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.

You Owe 9 Trillion Dollars

Congratulations, the United States gross national debt now exceeds $9 trillion.

You owe $30k. Your baby owes $30k. Your family of 4 owes $120k.

Your government put you in all this debt to make you richer, in case you were wondering why your life has felt so easy and virtually cost-free all these years.

Remember that when choosing a presidential candidate.

Why stop at $9 trillion?

Should the federal government make us all even richer by borrowing $18 trillion (so a family of 4 owes $240k) and leverage-investing it in the stock market for a higher return?

After all, Ben Stein recommended that you stay in debt to get rich: Payoff Mortgage v. Invest Stocks: Housing Myths Part 12

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)

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

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

Update 8/4/07: This article originally was based on Google Finance Beta's "10y" graph on 8/3/07 but the "10 year" graph did not cover 10 years (thanks, Google) so I re-adjusted the article for 8 years.

When Claims of +160% End at -20%

The Vanguard 500 S&P 500 index fund, often claimed to give a 12% return on investment (ROI) rate, closed today at $132.16, an excellent lesson in real returns.

Misleading "Average Annual Returns"

First, note that average annual return rates tend to overestimate your gains.

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.

What if you put your $100 in the Vanguard 500 VFNIX 8 years ago?

If you expected 12% per year, you expect to find your $100 investment to have grown to $260 after 8 years, a 160% increase over your initial value.

De Ja Vu: "Hey, this is where I started!"

However, the Vanguard 500 spent the better part of the last decade in the V-graph pattern of our simple hypothetical: The VFINX share price was about $130 about 8 years ago and closed at about $132 today, which is about 0% growth after 8 years.

Real Negative Returns

If inflation were about 3% per year, then the Vanguard 500 performed as if it had been losing your money at -3% per year.

The real value of your initial $100 is now about $80. You lost 20% of your real money over the last 8 years.

Opportunity Costs

Some say, "Invest as early as possible!", but today you can buy VFINX at about the same dollar price (less in real terms) as 8 years earlier and have the same nest egg at retirement as the person who invested 8 years before you--and meanwhile your money could have been accomplishing other things for the past 8 years.

Some say, "Invest instead of paying off your mortgage!", but someone who had a windfall 8 years ago and chose to invest the lump sum in the Vanguard 500 instead of paying off a mortgage would have done even worse than the real 20% loss by adding the mortgage's real negative return to the VFINX's real negative return.

"In the long run, we are all dead." -- John Maynard Keynes

VFINX eventually will rise again and you can find other timeframes with higher returns on investment (ROI) but remember that certain investments or markets can be flat or worse for a decade. Even if Investment A beats Investment B in the long term (several decades), Investment B might beat Investment A in the short- or mid-term. You might have an immediate goal such as paying off a mortgage or other debt that can make you thousands of dollars richer than borrow-to-invest schemes when alternative investments are in--or are about to enter--the doldrums.

Always do the math for your specific circumstance and do not rely on optimistic promises.

See:
Never Prepay Mortgage? Housing Myths Part 1

Negative 11% Home-Value "Appreciation" Rate Is Considered Good Now?

Negative 11% is one of the best "appreciation" rates in the nation.

The Real Estate Bloggers posted a list of the top 20 real estate markets over last year.

Look at Detroit (below).

If the "top" 20 home-value "appreciation" rates include double-digit negative rates, what do the worst 20 markets look like?

Top 20 Markets: Real Estate Property-Value Appreciation Rates over Last Year

Seattle 9.10%
Charlotte 7.00%
Portland 5.70%
Dallas 1.80%
Atlanta: 1.70%
Denver -1.40%
New York -2.30%
Chicago -2.80%
Cleveland -2.80%
Los Angeles -3.30%
Miami -3.30%
San Francisco -3.40%
Minneapolis -3.50%
Las Vegas -4.10%
Boston -4.30%
Phoenix -5.50%
Washington, D.C. -6.30%
Tampa -6.70%
San Diego -7.00%
Detroit -11.10%

Inflating Leveraged ROI Can Ruin You

Previous: Leveraged Investments: High ROI Is Not Always Best

The previous leverage article covered how the common method for measuring leveraged Return on Investment (ROI) can mislead you by underestimating the work and risk. Add overly-optimistic “magic” numbers to inflate ROI and this article shows how the combination of rosy estimates and ignored risk can trick you into a bad investment.

