed about 1.8% (3.xx% with dividends) but 1998 mortgages cost about 7% so your 1998-2008 leveraged investment bled a LOSS of NEGATIVE 3.xx% per year for a decade. Pro-leverage cheerleaders say things such as "up 20% since 1998" to conceal the dismal 1.8% annualized returns but remember that negative 7% compounded for a decade results in a 50% loss (DOWN 50% since 1998).)

(Update 6/28/08: The borrow-to-invest plan to lock in a low mortgage rate for 30 years often fails in the real world for a number of reasons: (1) the average American mortgage lasts for an average of only 7 years (according to ING) due to moving or other reason, so the average person does not keep a low rate for 30 years; (2) banks advertise ideal rates that apply to few people but the more realistic rate is the report of average rates actually obtained by borrowers (6.62% for 30yr fixed-rate $165k mortgage according to Bankrate.com's 6/25/08 weekly national survey of large lenders, or 6.45% plus 0.6 points for 30yr fixed-rate mortgage according to Freddie Mac's 6/26/08 Primary Mortgage Market Survey (PMMS)); (3) people like to quote their rate but forget total costs such as points yet 0.6 @ $200k is an instant $12,000 loss before you earn a penny in the stock market; (4) people like to quote their mortgage RATE but their actual, annual debt cost is the APY (Annual Percentage Yield, which is higher than the rate because APY accounts for compounding during the year); (5) internet forum users claim to have a 5.xx% or even 4.xx% mortgage but best credit in ideal market conditions is rare so telling the average person, "Leverage your house in the stock market. First, get a 4.xx% fixed-rate 30yr loan," is like saying, "Make a million dollars. First, get $900k.")

The Iron Rule of Debt

Borrowing usually costs more than investing earns, given equivalent risk (with borrowing, you pay inflation + risk + someone’s salary/bank’s overhead; with investing, you (hopefully) earn inflation + risk – fees - taxes; therefore, with borrowing-to-invest, inflation and risk cancel out and you are left with transaction costs at both ends). Even the abnormally low mortgage rates of recent past coincided with the stock market crash of negative annual returns, so someone could have borrowed at 5% to lose 20% in the stock crash (-5-20), for a net 25% loss.

Investing in income-generating enterprises rather than attempting pure price speculation might help your odds but leveraged investments remain risky even with income-generating investments.

Hope Springs Eternal: Everyone Wants To Be above Average

Even people who know that the average active stock/mutual fund picker will underperform the market by a percent or 2 (e.g. 6-7% instead of 8%) think that they will be the ones who will outperform the iron rule of debt, by both picking and timing both debt and investment correctly, and therefore earning more than their debt costs. Every leveraged investor believes that he/she brilliantly will borrow at 8% to earn 11% when we know that quite a few people will be like the poor sap in 1987 who borrowed at 11% to earn 8%.

Those who beat the odds will be the "poster children" to recruit an army of saps. Even many of the saps will recruit more saps by falsely thinking they earned 11% when they actually earned 8% and by falsely thinking they had a positive net return when they actually had a negative net return. Take the cheerleading leverage/arbitrage hype with a grain of salt and learn the true risk and math before you act.

Good luck to all.

Did this Couple Do Everything Wrong or Everything Right?

Two Wise Acres wrote about an older couple who succeeded in the real estate investment rental business by doing "everything wrong" by violating these "rules":

• 1. "Leverage Your Investments to Maximize Growth" (instead, they paid off a property before they bought another).
• 2. "Always Make Sure You Have Well-Drafted Leases with Tenants" (instead, they rented month to month with no lease).
• 3. "Maximize Rental Income" (instead, they charged 30% under conventionally-accepted "market rates").
• 4. "In Your Lease, Make Sure that You Contain Appropriate Restrictions on Tenant Alterations to the Property" (instead, they allowed renters to paint even the exterior of the building).

However, the couple followed these rules instead:

• 1.Minimize costs (debt)--and pass the savings to the customer without lowering your profit (low producer costs=low consumer prices).
• 2.Serve the customer, find a niche, and build loyalty--the biggest cost/effort/risk is spending for the initial setup and then (tick-tock-tick-tock) eating your costs while waiting for a 1st-time customer to "walk in the door" (this why companies spend so much to advertise and to track and profile customers) so the holy grail for renting is "finding your market" (flexible leases) and no vacancies (less turnover, less frictional losses, maximum utilization of your infrastructure, on the edge of your economic "production possibilities curve"), provided by tenants' loyalty and tenant-provided free word-of-mouth advertising/recruiting.
• 3.Undersell the competition--#1 leads to #2. Low price also increases the landlord's applicant pool so he/she can select and keep the cream of the renter crop.
• 4.Build/allow customer identity/community with your product--customers will lower your costs by doing free maintenance (paint the rental house) or will create new content or products for you (free R&D). A recent book argued that most innovation comes from the bottom up, from users who invent something new for their own use first (necessity is the mother of invention, and the customer/user knows his/her own needs better than existing companies know his/her needs) and then the big companies mass-produce what the customers invented for them.

