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)

Savers Are from Mars. Debtors Are from Venus. Episode 5

Turning Gold into Lead:
How To Lose $100k, and Your House, and Your Family

"Wendy's home had appreciated in value by about $100,000, only months after she and her husband bought it. So, they took out a second mortgage for almost $80,000 to enhance their new home. It was at 8% interest. When the housing bubble burst, that $100,000 in equity evaporated. But, the interest on that second adjustable rate mortgage by now had climbed from 8% to almost 16%, creating a monster of a monthly payment they couldn't handle. 'Then, it just gets pulled from right out underneath you.' Wendy says her marriage even broke-up over this. Now the couple faces possible foreclosure on the house" (KVOA).

Debtors often display this unfortunate tendency to turn even a $100k windfall into more debt, to eliminate increases in net worth, to eradicate any trace of even accidental equity.

Remember that the $100k was only a paper profit, not real wealth, because they did not sell the home at the high price (they ignored the basic, old "sell high" truism).

They ignored the chance to increase their income and instead increased their outgo (spending)--the opposite of basic financial advice to increase income and decrease outgo.

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.

Homeownership Cost Cliches: Housing Myths Part 10

Previous: House Depreciation-Maintenance: Housing Myths Part 9

Housing Clichés Can Cost You Dearly

The last article mentioned that counting just 2 factors (inflation and maintenance/repairs) can cancel any supposed real-estate “investment” appreciation but there are many more costs that can turn home ownership into a loss: mortgage interest, taxes/insurance/fees, and opportunity costs of missed investments.

Your mortgage costs DO increase every year and these increases disprove the "payments never go up," "payback with cheaper money," and "good debt" cliches.

“Your rent goes up but my mortgage payment does not” is just another way of saying that the "fixed" mortgage payment starts too high, in real (inflation-adjusted) terms (plus, rents DO NOT always go up). The mortgage-holder tends to assume that the first mortgage payment is the “just right” size and everything later is discounted (by inflation) but rarely considers that the last payment might be the “just right” size and everything earlier is at a penalty rate.

“I get to pay back my mortgage later in cheaper money” is another common cliché that undermines the first cliche: If postponing repayment is so lucrative, then you would want to pay little at first and more later, so mortgage payments that do not increase over time would be bad. The “cheaper money” slogan argues for the ultimate balloon-payment plan of paying $0 for 29 years and paying everything (several times the purchase price) in the last year.

Both of these common quotes misread the mortgage situation:

All mortgages have annual cost increases built-in but people overlook the increases by looking at the nominal payment rather than the accrued cost. If your mortgage rate is 5%, each year your new, extra cost is an additional 5% of the year’s debt. The mistaken belief of no payment increases is an illusion simply because the bank has pre-calculated your 30 years of cost increases and front-loaded your money-up-in-smoke interest costs.

You are repaying your mortgage with more expensive money (not cheaper money) because the interest rate is almost certain to increase the debt cost at a rate faster than the official inflation rate. The repayment would be "cheaper" only if the mortgage had no interest rate (or one less than inflation), but I have not seen any mortgages like that, so I think the banks have figured out that loophole. Unless you find a bank that is so stupid that it lends for less than its costs decade after decade, you are losing more money each year that you keep a mortgage.

A $225k 5% fixed-rate mortgage is about the same as taking 30 years to pay off a $225k 5% credit card debt. Debt is debt. Compound interest compounds.

Pre-paying principal is so powerful at lowering your costs because it reduces the compound-interest increases.

The only escape from annual mortgage-cost increases is to end the mortgage.

Non-debt home-ownership costs increase too and these costs disprove the "but eventually I'll have free housing" cliche.

Owning has many costs such as taxes and insurance that can increase faster than the inflation rate and faster than rent increases. Experiences vary from person to person but consider these real-life examples: One person rented for 7 years without a penny increase in rent while another person during the same period bought a house and saw property taxes skyrocket 50% in 5 years. Even with no mortgage, a homeowner’s costs can increase faster than a renter’s costs.