We will start with the same example as last time:
$250k: invest 100% cash (unleveraged) or 10% cash with 90% loan (leveraged)?

$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

Debt makes you 80% richer?

The example author concluded:

“As you can see, even though your risk increases with leverage, it might be a wise choice when you can increase your ROI by as much as 80% (16.9% is 84% increase over 9.2%) over the full cash in front option.”

The promised 7.7% spread (16.9 over 9.2) was not impressive enough so the author used a percentage of a percentage to make the pro-leverage number 10-times bigger (80%--Who doesn't want to earn 80%?). Almost doubling your ROI would be a good thing but let’s not get carried away too soon.

The pro-leverage conclusion depends on magic numbers.

How many rental markets have perfect 100% occupancy rates, i.e. no vacancies at all between tenants, and no missed payments? Here are some real-world rental occupancy rates/vacancy rates that I quickly found to see how the examples perform with real-life inefficiencies:

(Sorry if a long space appears before the table)

© 2007 HFF Market	Occupancy Rate (%)	Gross Rent Annual ($)	ROI Unleveraged (%)	ROI Leveraged (%)
Hypothetical	100.0	26,400	9.2	16.9
2001 Northeast	94.7	25,001	8.7	11.3
2001 US urban (inside MSA)	92.0	24,288	8.4	8.4
2001 US non-urban	89.6	23,654	8.1	5.9
2004-Sep. Texas 6 major markets	78.0	20,592	6.9	(6.3)
2003-Oct. Texas 6 major markets	77.5	20,460	6.9	(6.9)

Sources: Statistical Abstract of the United States, 2002, Community Connections

• In only one real-world occupancy rate did the leveraged ROI beat the unleveraged ROI.
• In one other case, leveraged ROI broke even with unleveraged ROI.
• In most cases, the leveraged ROI was worse than the unleveraged ROI.
• In 2 cases, the leveraged ROI is losing your money while the unleveraged ROI is still providing almost 7%.
• In the last case, the margin spread (+6.9% v. -6.9%) shows that it is the unleveraged ROI that is 13.8% points higher than the leveraged choice.

Can you feel that $225k of debt making you 80% richer yet?

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

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

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

“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.

The $200,000 Blunder: Housing Myths Part 2

Part of a series of articles on housing myths.

Some people will make a $200,000 blunder but think that they are making money.

Chasing Unicorns

Never Prepay Mortgage? Housing Myths Part 1 covered how would-be moguls fail to assess different risk levels when keeping mortgage debt to chase possible investment profits. Some people (real people, not hypothetical people) think that a money market (unlikely to go below 0%) might be the solution to avoid stock volatility. However, less risk means lower possible returns, plus money markets fluctuate too (some crashed below 1% a few years ago). Unfortunately, some people think that they can make money even when their investment rate is lower than their borrowing rate.

Avoid Major Math Mistakes

The first problem is that people apply income tax modifiers essentially backwards, doubling the error. People vastly overestimate their tax reductions by (for instance) applying a 28% discount to every penny of mortgage interest (more on this in a coming article) and then compound the error and also overestimate their investment growth by not applying 28% taxes to their money-market interest. The first step is to estimate a realistic, after-tax return on investment (ROI).

An easy way to account for taxes on compounding interest is to discount the interest rate by your tax bracket (a 28% tax on 5.05% interest is 5.05 x 0.72 = 3.636% effective interest rate). This method is imperfect (it assumes that tax payments/withholdings and compounding occur almost simultaneously) but is much less wrong than ignoring taxes entirely. One blogger who thought that he would have $134k actually would have closer to $119k, a $15k error.

The even bigger mistake is when people make a false comparison at the 15-year mark, which ignores half the costs of the unpaid 30-year mortgage, or they mix up a 15yr scenario with a 30yr scenario. A proper comparison must be at the 30-year mark for both altertnatives.