Real-life example: Another landlord (not Two Wise Acres' couple) offered low rent with no lease, let a renter nail/drill holes, and even added a major amenity without being asked or raising the rent. The renter returned the favors, paid to fix the apartment's (landlord's) refrigerator without bothering the landlord, and paid professional cleaners to clean the apartment when he moved out.

(I will write more about renter modifications in a future installment of my "Housing Myths" series.)

Did these Landlords Do Everything Wrong or Everything Right?

Ignore Average Annual Return Rates: Geometric Mean V. Arithmetic Mean

Previous: Vanguard 500 VFINX Loses 20% of Your Money from 8 Years Ago

Protect yourself from slick marketing: This article explains the importance of the geometric mean and how to calculate it to read and report returns on investment (ROI) accurately.

Misleading "Average Annual Returns"

The average annual rate of return tends to overestimate your gains because it is an arithmetic mean (an average based on additive units) which is inappropriate for multiplicative products such as compounded interest.

Using the arithmetic "average annual rate of return" for stock performance is like trying to describe how tall you have grown in ounces or asking, "How many inches do you weigh?"

Simple hypothetical of a $100 lump-sum buy-and-hold:

Year - Investment - Return
0 ............ $100 ......... -
1 .............. $50 ...... (50%)
2 ............ $100 ...... 100%

• Average annual rate of return: (100 + (-50))/2 = 25%

You started with $100 and you ended with $100 but your $0 gain shows +25% average annual return.

Of course, you actually have 0% gain on your initial value after 2 years.

Use the Geometric Mean Instead

Ignore the arithmetic mean (average annual rate of return) and instead calculate the more helpful geometric mean (annualized rate) to find the factor that, if repeated, would result in your current/desired balance; for n years, the nth-root of the products of the rates-expressed-as-positive-growth-factors. For our example above that halved (*0.50) and then doubled (*2.00) in 2 years:

• The square-root of (0.50 * 2.00) = a factor of 1.00

So $100 * 1.00 = $100. The factor of 1.00 is equivalent to 0% interest, since you can multiply by 1 forever and still have the same number with which you started (in our example, 0% per year for 2 years). A factor of 1.12 would equal 12% growth (per time period). Note that 3 years would require the cubed-root, etc.

A shortcut is the nth-root of the last-year's-balance-divided-by-the-first-year's-balance. For our example:

• The square-root of (100/100) = a factor of 1.00

The shortcut shows that you can ignore all the "paper profits" ups and downs (unrealized gains and losses) of your stocks or home equity and concentrate on the end points of initial investment v. final cash-out (assuming no intervening hard cash inputs/withdrawals). The geometric mean simulates a consistent year-after-year interest rate so you can compare a volatile stock to something with steady progress such as a 5-year Certificate of Deposit (CD).

Use Geometric Standard Deviation

Ignore arithmetic standard deviation and use geometric standard deviation. That calculation is a bit more complicated (involving logs) but at least know how to read it. Unlike the arithmetic version which is reported as a quantity (e.g. 5% mean with standard deviation of 3% indicates a range of 2-8%), geometric standard deviation is reported as a factor (e.g. 1.05 mean with standard deviation of 1.03 indicates a range of 1.02-1.08, and the nth standard deviation is the nth power of the geometric standard deviation).

Always use the right tool for the job and do not let Wall Street or Madison Avenue tell you otherwise.

Geometric Mean Calculator for Annualized Returns on Investment (ROI)

Simplify Your Bills and Life: Streamline Paperwork

The paperless society never materialized. A paper trail is valuable in a financial dispute but many people are awash in useless paper. You can keep what you need and shred the rest.