Opportunity costs of missed investments disprove the "renters end up with nothing," "at least I have home equity," and "mortgages are forced savings" cliches.

Neither borrowing 100% nor paying 100% cash to buy a house necessarily beats renting:

Borrowing $225k at 5% costs $11,250 in interest in the first year ($937.50/mo), not counting loan origination “points,” closing costs, taxes, repairs, and other fees/costs--none of which creates a penny of equity.

Anyone who likes to pay principal on top of the consumption costs can just as well save/invest on top of paying rent, so "owning" and renting offer similar equity opportunities.

Building equity depends primarily on the individual. Spendthrifts can find a way to stay in debt whether they rent or "own."

0% downpayments, interest-only loans, HELOCs, reverse mortgages, and other house-as-ATM "equity harvesting" all prove that home-"owning" is no guarantee of "forced" savings. An automatic payroll deduction into a money-market account might be a cheaper "forced" savings plan. A renter's security deposit has more equity than some no-money-down homebuyers do.

Renters might beat homeowners in the equity-building race because renters are more likely to have lower early payments and therefore benefit from the renown compounding magic of saving early (contrary to "mortgage payments do not increase" and its backward logic of high costs/low equity-building now and low costs/high equity-building late in the game).

Paying $225k cash for a house will avoid paying interest but then you have nearly a quarter-million dollars tied up in an illiquid asset that might appreciate nominally at 5% but can have zero or negative real “appreciation” after all input/carrying costs are considered.

You instead could invest the $225k cash in stock or other investments to earn net 5% ($937.50/mo) and keep your $225k stock equity while the interest/dividends/appreciation income pays your rent, maybe in perpetuity (depending upon exact rent, inflation, etc.).

The Good Cliche: There Is No Such Thing as a Free Lunch in Housing

Housing is consumption when you own as well as when you rent so do not be surprised by the possibility that homeowner’s net costs might be similar to renter’s net costs.

More Misleading Housing Cliches (Parts 1-9, in reverse order):
"Renting doesn't build equity like my house payments do!"
"I'm debt-free! . . . with a $500,000 mortgage."
"My mortgage rate is really 1/3 less and I want to get as big a tax deduction as possible!"
"Buy as much house as you can afford!"
"My mortgage is free because I'm renting to myself!"
"My mortgage doesn't count as an expense because you have to live somewhere!"
"I really increased my ROI by leveraging as much as possible with no-money-down!"
"Never prepay your mortgage!"
"I borrow against my house to invest in the stock market!"

Next: Home Decorating Costs: Housing Myths Part 11

The "Debt-Free" Deception: Housing Myths Part 8

Previous: Home Mortgage Tax Deduction Snake Oil: Housing Myths Part 7

The entire rent/own/mortgage debate is thoroughly confused, misguided, and backwards.

You are NOT debt-free if you have a mortgage. Mortgage is debt.

The love of mortgage debt is so bizarre that some people try to deny that mortgage is debt--and then accuse debt-free people of being in debt.

Have you ever had anyone tell you that they are "debt-free" only to learn that he/she carries tens or even hundreds of thousands of dollars of mortgage debt? The person might be justly proud of reaching some milestone in debt reduction but it is quite a feat of denial to pretend that the largest debt of his/her life does not count as debt.

RENT is debt-free for the tenant.

Someone once doubled the "up is down" mistake by asserting not only that mortgages did not count as debt but that rent did count as debt.

The person confused houses with housing, confused consumption with debt, and confused purchasing with financing.

• Housing is consumption, an ongoing necessity like food, but recognition of a future necessary consumption is not "debt" unless you want to tell everyone that you are heavily in debt to the grocery store because you will need to eat lunch 50 years from now.
• Debt is when you consume/take-title before you pay (becoming a debtor to the seller/provider), as opposed to pay-as-you-go (provider and consumer walk away even), or paying in advance (becoming a creditor to the provider).

The rent v. own debate is a false "opposite" and crippled by a logical flaw.

Renting and buying housing with cash are 2 forms of paying in advance. The question is if it is cheaper to pre-pay for 30 days or 30 years.

