Reader Profile: BW

The following is the latest post in my "Reader Profiles" series. Each post in this series details the financial situation and challenges of an FMF reader. The purpose of this series is to help us all identify with people like us (in similar situations -- not all will be, of course, but eventually I'm sure you will find someone like you here), get to know the frequent commenters on the site, and hear some financial wisdom/challenges from people other than me.

If you're interested in contributing to this series, then drop me an email. The series seems to be very popular with readers and I need a steady stream of new ones to keep it going.

Also, please leave constructive comments, questions, and so forth. Simply telling someone what a mess they have, how they have made poor decisions, and so forth is not helpful. There is a way to say, "That was a mistake, but here's what you can do to correct it" that both acknowledges the problem and offers a solution. It's this sort of feedback that this series is intended to solicit.

Next in the series is FMF reader BW. He answered my questions (in red below) as follows:

Please tell us a bit about yourself.

I'm a 26 year old male, married 2.5 years to a 26 year old female and we live in a Midwest city. I am a CPA and recently passed the CFP exam. I currently work for a RIA firm, while previously working in the tax department of a public accounting firm. My wife works in the office for a mid-sized corporation. We have no children yet, but plan to have one in 2014. We will probably have a total of 2 or 3 children, each about 1.5 to 2 years apart.

Describe your financial situation (who works in your family, how your income is (general), how your expenses are, etc.)

Gross income combined: $87,000 ($55,000 me, $32,000 wife)

2013 Expenses and Savings:

• Combined 401(k)'s including match (match 50% on 6% contribution): $650/month ($7,800/year)
• HSA: $250/month ($3,000/year)
• Mortgage (and escrow): $1,100/month (160k remaining on 30 year @ 3.625%)
• General Living Expenses: $2,000 / month (food, entertainment, cell phone, TV, electricity, gas, water, internet, gifts, etc.)
• Sinking Funds: $600 month (car maintenance, insurance, home maintenance, vacation - whatever is not spent in a given month is saved)
• Other Savings: $1,000/month (All $1,000 was going to purchase a car. Since that is finished, we are saving $5,000 for a new deck. After that, $500 for Roth IRA, $300 for new car fund, $200 to boost Sinking Funds more – Air Conditioner will need to be replaced sometime soon)

Net Worth:

• Emergency Fund: $16,000
• Sinking Funds: $15,000
• Checking: $2,000
• Wife IRA: $5,700 (Vanguard Total Stock Market)
• My 401(k): $2,000 (S&P 500 Index)
• Wife 401(k): $1,000 (S&P 500 Index)
• HSA: $1,000
• 2 Honda cars: $25,000 (Total for both)
• House: $185,000
• Mortgage: $(160,000)
• Total: $90,000

Insurance:

• Car: 100/300/100 liability and collision coverage on cars
• Disability: Both are covered at 60% through work
• Life: $1,000,000 30 year term for me and $300,000 30 year term for wife
• Health: Covered at 70% of cost at my work
• No umbrella as of yet, but something to think about in the future

What are the current financial issues you're facing (saving, paying off debt, etc.)?

Big Picture: We saved a bunch of cash to pay off some student loans, save cash for house down payment and purchase a new (used) vehicle. We are now starting to get retirement more under way and put things on auto pilot. We could (should?) be more disciplined with are budgeting. We could cut back on the general living expenses and save a few hundred dollars more a month pretty easily, I think. With having a child in the near future, we will need to decide if wife will keep working or not. I think at this point, the answer is yes, but the cost of child care will be a large factor and deciding if we will want to make the additional budgetary sacrifices (also depends on my wages over the next 12 to 18 months). Anyone experience this and have any general suggestions, besides increasing emergency fund and try living on my salary alone to see how the adjustment goes?

Short Term: After the deck is finished (by July 1st), I am thinking about putting more money towards the house to get out of PMI. We pay $45 per month to it and will need to get below $148,000 on mortgage to get there. I am more inclined to start the Roth IRA. Thoughts? Also, we might start allocating a portion of sinking funds (maybe emergency fund) to Wellesley Income Fund or Wellington (Vanguard). Does anyone have thoughts/suggestions on how they handle sinking fund accounts balances that they do not use every month? We are savings enough that it is just a big savings account that I allocate to different cells in excel every month. We have enough (generally speaking) to cover any expenses that come up every month out of the cash flow that is allocated to the sinking funds every month.