Use might some combination of these options:

• Keep a shredder where you take in and open mail. Reduce handling by making a keep-or-shred decision the first time you see something. Handling each item 3 times is like asking the mailman to triple your junk mail.
• Designate a container for what you keep (an envelope for a particular utility or a carry-handle box for everything) and then winnow the contents as necessary to use “make it fit” for inventory control.
• Save only a key page or part of a page (maybe a summary for the gas bill, maybe the itemized list for credit cards). You might get a 5-page statement of which you need only a third of the page.
• Save only recent bills (or more of recent bills and less of old bills).
• Save only “red letter day” details (important milestones).
• Save only endpoints (opening and closing a loan).
• Save only records of what you paid (v. what you owe, for which you often find no shortage of people to remind you).

Americans’ Net Worth in the Federal Reserve’s Survey of Consumer Finances (SCF)

What if a Quarter of Your Wealth Were Imaginary?

Net worth is a favorite topic in the buck-o-sphere (personal finance blog-o-sphere) and many people pounce on a government or media report to see how they stack up against their fellow Americans. You need to understand the source of the information and know how to read economic and financial reports correctly.

The Federal Reserve’s triennial Survey of Consumer Finances (SCF) and specifically its net worth numbers provide good examples on what to watch.

Time Lag

A report that comes out today might have no current data and instead be based on data from a few years ago. The 2003 SCF report used 1998-2001 data. The 2006 SCF report used 2001-2004 data. Most people will not see 2007 data until the 2009 SCF report.

Forgetting this point can lead to faulty decisions. One blogger recently linked to a 2003 article and compared his/her 2007 net worth to 2001 data.

Real (Inflation-Adjusted) V. Nominal Dollars

The SCF adjusts for inflation but its tables are not labeled as “real” dollars, making it too easy for the casual reader to assume nominal (un-adjusted) dollars. Further, the SCF uses a “current methods” adjusted CPI which assumes less of an inflation bite than the official CPI does.

How Do They Get People’s Financial Information?

The SCF is a survey, not a census. Like much government data, the results depend on “Gallup poll” types of problems such as sampling error, weighting, refusal to participate, and similar issues. The survey firm NORC conducts the survey of approximately 4,000 families to estimate the United States (a statistically significant sample). The accuracy of the Federal Reserve’s SCF depends upon the accuracy of Joe Sixpack’s financial self-knowledge when questioned by NORC.

Whose Net Worth?

The SCF’s “family” is technically the Primary Economic Unit (PEU) of a household. The SCF uses an unusual definition of “family” that includes single-person households. The PEU is a hybrid between other government definitions of family and households. The average US family is a bit over 3 persons and the average household is a bit under 3 persons.

“Age” is the age of “head” of “family” and the age of others in the PEU can vary from that, so 2 “40-year-old” households might have very different average ages (is the spouse 30 or 50?) and therefore have had different amounts of time to accumulate wealth.

What Counts?

The medians of many assets and debts are “conditional medians” that exclude zero to show a typical holding of a family that possesses the item in question (e.g., the median debt of debtors, not the median debt of everyone including debt-free people, which would lower the figure considerably).

The SCF counts a 401k but it ignores a defined-benefit pension (by the way, the proper absence of a defined-benefit pension from “net worth” is another reason why net worth is for measuring current wealth and is not very good at estimating future wealth). The SCF also ignores Social Security. The SCF appears to ignore tax liabilities.

Paper Profits

Net worth includes volatile asset prices (stocks, real estate) that can bubble or crash. Median unrealized capital gains ("paper profits") accounted for about 25-30% of median net worth for all but the youngest age group (under 35) in 2004 (before the 2005-2006 housing bubble apogee). Remember that about a quarter of median net worth is not real yet.

The only bad part about learning all this is that you might get upset more often when you see how other people misuse the SCF and similar statistics.

Leveraged Investments: High ROI Is Not Always Best

A recent leveraged-investment discussion revealed that people can calculate a high Return on Investment (ROI) from borrowing by not counting the debt principal as a cost and (in one case) not counting the debt interest as a cost.

Consider a choice to invest $250 cash v. $250 debt:

Investing cash to earn 10% earns 10%.
Investing debt at 5% interest-cost to earn 10% earns net 5%.

However, it is common to claim that debt gives the higher ROI.

Free money, for the asking, no strings attached, no debits

Financial analysts can claim that debt gives the higher ROI by not counting the debt principal as part of the investment, yet counting the net returns from debt (your ROI sprouts from "nothing"). The argument is that the debt is "not your money," although a credit check of your name would not agree completely and at the very least the argument ignores the legal liability, risk, insurance requirements, effect on credit score, credit score's effect on other loan rates, etc.