Renting and buying with cash are similar to each other and it is the mortgage that is the complete opposite. Too many people make a leap of logic of confusing paying-in-advance with spending money that they do not have, which is an entirely different kettle of fish.

The landlord is debtor to the tenant.

The tenant pays in advance by paying on the first of the month for housing in the coming month, which puts the landlord in debt to the tenant. The tenant is the creditor and the landlord owes a month of housing.

Semantics

A lease is a mutual obligation on both parties. Technically, you might argue that you are in debt to the electric company because the company does not bill you until after you consumed the electricity, but by that logic you are in debt when you are eating at a restaurant before the waitress brings the bill. The distinction with restaurants, electric bills, and credit cards is that they provide a grace period with no interest charge (treating the transaction as pay-as-you-go).

The practical test for "debt-free": You are in debt if you are paying interest. You are debt-free if you do not pay interest.

Next: The Accidental Money Pit - House Depreciation-Maintenance: Housing Myths Part 9

Home Mortgage Tax Deduction Snake Oil: Housing Myths Part 7

Previous: Hidden Burden of Overbuying: Housing Myths Part 6

The Home Mortgage Income Tax Deduction NEVER Saved ANYone ANY Money

Taking the Mortgage Deduction Always LOSES You Money

Mortgage Tax "Savings" Are Always Losses

Taxes are losses. "Tax savings" are NOT real savings. Tax reductions reduce tax losses of your initial "pile" of income from, say, negative 10% to negative 9%--but still negative (still a loss). In most tax cases, the best you can do is break even by keeping what you started with (0% loss). There is almost never a chance of real gain or real savings.

The mortgage-interest tax deduction is worse than many tax deductions.

Mortgage-interest "tax savings" are NOT savings. Mortgage-interest "tax savings" are losses because you pay more to qualify for the "benefit" than you get in return. The economic illogic is stark. Would you start a business to make a widget that costs you $10 to make and sell it at $1? Would you borrow money at 10% interest to put it in a bank account that earns 1%? The simplest example of the mortgage-interest tax deduction is that you must pay $10 to "earn" $1 (at a 10% marginal tax rate) for a net loss of $9.

That is a return on investment (ROI) of negative 90%, a 90% loss. A 25% tax rate would return a loss of negative 75% ROI. Does working to "get" or "keep my mortgage deduction" sound like the road to wealth?

Even the "net loss of $9"/"90% loss" way of thinking is too optimistic (for the following reasons):

The standard deduction makes a mortgage an even worse deal.

Tax Deduction Cancellations: The government giveth with one hand and taketh with another.

Assuming for a moment that mortgage interest is the only itemized deduction:

• A 2006 single person could pay $5,150 in mortgage interest and not save a single penny in income tax.
• A 2006 married couple could pay $10,300 in mortgage interest and not save a single penny in income tax.

Everyone gets these $5k-$10k tax-deduction amounts regardless of housing situation.

• A couple who paid $10,300 rent gets a $10,300 tax deduction (standard deduction) without having to pay a penny of interest.
• A couple who paid cash for a house gets a $10,300 tax deduction (standard deduction) without having to pay a penny of interest.

Update 5/6/09: The new 2008 IRS property tax deduction without itemizing means that a couple under 65 years old gets a $12k standard deduction and a senior-citizen couple age 65 or older gets a $14k standard deduction.

"Estimates suggest that approximately 40% of homeowners do not itemize" (Congressman Baron Hill D-IN).

The mortgage holder can deduct mortgage interest instead of taking the standard deduction. A mortgage holder only gets an extra discount on the extra marginal amount of itemizations that exceed the standard deduction.

(The total itemized amount can include other items such as property tax but I will refer only to mortgage interest for simplicity. If a couple already has $10k of itemizable spending even without a mortgage, that level of spending might explain the lack of savings--and perhaps a reduction of spending would help more than the addition of debt.)

The mortgage-interest tax-deduction effective rate is NOT your top marginal tax rate.

The effective rate accounts for the trade-off of losing the standard deduction to take the itemized mortgage deduction instead.