Our Example (from a real person)

• $200k 30yr 5.875% mortgage (at bankrate.com calculator).
• $1,183.08/mo minimum mortgage payment.
• $500/mo extra available in budget.
• 5.05% money market investment opportunity (annual interest compounded monthly at planningtips.com).
• 28% federal marginal tax bracket (no state tax included here).

Keeping mortgage to invest loses over $100k

Minimum mortgage payments total $426k ($200k loan + $226k interest), offset by $325k after 30 years of money market for a net loss of $101k.

Paying mortgage early gains over $100k

Paying an extra $500/mo on the mortgage principal would pay off the mortgage after 15 years, for a total cost of $300k ($200k loan + $100k interest).

What people forget to count is that if you pay off your mortgage after 15 years, you then can invest your old mortgage-payment amount ($1,183.08/mo) plus your over-payment amount ($500/mo) for the next 15 years (remember that you paid both these amounts for the whole 30 years in the investment scenario too). In our example, $1,683.08 @ 3.636% for 15 years is $402k, or a net gain of +$102k more than the mortgage cost.

The $200k blunder

So, borrow to invest for a net loss of $101k, or eliminate debt and then invest for a net gain of $102k. That is a difference in fortunes of $203k, the difference between buying a second house or paying twice for one house.

A future article in this series will cover why the vaunted mortgage deduction would not fundamentally change these conclusions.

Next:
Home Mortgages Are Bad Investment Tools? Housing Myths Part 3

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

Prosper Private Lending Service: Do You Want To Be a Collection Agency?

Lazy Man and Money mentioned his tribulations with Prosper.com, a service where individuals buy and lend to each other.

I had looked at Prosper some time ago, and decided not to lend money there at that time for the following reasons:

• The advertised high interest rates are for the lowest-rated, riskiest borrowers and the forum told tales of defaults so it seemed unlikely to net a significantly high return (lend to 2 people at 25%, 1 of them defaults with the first due date, so you average a loss at -37.5%).
• You have to win the loan by bidding down against rival lenders so it seemed unlikely to net high rates with the highest-rated, reliable borrowers—yet there is always a chance that even an A-rated borrower might default.
• To diversify to hedge risk would require many hours of work to bid small amounts to many borrowers (you can lend $50 to a person who is seeking $5,000 in loans from many lenders).
• Bidding means that you might waste time in research with no result and 0% interest.

I know that some lenders will beat the odds but I suspected that lending at Prosper would require much work, time, management, stress, and risk but with an uninspiring probability that it would not significantly outperform an FDIC-insured 5% Money Market/CD account or moderate-risk stock index fund.

Please share your experience if you have used Prosper or a similar service.

Complete the Prosper motto: "Where people come together to . . ."

Update 6/1/07:

• Time: 2 timesavers are (1) you can set criteria and Prosper will auto-fund loans from your account, and (2) you are not allowed to be your own collection agency (this means that either the money gets repaid or it doesn't).
• Rates: Lazy Man's Prosper portfolio (thank you) shows A-grade loans at twice the rate that this Prosper page shows for average A-grade rates, about 20% v. 10% (which means other A-grade loans can be significantly less than 10%).

Update 6/2/07: My Personal Finance Odyssey and The Finance Buff expressed a caution similar to mine.

Update 6/21/07: You cannot cash out whenever you want as you could do with a money market. You cannot cash out early with a penalty as you could do with a CD. You must collect a few dollars per month and wait 3 years (a common loan term) to claim your full profit, if any.

Update 6/23/07: My Personal Finance Blog is pulling out of Prosper. Another point that new Prosper lenders might overlook is that "no defaults yet" after a year does not mean much because you might need 2 years just to get your principal back when I imagine that debtors are getting bored of paying and the luster of their vacation/wedding/business-that-did-not-take-off is long forgotten.

Update 6/25/07: My Money Blog posted data which so far support my 6/23 concern that defaults will increase over time.