Infinite ROI, infinite profits

Excluding the debt principal from the initial value of an investment certainly can raise the apparent ROI. However, that argument suggests that 0% downpayment gives you infinite ROI when we all know that, for any given dollar amount of investment, you would be poorer by borrowing more of it and richer by borrowing less of it (as in the "Consider a choice" above, and the example below).

Wait, there is no such thing as a free lunch after all

While a high ROI seems efficient, at some point you want to maximize your profits in dollars rather than percentage points. You cannot buy lunch with percentage points. You need dollars.

Look at your real estate profits here in Net Operating Income (NOI):

$250,000 [100%] paid in full in cash:
--$26,400 in rents - $3300 expense = $23,100 NOI
--$23,100 / $250,000 = 9.2% ROI

$25,000 [10%] cash down payment [plus $225,000 mortgage]:
--$18,879 in mortgage payments + $3300 expense = $22,179
--$26,400 in rents - $22,179 = $4221 NOI
--$4221 / $25,000 cash in front = 16.9% ROI

example from: Using Financing for Real Estate Leverage

The NOI trend gives you an idea of your hard-earned money that you keep by putting a larger downpayment on your mortgage (although this is a rental example).

These types of examples are very common to extol leveraging but you can see the trend that the more you pump up the ROI, the less money you make.

Cocktail-party bragging rights to the higher but leveraged ROI will cost you $18,879.

How high an ROI do you want?

(PS: The NOI informs you that the leveraged ROI is inflated because it ignores that you left $225k cash idle and (apples to apples) the actual leveraged ROI here is only 1.7% ($4221/$250k), or 0.9% ($4221/$475k) if you include the $225k mortgage to discount for debt risk.--Note added 7/25/07, last updated 7/30/07)

-

Leveraging multiplies scale, volume, and risk but I will leave that for a future article. Alternate uses for the same money (opportunity costs) such as stocks or arbitrage are separate choices and each can be leveraged or not leveraged.

Next: Inflating Leveraged ROI Can Ruin You

See also:
Never Prepay Mortgage? Housing Myths Part 1
The $200,000 Blunder: Housing Myths Part 2
Home Mortgages Are Bad Investment Tools? Housing Myths Part 3
Homeowner Profits Ignore Huge Costs: Housing Myths Part 4

Beware Vanguard 500 Faulty Logic & False Performance Measures for Investments

The Vanguard 500 S&P500 index fund is popular in the buck-o-sphere (PF blogosphere) and bloggers often cite its historical annual rate of return of 12% since inception in 1976. However, besides the usual caveat that past performance is no guarantee of future performance, too many people ignore another vital factor. The Vanguard 500's real performance is not nearly as stellar as many believe.

Confusing Nominal V. Real (Inflation-Adjusted) Returns
& Confusing Today's Inflation Rates V. Past Rates

Dough Roller recently remembered earning more than 10% on Certificate of Deposit (CD) during the high inflation of the 1970s/early-1980s. Indeed, consumer prices rose 13.3% in 1979.

Forgetting to count inflation--and forgetting that past inflation was quadruple current official rates--will cause you to overestimate historical investment performance. The Vanguard 500 averaged 12% annually since mid-1976 but double-digit inflation makes a 12% return pitiful. A fund with 12% growth during 12% inflation is no better than a fund with 3% growth during 3% inflation.

Before you "beat the market," at least beat inflation.

"Beating the market" compares your fund relative to other funds, which could mean that your fund lost a lot while other funds lost even more. This is small consolation, since schadenfreude will not pay your bills.

You need real, after-tax gains to buy food in retirement.

Use real rates of return (not nominal rates of return) to get a more accurate measure of historical performance. This lesson applies to any investment.

See also:
Vanguard 500 VFINX Loses 20% of Your Money from 8 Years Ago
Destroy Your Retirement Nestegg with Happy Thoughts
Never Prepay Mortgage? Housing Myths Part 1

Destroy Your Retirement Nestegg with Happy Thoughts

Magic Numbers:
Pick One . . . Whichever One Makes You Happy

My recent article about investing vs. paying off your mortgage, Never Prepay Mortgage? Housing Myths Part 1, has a bigger lesson for the subprime mortgage and Collateralized Debt Obligation (CDO) mess.

“Prove” anything by picking the magic number.

My article noted how a 2001 Fool.com article predicted a 12% annual return on investment (ROI) for an S&P500 fund but in early 2007 the 10-year average was only 7.7% (even using "Bull's Math" (optimistic Wall Street math)).

The second mistake is forgetting what an average is.