If a couple with a 10% top tax-bracket paid $20,300 in interest, the relative income-tax reduction (compared to not taking a mortgage) would be only the marginal rate of the marginal amount, 10% of the $10,000 ($20,300 paid - $10,300 standard deduction), a relative tax reduction of $1,000.

The so-called "tax saving" is:

• NOT at the full, top, marginal rate. It is less than half of the top rate, not a 10% discount but a 4.9% discount ($20,300/$1,000).
• NOT a net saving. The couple has saved nothing and in fact lost at least net $19,300 ($1,000 - $20,300).
• NOT a real gain. It is only a tax-drain shift from negative $1k to $0 (vis-a-vis the IRS) so the real loss of wealth is the full $20,300 ($0 - $20,3000).

Households at the highest marginal rates, who might think that they would merit the biggest tax reduction, might find their deductions canceled by the Alternative Minimum Tax (AMT) at $42,500 income levels for singles and $62,550 for married couples in 2006.

Any way you slice it, the borrowing cost always overwhelms the tax reduction.

Net Loss: Mortgages Harm Net Worth

Consider 2 couples facing the earlier scenario who start the year with $20k cash:

• The one who denied $1k to the IRS by paying $20k interest to the bank lost all $20k and has $0.
• The one who paid the extra $1k taxes to avoid paying $20k interest lost $1k and still has $19k.

What a difference a year can make.

Would you rather be negative 5% (lose 1k of 20k) or negative 100% (lose 20k of 20k)?

The mortgage tax deduction is 20 times worse than borrowing from Peter to pay Paul.

Borrowing $1k from Peter to pay $1k to Paul is a classic example of going nowhere fast.

However, the mortgage deduction is much worse and actually puts your finances in reverse because you are avoiding paying $1k to Peter only by paying $20k to Paul.

"Hey, what happened to my $1k tax-deduction money that I wanted to keep in my pocket?"

Sorry, your mortgage-interest deduction goes in the bank's pocket, not yours.

IRS "Teaser" Rates:
The evaporating tax discount races to zero.

The effective tax discount, if it existed at all at first, diminishes each year as the amount of mortgage interest paid decreases each year (the "mortgage payment" is mostly interest at the beginning and mostly principal at the end of the loan--and the principal is not deductible).

Therefore, not only might you not get an advantage on the full amount of interest paid in each year that you do itemize, the diminishing interest payments mean that you might not itemize for the full 30 years (not in later years).

If you itemize only for the first 20 of 30 years (because the diminishing interest eliminates the itemization advantage in later years), and during the 20 years your average itemizations exceed the standard deduction only slightly, you get very little tax advantage.

You can pay tens of thousands of dollars of mortgage interest with no itemized deduction for the costs.

Deduct half a million dollars without paying a penny of interest.

The biggest mistake that a person can make is to multiply his/her lifetime total of mortgage interest by his/her top tax bracket, which can grossly overestimate the tax advantage and underestimate the costs (as explained above). Do not make the mistake of assuming that you get a tax advantage on 100% of all mortgage-interest paid when you might get a relative advantage on, say, only 20% of all the interest you paid.

Compare the dollar amount from itemized deductions to $300k of a couple's standard deduction over 30 years or $500k over 50 years.

Why not take the $500k of deductions without paying interest?

Next: The "Debt-Free" Deception: Housing Myths Part 8

Do Not Confuse Houses with Housing: Housing Myths Part 5

Why Housing Is NOT an Investment
Why Home Mortgages are BAD Debts

Previous: Homeowner Profits Ignore Huge Costs: Housing Myths Part 4

“You Have To Live Somewhere” and Getting Rich by Eating Twinkies

Some people try to close their eyes to the bad investment of a home mortgage by asserting that the bulk of the borrowing costs “don’t really count.”

The common “You have to live somewhere” argument confuses opportunity costs/benefits and confuses houses (durable goods) with housing (the use of the durable goods).

