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April 01, 2010


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That's all well-and-good for a smaller mortgage. When you start talking about $500K+ mortgages, you're talking about a difference of nearly 50%. I'm looking at a 15-year monthly of $4600 vs. a 30-year monthly of $3124. BIG difference.

I just finished reading the comments on the two links above: and the . Really interesting, and if you have the time give them a look.

The whole discussion about better to pay off or keep the mortgage invest the difference comes up now and again. FMF states it clearly one is not necessarily better that the other. Just different strokes for different folks. FMF did you ever hear from John K again? I have never seen you have to warn anyone before. And I have seen and participated in some spirited discussions here.

The second link on HELOCs IS controversial. I don't claim to be brillant but then I'm not a complete dummy... the whole HELOC (home equity line of credit) well frankly hurts my head. I guess that's the number 1 reason for me not to try it. Don't buy or invest in what you don't understand.

The time to take on long-term debt is when inflation is low, and no-one expects it to increase.

A strategy:
The difference between $4600 and $3124 is $1476.
Take your $1476 each month and invest it somewhere that pays 7.6% (annual rate compounded monthly).
After 15 years that savings will have grown to $4600.
Each month for the last 15 years (i.e. the rest of your 30-year mortgage) use the $4600 compounded savings from 15 years earlier to make the monthly payment.

The risks/issues/benefits:
1. 7.6% - before or after tax? You pay tax on the interest/dividends/capital gain earned, but are getting a deduction for the mortgage interest, so they partially cancel out. Especially if you are in a high tax bracket and the 7.6% is taxed at a lower rate (such as 15%) while your deduction is saving tax at a higher rate (28 or 35%).
2. Can you earn 7.6% risk-free over 15 years? Probably not, but over most 15 year periods, you'll come close with a stock market index fund. Less than 30 years ago, you could have earned 10% on an FDIC-insured CD. Those rates could return if inflation picks up.
3. Do you have the discipline to put the money away each month? For most people the answer is a resounding NO, but that's not a flaw in the strategy, it's a flaw in the people!
4. If your income rises with time, then you will appreciate your savings today much more than you will feel the pain of the payments later (even if you don't pull off the entire 7.6% gain of the strategy.)
5. Even if your income doesn't rise much, any future inflation will have the same effect - reducing the pain of future payments.
6. If you have an emergency of some sort, you can access the money. Of course that defeats the strategy, but if you were about to lose your home and used the money to make payments while unemployed, or if you paid for surgery you otherwise couldn't have, then you're not going to be too concerned about those later house payments.
7. If you are later in your career, and looking at a lower marginal rate when you make the later payments, then it would be good to defer tax on the investment gains (e.g. focus on cap gains instead of interest/dividends), so you can pull them out at lower rates when you make those payments.

I bought a home late last year and had the option to pay $500K cash, or take a mortgage ($400K 15 year or 30 year, fixed or adjustable), and I chose a $400K 30-year. It's costing me more today, but I'm betting that 10 or 15 years from now, it's going to have been a profitable decision.

BillV --

Nope, haven't heard from him for awhile.

@BillV: The HELOC concept is actually very simple. Interest is calculated on the daily outstanding balance. From the moment your paycheck is deposited until the moment you spend it, your outstanding balance is reduced, and hence the interest due is reduced.

Whether it is a GOOD strategy or not is a different question due to the pros and cons listed around the original posting.

I think converting your entire mortgage to a HELOC is ridiculous, because the savings (less than $500 per year) don't seem to justify the risk.

Personally, I think you could play it both ways, and also leverage it - it is not an all or nothing deal. Assume you have an emergency fund of $40K, and have monthly income of $10K. You could open up a $50K HELOC, pay off $50K of your mortgage using your emergency fund plus borrowing $10K of the $50K. (Opening up the HELOC doesn't mean you HAVE to borrow all the money, it just means you CAN.)

At this point, you have NO emergency fund, and a $10K debt. BUT your mortgage principal balance is reduced by $50K.

Each month, your $10K check briefly reduces your daily interest cost on the HELOC to zero, and the balance creeps up during the month as you spend the money before the next check comes in.

If you never have an emergency, you have avoided interest on $40K of your mortgage principal, and effectively cut the interest rate by half on $10K.

If you DO have an emergency, then you are forced to access the other $40K which you had available on the HELOC.

At this point, you are paying the HELOC interest rate on that $40K instead of the (presumably lower) mortgage interest rate. Depending how frequently, or how soon after you start the HELOC, this happens, the total HELOC interest paid may be more or less than what you would have paid on the mortgage.