The problem for your retirement nest-egg is that a return to 12% annually does not fix the predicament. To average 12% after a decade of 8%, you need the next decade to provide over 16%. However, we are coming due for a recession (cycles are inevitable) and a steady 16% for a decade seems unlikely. Moreover, if a coming particular year does “only” 12%, you need another year at 20% to average a 16% decade to make up for the first decade’s 8%. If the S&P500 returns a modest 8% in a future recession, we might need the S&P500 later to return 25% simply to average 12% in the 21st Century.

“Experts” apparently made this mistake in financing the housing bubble.

Experts at an early-2006 conference on home-equity-loan securitization assumed a worst-case scenario of +3% asset (home) appreciation per year. It seems as if they assumed the worst stress-test condition to be the long-term trend rate of residential real estate appreciation, barely treading water with inflation (if we continue 2-3% core inflation).

The bigger they are, the harder they fall.

The glaring error is assuming that the price basement will be the historic average, rather than the lower numbers that created the average. +1 and -1 average to 0. It is mathematically impossible for every year to be either average (0) or above average (+1). Some years must be below average (-1) to make the average. If you then had a few years at +10 (far above average), you cannot assume that your future floor will be 0 (the average) because now you need a few years at -10 (far below average) to return the average to 0.

The big problem ahead

Standard & Poor's (S&P) and Moody's are reducing the ratings of mortgage securities, which is like telling a new owner, after the purchase, that his/her "6-pack" of soda only has 5 cans, his/her "30mpg" car only gets 20mpg, or his/her "3-bedroom" house only has 2 bedrooms.

The valuation errors contributed to the housing bubble by (1) overestimating the profit in home-mortgage sales, (2) thus overselling the financing product, (3) thus causing the inflation of too many dollars chasing too few assets (the home, necessary to cash the profit on the home-mortgage product), (4) thus contributing to the asset bubble, (5) but also underestimating the risk, (6) thus underdiscounting/overpricing securitized debt/CDOs, (7) thus sticking buyers/investors with insolvent lemons, (8) and the double whammy of evaporating home equity and evaporating securities equity creates yet to be seen ripples in pension/retirements funds, consumer spending, employment, Federal Reserve monetary policy, stock market performance (+25% or -10% for the S&P500?), and the economy writ large.

See also: Beware Vanguard 500 Faulty Logic & False Performance Measures for Investments

Is Your Baby Cost-Free?

How much does a healthy baby or child cost?

Some new parents get carried away so it might be healthy (financially, physically, and psychologically) to remind yourself of the basics.

The true consumption items

• $1,250/yr formula, food, and diapers.
• $0 breast feeding
• $0 for CDC free child vaccinations, or nominal administrative cost.

You will have a US federal tax deduction of about $3k and a tax credit of $1k per child, which means that $1k-$2k of child costs will not lower your previous discretionary income at all. Even with a few pediatrician check-ups, depending upon your health insurance and tax brackets, you might make a profit off your baby.

Play time

Patty Cakes and mud pies are free.

Durable goods

Freecycle.org seems novel only if you are unaware that shared hand-me-downs are the normal way that an entire extended family would outfit new parents for generations.

• Furniture: It used to be normal to use “grandma’s crib,” the one possibly hand-built by your great-grandfather in 1900, the one in which your mother slept and you slept. In between, your aunts and cousins slept there. “A diaper-changing table” was known as “a table” or “a blanket on the floor.”
• Clothing: It used to be normal for children to wear their older cousins' outgrown clothes, and for a younger brother to inherit his older brother’s winter coat (that is 1 coat for 2 children, not 5 coats for each child). Your 2-year-old niece has absolutely no use for her 6-month-old-sized sneakers.
• Toys/books (including educational): It used to be normal to recycle toys, especially the very early baby ones that a more possessive toddler scarcely remembers as “mine.” Unless your family changed language, items such as an older, in-the-extended-family “Jack and Jill” book should be fine.

You might have some cost for new and replacement durable goods but spending a fortune is very often voluntary rather than necessary.

How to turn free or almost free into a $14k/yr loss

Musings on Personal Finance mentions that the average middle-class family spends $4-5k/yr on a baby's first 2 years but remember that is what is spent, not what is necessary. SureBaby.com claims $9-11k for the first year but that includes “baby furniture” and “baby gear.” MSN/Money claims $14k/yr (a quarter-million dollars to age 18) but that is for your “basic upscale baby.”