(UPDATE: Economists recognize the distinction between house (asset) and housing (consumption) by referring to housing as a "shelter" "service"--although government's misuse of this valid distinction in its statistics and policies is another matter; see the Bureau of Labor Statistics (BLS) Consumer Price Index's (CPI) Owner's Equivalent Rent (OER) controversy.)

Rental Opportunity Costs/Benefits Negate Each Other

If the house was an income-generating investment, you could offset your borrowing cost with rental income. Living there yourself instead of renting to others (“renting to yourself”) means that you save writing a rent check to a landlord only by foregoing the receipt of a rent from a potential tenant of your own.

Imagine if you rented a house from someone but you bought an identical house next door and collected rent from your new house next door; the rents would cancel each other and net zero (paying rent to a landlord, collecting rent from a tenant). Owning and occupying a single house has the same result, net zero (not paying rent, not collecting rent). Therefore, the entire cost of the house including purchase/interest/maintenace/etc. is still an extra cost and not defrayed by anything. In other words, your savings are “not paying rent” but your costs are “not collecting rent” so you have not avoided one cent of the additional cost of house price and mortgage interest and insurance and maintenance and taxes.

Housing Is Consumption, Not Investment

You do have to live somewhere. That is exactly why housing is consumption, not investment. Do not confuse the house with housing; housing is the use of the house (shelter service). Housing is the consumption of time in a place (the house). When you "rent to yourself," instead of selling the consumption to a renter, you are consuming your own inventory.

No Such Thing as a Free Lunch: You Cannot Have Your Cake and Eat It Too

“Renting to yourself” means that housing is consumption (not investment) because time is money and the value of living in your house yesterday is gone with yesterday, not saved for tomorrow. Further, only one person can use a particular space at any one time and even renting one of your house's rooms to someone or other "shared space" is a reduction in your own consumption of housing, a reduction in your use of your own house (zero-sum game). Do not double-count.

Get Rich by Eating Twinkies?

You constantly consume housing like you constantly consume food.

Buy and eat a Hostess cake without trying to claim that paying to eat the cake is making you wealthy. Likewise, pay to consume housing (time in space) without trying to claim that paying to sleep in a room is making you wealthy.

Borrowing for Consumption Is Bad Debt

A typical rule of thumb is that so-called “good debt” (actually, less bad) increases productivity or generates income more than it costs (e.g. a tractor increases crop yield). “Bad debt” is everything else. Most people would see danger in taking loans to pay rent yet borrowing for instantly-consumed housing via a mortgage is essentially the same type of debt.

A 30-year mortgage is (in principle) no better than taking a 30-year loan to borrow 3 decades of rent in advance.

Think about that. In the first year of a 30-year rent loan, you could invest 29 years of rent in the stock market (a stock asset instead of a real estate asset).

(In practice, the securitzed mortgage and tax subsidies make a mortgage loan cheaper than a rent loan, but the principle is the same.)

The marginal asset value of a house, over and above the consumption cost of housing, is a separate factor that you can treat as a distinct investment.

You can try to use the historically minimal real appreciation of real estate as an investment but the appreciation is often small potatoes compared to the consumption cost/value of the house-for-housing--and the appreciation often is largely cancelled by costs (taxes, insurance, inflation, and especially borrowing costs if leveraged).

Satisfy your housing consumption and then choose the best investment for your surplus money (real estate? stocks?).

Before you borrow a quarter-million or half-million dollars, know if you are borrowing for investment or consumption.

Next: Hidden Burden of Overbuying: Housing Myths Part 6

Home Mortgages Are Bad Investment Tools? Housing Myths Part 3

The Lure of the No-Brainer Get Rich Quick Scheme

Part of a series of articles on housing myths.

Previous: The $200,000 Blunder: Housing Myths Part 2

Home Mortgages Are Leveraged Investments
. . . Just Like Our Greatest Financial Scandals

The greatest financial scandals of the past century were caused not by the specific financial product purchased but by the method of purchase—leveraging, i.e. borrowing to invest on a gamble that the investment would win the race against the loan interest (1920s stock market, 1980s junk bonds, 1990s derivatives, 2000s day-trading). People borrow because they see a high-margin arbitrage opportunity (an arbitrage opportunity is a disequilibrium in asset prices, a profit potential, which invites trading until supply and demand correct the gap). A low arbitrage margin that is below borrowing costs means that it only pays to invest cash and therefore your total profits (or losses) are limited by your amount of cash. For a house investment, you would choose a house price that did not exceed your cash, or you would find co-investors to pool cash to meet the house price.