If that sounds too risky, then open up only a $10K HELOC and keep the emergency fund elsewhere. You avoid the mortgage interest and pay the HELOC interest but only on the daily balance.

The primary risk is that the HELOC interest rate will rise or that the size of the line of credit will be reduced. As many people have discovered in the last few years, the line of credit may be reduced just when you need it most. Depending on your other financial circumstances, those risks may be worth taking. (You may have sufficient liquidity to pay off the HELOC if it stops being a good deal.)

Also, the cost of opening and maintaining the HELOC has to be weighed against the savings it generates. AND - as someone else pointed out on the original article - you may not get a HELOC if you don't have a large equity position in your home.

If you use my numbers on a 5% mortgage, you save $2500 in mortgage interest each year. If you only use the $10K strategy, you save $500 per year. Plus you have to pay the HELOC costs and interest. In most cases, it won't make sense.

If you implement this strategy with a fixed rate mortgage, you don't reduce your monthly mortgage payment via this strategy, but you do incur the cost of the HELOC. This artificially makes the strategy look better than it is because you prepay your mortgage and save tons of interest on that loan. Even $500 per year looks good if I call it $15,000 (the 30 year savings).


>The point is still relevant -- you can save a ton of money by >reducing the amount of time it takes for you to pay off a loan (any loan at all.)

However, only considering the total interest payment isn't enough... The money is due at different times- it isn't fair to compare total interest paid over 15 years with the total interest paid over 30 years.

As an extreem example I would be extatic to take a loan with a 1000 year term at 1% interest. The total interest would be far larger, but I (and my descendents) could put the money I would have paid toward a shorter loan in a CD and come out far ahead.

-Rick Francis

Thanks Mark. that helped a lot. Not that I was thinking about doing it, but so many were raving about.

I just couldn't wrap my brain around it. I got the part about depositing the whole pay check and paying your bills, but what about walk around money? All that stuff one buys (or at least I do) with cash. The occasional cocktail, knick knacks and other junk that I know other FMF'ers don't buy, but I do. (I'm joking folks)

BTW, Mark,
A couple of years ago, maybe 5, my wife and I took out a home equity loan. We did that in case we had an emergency. we usesd a bit of it and paid it off two years later. we kept the loan, paying 50 dollars a year--maintenance fee, or whatever. June of 09 the bank closed our account. Nothing was due. they just said, thanks, have anice day. we thought about complaining/ appealing but as we really no longer needed the back up we let it slide. 1. I hadn't heard about this stuff yet; 2. Did I mention, get ready to laugh. we openned the first cause the bank called us up and said come get some low cost money, please! It will be good for you. Okay, I exaggerate a tad. BUT not by much.

PS. there were family health issues that made it seem to make sense. We thought we would have to help out my bride's son's family. That's another story.

I'm a fan of saving up first and buying the house for cash outright. It takes a while to do (means your first residence must be quite modest) but after that you are bringing in some nice cash flow.

Wasn't it Ben Franklin who said "Neither a borrower nor a lender be"?


@Mike Hunt - why you are saving the money for house to buy it outright, you are paying rent. The rent goes up every year. At some point - may be very soon if we get inflation - you are paying more in rent than what you'd have been paying for mortgage. Actually, in a normal not overvalued real estate market, the cost of mortgage+taxes may be close to the rental of an equivalent property. The key here is "equivalent" of course. The first condo I bought by the way, my expenses went down compared to rental rather than up. Something to think about.

Also, a lot depends on the inflation. Your mortgage payments with a fixed mortgage stay constant, but the prices of everything including the rental and houses goes up. The value of your savings relative to purchasing power goes down as well. So - don't borrow if you expect low inflation; borrow if you think we'll get inflation.

Real estate market is important too. If you look at prices and they appear overvalued - i.e. many houses on sale, the houses stay on the market for a long time, the cost of buying of equivalent property (!) greatly exceeds the cost of rental, then it makes sense to wait and save. But if the real estate starts going up - good luck saving while paying more and more in rent.

Some of these quotes are a bit outdated.

Regarding cost of debt. When the interest rates are as low as they are now, the mortgage debt is actually quite cheap. Especially if you expect inflation.

So it's not as simple. 30 year vs 15 year or paying cash vs borrowing depends on many factors - interest rates, deductibility of mortgage in individual circumstances, one's financial situation, expectation of inflation, even individual preferences. There is no one solution for everyone.