If you are determined to commercialize your child, you certainly can find ways to part with your money for all these services that the new Mom’s Mom and Grandma used to provide for free:

• $400 to learn how to give birth (Lamaze class).
• $80/hr to learn how to give milk (“lactation consultant”).
• $200-$400 to learn how to play/bond with your baby (“mommy and me yoga” class).
• $300 birth announcements.
• $60 Teletubbies cake.

Voluntary big-ticket items

• Daycare: One reason that the “traditional family” has been traditionally common is because it (including Mom, Dad, Auntie, Grandpa, cousin babysitter) does not need commercial daycare cost. However, people are free to choose non-traditional families and commercial daycare. Look at these 3 real families; one couple chose the stay-home-spouse method to avoid commercial daycare, another couple chose to stagger their 2-job work schedule to avoid commercial daycare (even 2 single parents could make a similar arrangement), and another couple decided that they both wanted to work “9-5” so they chose commercial daycare as a lifestyle choice.
• Education: You can do homeschooling relatively inexpensively (a good encyclopedia CD-ROM provides impressive bang-for-your-buck since even most parents know only a tiny fraction of its knowledge). Public education is expensive but you pay for it through taxes whether you have children or not so having a child does not change your cost much. You can choose to pay for private school in addition to public school. You can choose to pay for college, or not pay and let your new adult son or daughter decide how to spend his/her own money.
• Housing: It used to be normal for young children to share a room or to have a "girls' room" and a "boys' room." Even the affluent Brady Bunch had only 2 rooms and 1 bathroom for 6 children. You also can split a room into 2 rooms with affordable interior walls.
• Vehicles: It used to be normal for 2 families to fit inside a single mid-sized sedan for family outings. Even the extra space for baby-seat regulations does not require today’s smaller families to buy a $30k minivan or SUV—unless it is to fit the $10k of ski equipment and Gameboys.

The "Dog Food Effect": Who is the spending really for?

Spending to provide a healthy, happy child is different from spending to use a child as a billboard for the parents’ ostentation. Babies know when they are warm but not when they are fashionable. Many of us have seen the child who unwraps a present and throws the toy aside to play with the packaging. “Dollar store” toys can be just as astoundingly educational and fun as boutique toys when you are fresh out of the womb—it is all new to you.

Many baby products are examples of the "dog food effect," marketing slang for when a product must appeal to the buyer rather than to the actual user of the product. Choose safety and fun for the child over prestige for the adult.

By the time the child has been socialized to fashions and brands, the child can start thinking about getting a “job” to pay for wants: The “lemonade stand” stage is an important part of education and socialization.

“Savings” Pitch Tricks You into Overspending

More Dark Alchemy:
“News”=Advertising
“Saving”=Spending

Free Money Finance cited a finance article about 15% of US households with $0 net worth. The article is a perfect example of tricking you with slick sales marketing that masquerades as news.

First, however, look at the faulty analysis:

• The article cites 15% of households with $0 net worth but is on thin ice when it converts households to individuals—unnecessarily (what is wrong with simply saying "1 out of 7 households"?).
• The 2.6 persons per household includes babies and college roommates.
• The logical flaw is the article's assumption that a $0 household has 2.6 persons each with $0 net worth. Each household member can be wildly different from one another—think if your roommate were Casey Serin.
• Besides, since about 15% of households are led by a “householder” under 30 years old, 15% of households with $0 net worth is not “shocking” (as the author asserted).

How To Twist “Savings” To Trick You into Overspending

• The author claims “shocking” news to scare you into “saving” more.
• Even more importantly, the pitch actually gets you to spend more money.
• There is no mention of debt reduction. The author ignores the most basic method of increasing net worth (reducing debt), and also ignores basic savings, and skips straight to investments and advertises specific mutual-fund and stock picks.
• Swallowing his advice means that you probably will be paying fees to someone, probably while paying interest (on unpaid debts) and taxes elsewhere along the way.

The Old Borrow-To-Invest Scheme Again: Who Profits?

It is no surprise when someone advises you to do something that would profit him/her (e.g. to buy a mortgage, student loan, insurance, investment, or anything). The strange part is that people continue to fall for it.

If you pay off debt early, the bank gets less profit off you and the stock market does not get to profit off that money either. It is no surprise when the banking and investment industries (including “free” websites that make money off the stock-market culture) urge you to invest instead of paying off debt; they make money off you coming and going.

When your “impartial” friend makes that same recommendation, you might find that you can trace his/her conviction to advice from the investment industry.

Cast a Jaundiced Eye on the Old Spend-To-Save Advice

Investments are great vehicles for surplus funds but do not confuse true surpluses with amounts above minimum debt payments.