If, however, expected profit exceeds the cost of borrowing, it seems as if you can make money far beyond your ordinary means by borrowing as much as possible--but this belief has ruined many people. It is one thing to take $100 from your wallet and lose it in the casino. It is quite another to borrow $10,000 and lose someone else’s money in the casino—and then have to pay back $30,000 after interest. Derivatives are not “bad” (they are a useful tool) but they got a bad name when the real culprit was foolish leveraging. Home mortgages are leveraging.

A Home Is an Especially Poor Choice for a Leveraged Investment

Leveraging to invest is risky but at least makes some sense when the investment appreciates faster than the debt (borrow at 5% if the asset grows at 10%)--and there is no guarantee on that. Moreover, owner-occupied, non-rented, residential real estate is one of the worst candidates for leveraging because the odds of such real estate netting more than the real borrowing costs is very low. In fact, you are almost certain to lose money.

Price Volatility with Sticky Ownership Is a Bad Combination
The Risk of Short-Term Market Timing

Volatile prices require proper timing of the market, which requires agility to buy and sell at the proper time. A home (primary residence) has volatile pricing but is very illiquid and fails miserably at these investment requirements. Some experts such as Ben Stein actually tell people not to bother timing and instead to buy what you want when you want it--and many do just that. You will hear examples of some people who, often by accident rather than plan, bought and sold at the optimum times and made a killing on price fluctuations but you also can find people who won the lottery yet that does not mean that buying lottery tickets is a good financial plan. Houses can take months to sell and most people sell for non-investment reasons (change jobs, divorce, etc.), so sales are rarely timed to maximize investment profit and might even result in the dreaded buy-high-sell-low.

Arbitrage Doesn't Live Here Anymore:
The Long-Term Investment Return Is Too Low To Pay for a Loan

The real (inflation adjusted) long-term appreciation of US residential real estate has averaged about 1% annually (or less) since 1890 while the real, after-tax, net mortgage cost can be 2-4 times the home appreciation rate. Borrowing at 3% to earn 1% is a loss. Borrowing at 2% to earn 1% is a loss. Nominal-dollar borrowing at 5% to earn 4% is a loss. There is no leveraged arbitrage profit possible in the long term, absent a quirk of timing. Saying that the debt is for a home does not change the laws of mathematics. In other words, a house bought with cash might tread water and barely hold its value over the long haul but a loan cost easily can put a house investment in the red. Even if you live in the house for 60 years (twice the common mortgage term), when all the carrying costs are factored, you probably are losing money by borrowing to invest in a home.

Pay interest if you must but do not deceive yourself that spending more than you are earning is a road to fabulous riches.

A basic investing rule is not to risk more than you can afford to lose. An easy way to follow this rule is to risk savings and not borrowings, i.e. do not leverage investments.

Avoiding “rent” does not save the investment model, as I will cover in 1 or 2 coming articles.

Next: Homeowner Profits Ignore Huge Costs: Housing Myths Part 4

Never Prepay Mortgage? Housing Myths Part 1

This is the first in a series of articles on housing myths.

Should You Prepay Your Mortgage?

“Rule #1” of personal finance is to pay off debts because killing anti-savings is the best savings in terms of real, after-tax, return on investment (ROI). Unfortunately, the complexity of comparing relative interest rates with differing tax rules can confuse people into breaking this rule in the wrong circumstances.

Risk: A Bird in the Hand Beats Two in the Bush

The first problem is that people treat assumptions as if they were measurements. The second problem is that uncertainty is greater on your income side of the equation: The odds of you losing your job or seeing your stocks drop is greater than the odds that the bank will forget to collect its monthly mortgage payment.