Update 6/26/07: How To Measure Prosper Profits Accurately

Dropout Pays Cash for Home

So many people imitate the most popular but unhealthy ways of finance that it is important to know the full range of possibilities in order to make an informed decision. Here is a parable of a hypothetical Jack and Jill.

How to drop out of high school and pay cash for a house at 21 years old (legally and honestly)

Jack drops out of school at 16 and gets a GED by taking the test. He gets entry-level jobs totaling a modest 60 hours per week (still time to take a community-college course) and $25k per year. Living at his parents' home with free room and board (as a normal teenager would do anyway), it is possible to save $15k per year and still keep some pocket money. An after-tax 5% interest rate compounds to about $100k while age 21, mostly before he is old enough to legally drink his paycheck at bars.

Jack can buy a $100k home in cash, or marry Jill who did the same plan so they can buy a $200k home with no mortgage, or the interest alone will pay for most of a studio rental while about $10-15k per person per year continues to go into the bank.

Jack and Jill might have risen to assistant manager by 21 years old and, with no home mortgage, it is affordable to finish the college degree in cash.

There are many ways to reach your goals, as long as you have a good plan.

Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?

Beware Phantom Wealth

Many people misuse "net worth" both on financial blogs and offline. Net worth is a simple snapshot for an immediate liquidation. Positive net worth is "solvent" and negative net worth is "insolvent" (unable to pay all your creditors even if you sold everything immediately). However, most people have no intention to liquidate and misapply the measure for long-term planning. Here are the 3 biggest mistakes that can fool people into false complacency:

1. Paper Profits: Investments have not made a penny until you cash out the profit ("realize" the gain). The housing bubble is bursting and middle-class people are waking up to find that their houses are worth $100,000 less than they thought. 401k profits are unguaranteed against market losses and uninsured against blatant theft. One 61-year-old woman found that her 401k lost nearly a half-million dollars before she knew it and a fraud victim found a 401k account cleaned out at $0. Social Security is no better, as those periodic statements of future payments include fine print that declares the estimates void of any guarantee, and the government rewrites your fictional “account” balance any time it wants by changing the retirement age or changing the calculation formula.
2. Real Costs (Present Value, Future Value, and Time Value of Money): Not only is $1 today worth more than $1 tommorrow in a typical inflationary environment, but people forget that different discounts apply to different assets/liabilities. $10,000 in a mutual fund does NOT cancel out $10,000 of credit card debt if the fund earns 11% but your debt costs 13%. Instead, you would lose about $5,000 over 40 years so, if you are trying to measure your long-term financial health, you should discount your mutual fund to $5k or increase the debt value to $15k (I will adress the misuse of tax-deduction modifiers in a future post). Another dangerous ommission is tax liability.
3. Illiquidity: It is not your money anymore, or not yet, as nowadays so many people sign away rights to their money by chasing tax deductions which restrict access. Whatever money people do not make inaccessible in retirement funds, they trip over themselves to bury in real estate (more on this in a future post).

Phantom Wealth and Broke Millionaires

These factors can result in an alleged paper “millionaire” who cannot make a mortgage or car payment. There are people who complacently carry tens of thousands of dollars of credit card debt because of an imaginary "wealth effect."

As for restricted nanny-state allowances (Social Security, IRA, etc.) and non-money assets (home equity), most people will not convert them into direct buying power until almost 70 years old (relocating home equity from one address to another does not change anything)--and maybe never before they die (when the heirs liquidate the house to pay off the legal, tax, and health-care bills).

Meanwhile, borrowing against assets is a sucker's game.

Resist the urge to borrow against your inaccessible wealth. Paying the interest penalty to borrow against asset value tells you that the asset itself is unavailable, which is why you have to pay someone else to use your own rumored "wealth."

That is quite a trick, being “wealthy” and still having to borrow money. If your "net worth" meant that you actually had money, you could lend to other people and make money by earning interest--instead of losing money by paying interest. Some people pay twice, since they paid an 8% mortgage to "build equity" and then paid another 8% for a home equity loan, which combined is not much different than a 16% credit-card rate. Try defining your wealth by the absence of borrowing.

Next: Learn how to measure wealth realistically in "Practical Wealth V. Phantom Wealth."