You might do all the math specific to your situation and occasionally find a circumstance where borrowing to invest will (1) profit you as well as (2) profit others—but make sure that #1 is indeed part of the result.

How To Measure Prosper Profits Accurately

See "Prosper Private Lending Service: Do You Want To Be a Collection Agency?" for background.

Prosper.com lenders are apt to overestimate their profits:

• Your returns might appear high at first (when borrowers make the first payment because they are still eager and excited about their new money and the novelty of Prosper) but do not be surprised if defaults increase over time as borrowers get bored of paying and the luster of their vacation/wedding/business-that-did-not-take-off is long forgotten.
• You never know your final profit until the last payment is made (or not made) 3 years later.
• You can spend 2 years simply hoping that you get your principal back.
• After that, spend another year seeing if you will get the promised 15% above principal or if the borrower will skip the last year of payments so you net 0% above principal—which would be a real 6-9% net loss after you account for 2-3 years of inflation.

Formula To Track Prosper Return on Investment (ROI)

Therefore, perhaps Prosper profits should be tracked by making the loan, recording a -100% return (100% loss), updating to a -97% return after the first payment, and so forth.

Do Not Inflate Net Worth: Ignore Taxes at Your Peril

Hat Tip: Ed provoked this post.

Part of series: Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?

Do not deceive yourself by inflating your net worth.

Yes, it is difficult to estimate some items but it is better to underestimate your wealth and later be pleasantly surprised than to overestimate and lay a trap for yourself.

The taxman cometh.

People often leave taxes and regulatory costs off their liability list but you can be sure that the government will ignore such creative accounting and will not forget to take its slice ("But look, my blog says I don't have a tax liability because I typed it that way.").

Remember what "net worth" is.

Net worth is a snapshot of what you would have if you liquidated now. If liquidating your IRA now would incur a 35% income-tax rate plus 10% penalty, then the accurate net worth of your IRA now is about half of what your account statements say.

To say that you would not liquidate now and things will be different later is to ignore net worth. If you use a non-net-worth measure, do not call it net worth.

It is better to understand the limitations of a measurement than to cook the books.

Even if you somehow accurately predict a $1 million nest egg for retirement and dismiss your tax liability on it as "only" 10%, leaving the tax liability off your books is a $100,000 error.

To estimate what your net worth will be decades from now is a very difficult endeavor because you would have to guess at fluctuating IRA and home values, variable inflation rates, uncertain future income and saving rates, and the competing compounded interest/returns of both investments and debts.

That difficulty is why it is easier to estimate your net worth now with all liablities from current tax brackets and current laws.

Is the American Dream Dead? Debunking the Pew Charitable Trusts' Economic Mobility Project

The recent Pew Charitable Trusts Economic Mobility Project’s claim that the American Dream "may well be shifting" (about sons not doing as well as their fathers) has been spreading through the mainstream media like a rash and Flexo at Consumerism Commentary asked me to explain my skepticism so here is my quick impression:

It is always a good idea to go to the original report and check the “methodology” section, often buried in the footnotes, to see how the report created the results.

We start with Pew’s own numbers:

Real Income of Men Age 30-39

1964 $31,097
1974 $40,210
1984 Missing
1994 $32,801
2004 $35,010

• The “falling behind” media headlines highlight the 2004 v. 1974 comparison but comparing 2 isolated data points is notoriously dangerous and you can see even from the short chronology above that the long-term trend shows an increase while 1974 is an “outlier” (aberration that deviates from the trend). The 1994 figure is also lower than 1974 even though during the 1990s the media told us ad nauseum how the 1990s was the greatest economy in history. The 2004 figure is higher than the 1994 figure so why isn’t the current decade greater than the greatest?
• The “falling behind” media headlines highlight the comparison to a 1974 baseline but 1970s baselines are frequently misleading. If you ever want to “prove” decline, the 1970s is a good place to shop because of a peculiar set of economic convergences at that time. The numbers often appear to show the 1970s as a worker’s paradise even though this was the Archie Bunker decade of stagflation, an energy crisis, price controls, gas rationing, and a high Misery Index.
• The report calculates income oddly, considering the topic of economic progress. The report’s idea of “income” excludes non-cash employer-provided benefits such as health insurance and retirement benefits but it does count government welfare checks. In other words, if your dad collected a lot of welfare, the report counts that as doing well. In Pew’s world, being on the dole is better than having health insurance or a pension.

The report has much more to question (a 30-year generation instead of a 20-year generation, the international comparisons, etc.) so feel free to see for yourself and post comments.