You need to consider the risk or likelihood of an ROI. A fixed-rate mortgage has a fairly certain negative ROI. You might compare a 10-year fixed-rate mortgage to 10-years of CDs to compare contractually-guaranteed rates. Bond yields fluctuate but without anywhere near the principal-loss-risk of stocks so you might compare a 30-year mortgage to a 30-year Treasury bond.

Trade-Offs: There Is No Such Thing as a Free Lunch

You will notice that ROIs decrease as they approach the certainty of mortgage debt and it is very difficult to find similar-to-mortgage-certainty investments that pay more than mortgages cost. Risk being equal, debt will cost more than savings will earn (hence Rule #1). This must be so for a bank to make a profit (in a simplified business model).

Investments that appear to pay better than paying-off-debt usually offer possible profits in exchange for more risk, or offer short-term “teaser” rates.

Testing the "Never Pay Off Your Mortgage" Advice

Chazzman2000's comment at The Simple Dollar mentioned this Fool.com article as an exception to Rule #1, because the Fool.com article argued that you can make a bundle by investing in the stock market instead of paying your mortgage early. Fortunately, that article was written in 2001 so let’s see what would have happened to someone who read the article, closed on the exact same suggested mortgage that same day, and poured the extra money into an S&P500 index fund ever since (I randomly chose SWPIX, which did its intended job of tracking the S&P500, labeled GSPC in the chart):

The 2001 article claimed that it would estimate only a “mediocre” 12% annual return but SWPIX’s actual 5yr average is now 8.23% and its 10yr average is 7.70%, which is less than the 8% mortgage rate. If you had put the extra $300/mo. on the mortgage for the last 6+ years, by now you would have paid $6,569.45 less interest and have built $29,069.46 more equity than if you had made the minimum payments, for a combined benefit of $35,638.91, which is about the same as and probably better than the SWPIX alternative (if we counted every last detail).

Tax deductions probably would not rescue the SWPIX choice but I will cover tax-deduction myths in a coming article.

Update 6/19/07: My comments to The Simple Dollar did not always get published but his latest post seems to echo what I and others have been trying to say.

Update 6/22/07: The questionable 12% S&P500 promise resurfaced in a June 12 MSN/Money Central article that Mighty Bargain Hunter questioned.

Update 10/28/07: Note that I generously assumed the fictitious 8% S&P500 rate but the actual nominal growth from 3/01 was little above 0% and the real "growth" after several years probably was a negative loss.

Next: The $200,000 Blunder: Housing Myths Part 2

Savers Are from Mars. Debtors Are from Venus. Episode 2

Mind-Boggling True Story

Like Mother, Like Daughter

Deborah Beatty has no job but took a mortgage for a new New Jersey 3-story home with a view of the Manhattan skyline and Statue of Liberty and then did not pay the payments. Her daughter makes less than $20k/yr as a graduate student but took a $600k mortgage split into 8.75% and 12.5% interest rates and then did not pay the $5k/mo payments—maybe because the payments were more than 3 times (300%) her entire gross income.

“Beatty acknowledged the mortgage was probably too good to be true” (Union-Tribune of SD).

On what planet is $600k debt @ up to 12.5% and payments 3x gross income “good”?

(The quote might only refer to the mother’s unspecified loan but I suspect that she approved of her daughter’s loan and that the mother's loan was little better.)

Take the quiz: Do you find these loan offers attractive or repulsive? Answer in comments.

How To Avoid Debt: Stop the Debt Spiral before It Starts

The best way to avoid debt is to question why you are considering debt and reckon your happiness in both the debt and no-debt alternatives.

Let's say you want to buy a $200,000 house. The best method is to pay cash. Who has that kind of money? You do, and more, if you are willing to take a mortgage for it, because you pay the full price plus interest eventually. Right now, setting aside fees, etc. to simplify the example:

• Buying a $200,000 house with cash costs you $200,000.
• Buying a $200,000 house with a 15-year mortgage costs you $300,000 ($100,000 interest).
• Buying a $200,000 house with a 30-year mortgage costs you $440,000 ($240,000 interest; the interest exceeds the house price).