@Mark - it's a reasonable analysis, but I take exception with this quote: "The time to take on long-term debt is when inflation is low, and no-one expects it to increase." If you expect the inflation to increase, you want to take low interest debt because then the inflation will eat away at your premiums. It's when you expect deflation than cash is king. Imagine buying a home in the late 60s - early 70s, then hitting double-digit inflation in the 80s. In the early 80s, some people were paying 9% on their mortgages taken before while earning upwards of 13% on regular CDs.

Keeping our debt load low for our first home was very important to us...I think almost everyone would be better off financially if they only bought within their means. We made sure that we bought a house we could afford even if one of us lost our job...

I actually taled this over with one of my friends recently. He said that no one can account for job loss. I said that everyone should account for it and explained how we had an emergency fund and a variety of other backups. He looked at me, blinked, and changed the subject. Oh well...

@ Kitty

Just because you don't own a home/place to live doesn't mean you ARE paying high rent or paying rent at all. you could move in with family, do a side job for free rent (like live in a garage apt and keep the yard nice for an elderly couple), get a roommate, live in a place below your means.

My sister pays about $600 for utilities, insurance and property taxes (her house is paid for). My rent is $600 and it includes utilities. It's in a safe, but older, area with no amenities. So we are not paying anymore on "rent" than we would be spending were we in a house.

@Laura - this is true, but these aren't common situations. Maybe for a young person, but not for a family. One cannot impose on their family for years; and not everyone looking for a place to live can find an elderly couple.

Similarly, one can buy a house and rent rooms out as some guy I used to know did. But again, it's not a common situation, not for long enough to save to pay for house for cash. It also depends on if you are in falling or rising real estate market. If the prices are falling, it makes sense to wait if at all possible. If real estate prices are rising than trying to save to buy a house for cash doesn't make any sense whatsoever, at least unless you think real estate is in a bubble already and will crash in a few years. You can get an idea about the latter based on 1) cost of ownership vs cost of renting equivalent (!) properties 2) relationship of prices to salaries.

Incidentally, first time I bought a condo, the amount of money I paid in mortgage+property taxes was similar to what I paid in rent; actually less if I adjust for deductibility - as I live in NY state, state taxes alone were higher than standard deduction. So it made a lot of sense for me to buy, even with only 5% down. Second time, after I got a job transfer to a more expensive area the prices there for a condo I liked were slightly higher than what I was comfortable with and the prices were starting to fall (1989). My relocation package from my employer allowed me 3 years to move and paid for my commuting for 2 years. So I waited for two years during which time I saved more money and the prices fell. Now the price for my own condo fell as well, but the interesting thing is that when prices are falling than the difference between less expenive and more expensive properties get smaller; when prices are rising it's the other way around. So in 1991 I bought exactly what I wanted with 20% down and for 125K instead of 145K. Incidentally, because I owned rather than rented, the relocation package I got from my employer included help with selling my property and buying (quicker approval on mortgage + all closing costs). Had I been renting, I wouldn't have gotten any help with purchase.

By mid-90s the price of my condo fell all the way to low 90s, but I didn't really care as I could easily afford the payments. Especially as my salary was rising, so I paid a smaller percentage of my income for housing than when I bought. But in 97, I decided to upgrade to a townhouse. So I bought a townhouse for 180K with 40K down. But as the best I could get for my old condo was 113K, I decided to rent out. After a few years of renting - with nice positive cash flow - I sold my old condo for 215K and used the money I cleared from sale (with a small addition) and paid off my mortgage with a single lump payment (still not 100% sure it was the right thing to do - future will tell). BTW - all of my mortgages were 30-year: I saw no reason whatsoever to tie myself up to higher monthly payments. I like to have money to save just in case as well as money to enjoy while I still have some energy.

Oh, and even with the crash, my current townhouse is worth 400K. So now, I own a 400K property free an clear. And I didn't even need to save every penny to have it nor did I need to spend all these years of my life staying with family (which was in Chicago anyway) or taking care about somebody else's property.

At any rate - these are individual decisions, based on individual circumstances and preferences. The blogs and people like Ramsey (whom I couldn't care less about, as I've never had debt issues) seem to suggest that there is one-fits-all solution. It's not true. There are different circumstances, preferences and environment. 15-year mortgage vs 30-year mortgage vs cash are really investment decisions and as any decision (i.e. buy stocks or bonds or CDs) they can work for the best or for the worst. Oh, and in terms of what most millionares do - did I mention that mine is a seven-digit net worth? Guess what, if I were to "upgrade" now I'd take a mortgage even though with the money from my current place I could pay cash. Also some of my friends have seven digits in investible assets, and they took a mortgage on their vacation house when they easily have twice the cost of the place in only one of their investment accounts. Posters and bloggers love to talk about what millionaires do when they really don't know any millionaires....

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