Steps to Financial Freedom: How long a vacation can you take?

Previous: Give Yourself a Raise: Best Saving Is Not Spending

How long a vacation can you take?

Financial security or financial independence or being independently wealthy ultimately means being able to pay your bills without working. This might seem like a fantasy for people who today are behind the eightball but almost anyone should be able to achieve financial independence by taking one achievable step at a time (the sequence is not exact and steps can overlap):

• Stop the negative savings (reach the breakeven point of income=outgo).
• Pay off all debts.
• Build a financial buffer (have a week’s expenses set aside, then 2 weeks’, then a month’s, etc.). Do not stop when you have reached the “standard” 3-6-month buffer in savings. Keep going and extend how long you could go without “standard” income. You are on the right track when you can measure your buffer in years. After all, many people plan for a decades-long vacation and call it “retirement” but ignore the artificial barrier of “retirement age” and “retirement accounts.” Eventually, your buffer will extend into your golden years.
• Minimize and eliminate the need for active income (going to work)—although it is smart to work more than you need to build your savings. Meanwhile, use the resulting savings to build passive income (interest), although remember that future interest income is uncertain, such as a few years ago when the Federal Reserve slashed rates. You will be fairly comfortable if current passive income meets current regular expenses and you have the principal for emergencies. Although nothing is 100% certain, accumulate wages and interest into a lump of principal that will cover a lifetime’s expenses.

Give Yourself a Raise: Best Saving Is Not Spending

Previous: Best-Worst Financial Measures: How To Track Your Financial Independence and Security

How To Give Yourself a Raise: The Best Saving Is Not Spending

You generally have more control over decreasing your spending than you do over increasing your income, so lower spending is the best way to give yourself a raise.

Minimize Fixed Overhead, the 800lb Gorilla

The most important way to lower expenditures is to minimize your fixed overhead, i.e. regular expenses. Housing might be necessary but your current housing cost might not be necessary. Utilities might be necessary but your current cable and cellphone plans might not be necessary.

The magic part: lower spending (1) creates wealth and (2) reduces the need for wealth at the same time

Minimizing expenses is your most powerful tool because it has a double benefit and creates a virtuous cycle: Lower costs this year to increase your savings this year, so next year you have higher savings against the continued lower costs, so your financial buffer will last even longer if you do have an emergency. This type of “compounding” is as good or better than compound interest, especially since you pay taxes on interest earned but you do not pay taxes on money not spent.

Next: Steps to Financial Freedom: How long a vacation can you take?

Best-Worst Financial Measures: How To Track Your Financial Independence and Security

Five Cent Nickel's recent post shows that he and the rest of the buck-o-sphere (personal finance blogging) are still crackling over net worth and practical wealth so here is further elaboration of my thinking:

How To Track Your Financial Independence and Security

The first step is to choose your lifestyle (do not let a lifestyle choose you--take control of your life). The best financial measure depends upon your exact purpose. If you are planning to sell your million-dollar mansion and move into a $100k condo, then you want to track both those prices. Even so, it might be more prudent not to count the difference as wealth until the money is in your bank account. If, however, you plan to stay at your current consumption level without wrenching changes (e.g. you will stay in the same place or a similar-value residence for the rest of your life), then ignore your home value, ignore your treasured collection of collectible Star Wars action figures, and ignore anything else that you would not cash-out.

Measures to ignore:

• Net worth
• Income (general): Any income recommendation such as “80% of pre-retirement income” is nearly worthless because it ignores expenses (costs/outgo)—and expenses are the whole reason that you need income.
• Gross Income: Guidelines about what percentage of gross income to spend on Item X are nearly worthless because (1) taxes and deductions vary widely so net income varies widely, and (2) the value of “$100” of Item X can vary greatly by how much is asset value versus interest or related fees.
• Net income: Even “25% of net income” for Item X can mean very different things to different people depending upon other regular bills (medical costs, etc.). Further, income can vary and future income is less certain than past income (savings are your residual past incomes).

What to measure:

Financial security = liquid wealth divided by total expenses
e.g., divide by monthly expenses to see how many months you can go without income.
Remember to amortize infrequent expenditures (automobile purchase) into a monthly budget.

Expenditures are key

The critical value is your minimum necessary expenses, relative to available wealth (i.e. savings, not income). In other words, compare past surplus income to future costs; past income v. future outgo. You want to maximize your past, surplus, accessible income (savings/liquid wealth) and minimize your expenses.

Next: Give Yourself a Raise: Best Saving Is Not Spending