Why would you want to pay $10 for a $5 sandwich, $40,000 for a $20,000 car, or $440,000 for a house that is only worth $200,000?

Joe Consumer orders gadgets online or buys trinkets while traveling to save a few bucks of sales tax but then spends an extra quarter million dollar surcharge (mortgage interest) on the biggest purchase of his life.

Yes, inflation and tax deductions slash the pain but not the point.

Ameriquest Mortgage Refinancing

Crossposted from Inexpensive Home Building

The mainstream media are finally doing many stories on risky mortgages. Ameriquest was one of the first bubble lenders to admit financial trouble.

From Wikipedia:

Ameriquest is one of the United States's leading wholesale sub-prime lenders. It is a private company, owned by Roland Arnall, founded in 1979, in Orange County, California, as a bank, Long Beach Savings & Loan. The bank moved to Orange County in 1991 and was converted to a pure mortgage lender in 1994, renamed Long Beach Mortgage Co. In 1997, the wholesale part of the business (funding loans made by independent brokers) was spun off as a publicly traded company, called Long Beach Mortgage; the retail part of the business was renamed Ameriquest Capital and remained private. (In 1999, Washington Mutual purchased Long Beach Mortgage.)

Ameriquest is best known for its subsidiary, Ameriquest Mortgage Company, which makes direct loans to customers. Its Argent Mortgage Company affiliate works with independent brokers. It has offices nationwide, and more than 12,000 employees. Other subsidiaries are Ameriquest Mortgage Securities, Long Beach Acceptance Corp., and Town & Country Credit.

Ameriquest was among the first mortgage companies to use computers to search for prospective borrowers, and to speed up the loan process.

...

Sub-prime lenders made $587 billion in new mortgages in 2004, up from $390 billion in 2003, according to National Mortgage News. Ameriquest's share of that is estimated at over $50 billion.

In 1996, , the company paid $3 million to settle a Justice Department lawsuit accusing it of gouging older, female and minority borrowers. Prosecutors accused it of allowing mortgage brokers and its employees to add a fee to these customers of as much as 12% of the loan amount.

In 2001, after being investigated by the Federal Trade Commission, the company settled a dispute with ACORN, a national organization of community groups, promising to offer $360 million in low-cost loans.

On 1 August 2005, Ameriquest announced that it would set aside $325 million to settle attorney general investigations in 30 states. In at least five of those states — California, Connecticut, Georgia, Massachusetts, and Florida — Ameriquest has already settled multimillion-dollar suits.

In May, 2006, Ameriquest Mortgage announced it was closing all of its retail offices, and will emphasize in the future its loans through brokers, a channel that is not covered by the predatory lending settlement with the Attorneys General.

The issues confronted by companies like Ameriquest are considered by many industry experts to be the major contributing factor to the rapid rise of Certified Mortgage Planners, certified industry experts that work in concert with Certified Financial Planners in harmonizing the home finance products utilized by consumers with their larger financial portfolios.

Home Equity Loan Buys Sports Car

People continue to borrow home equity loans to buy toys.

Today's Car Talk radio show caller bought a $14,000 used luxury sports car with home equity. The car had a bad transmission, but he was more interested in the Candy Apple Red color.

The big problem with the housing bubble is that not only did new buyers overpay for homes but also that existing home dwellers who had manageable mortgages embarked on spending sprees based on the imagined paper "wealth effect" of higher appreciation. They treated their houses as ATMs by taking out home equity loans or the similar Home Equity Line of Credit called HELOC. So, even people who had bought before the bubble and had good finances have endangered themselves by bubble behavior.

Appreciation can be temporary. Debt is certain.

The big mistake people make with debt is that they assume that present conditions or trends will remain the same ("I make enough for that payment."). Every scientist should know the danger of extrapolating current trends into the future and the uncertainty is why stock disclosures warn that past performance does not guarantee similar performance tomorrow.

Make your life easy by not volunteering to lock yourself into future burdens, especially unnecessary ones.

Yes, a broken $14,000 sports car counts as an unnecessary one.