Medium Term: If we have extra money remaining in the budget after child is born, does anyone think it would be best to start on the mortgage, rather than saving for college? As of now, I am thinking about trying to save $200 to $250/month/child for college. I think at this low level, it is probably best to save in 529 plans (I receive state tax deduction) or taxable accounts. Anyone have experience with paying off house before kids go to college and using old house payment (and maybe even slowing or stopping retirement) to fund college? What about 529 plan vs. taxable accounts?

Long Term: In the next 7 years or so, we will have to decide if we want to send children to private, catholic school. Cost for K-8 is about $4,500 per child, per year and increasing. High School is $12,000 per child, per year. We live in a school district with great schools, so we always have that to fall back on. The cost/benefit in my mind does not work out, but wife is really pushing for it. Thoughts?

Any other thoughts/ideas/suggestions for us?

What are your plans for the future (retire early, build your career, etc.)?

• I want to build the career more to be able to afford wife staying at home to raise children. I think this is possible, but it is hard to predict.
• Be mortgage free by age 50. This is in 24 years or so. This will largely depend on if we decide to ever upgrade house or not.
• Net Worth of $10 Million. This will depend on inflation numbers, market performance, etc. It is just a big, round number goal to shoot for.

What's your best piece(s) of financial advice and/or your general philosophy on personal finances?

• No debt, except for home debt. This must be paid off by retirement (but hopefully earlier) and only purchase home 2 to 3 times gross pay (no more than 25% take home pay).
• Save 15% of gross pay (including company match) for retirement, starting by at least mid/late 20's.
• 3 to 6 months’ worth of emergency savings.
• Once you have house at (or under) 25% of take home pay and are saving 15% for retirement, you can live a little bit, but not too much. Try to always be anticipating what expenses are coming. If you do that, it really cuts back on having to use the emergency fund, because nearly all expenses can be thought about a head of time.
• Get on same page financially with your spouse.
• Invest in index funds. We are 100% US stocks now, but will be moving towards 50% US and 50% International. I am just fine with the risk, but at some point in our 30s we will start allocating more money towards bonds.

Comments

[Bobby @ Ban Excuses]

Your expenses seem rather high for two individuals living on their own. Are you going to cut back on some of your personal spending when the children come? How much are you paying in taxes?

[BW]

This is BW. Taxes are $12,500 per year. I think we would have to cut back on personal spending when children come to make everything work.

[werty]

BW - If it helps to compare, my fiance and I also live in a midwest city and spend about what you and your wife are spending for expenses and mortgage. I calculated about 20% of our spending is work related (lunches, commute, clothing, etc) and 40% is mortgage. We are getting married in September and discussing having kids starting in 2015. Our goal is to save up the cost of 1 year of child care between now and then (goal $14k)as a way to help decrease our spending now in prep for adding expenses of a child. we don't want to make too many changes (add baby, cut spending) all at one time. YMMV

[Mike Hunt]

Hi BW, Mike Hunt here.

What age to you want to be worth $10M by? You have age and time on your side but need to start to plan on how do you grow your career or a successful business to hit this target.

-Mike

[Ivy]

I wouldn't put sinking funds in the market. Ours are similar to yours - and even if not spent every month, they are usually spent on annual basis. Is the extra you can gain on $15k worth the risk riding the short term fluctuations? For us it isn't, but then our sinking fund is a small portion of net worth

Regarding long term and school choices - why are you putting so much thought in this now (it seems you are having discussions with your wife on this), if you don't have kids yet. Private vs public also depends on the child personality - some thrive in public school environment, other may need the more structured setting of a catholic school. And what if you have a special needs child? Friends of mine do and they had to look at very different set of options. Don't waste time trying to decide this in advance.

On the Roth IRA question I am generally in favor and we max ours every year - I see these funds as flexible enough to be used for retirement or college, or whatever needed (at least the principal). But make sure that you continue to contribute enough to your 401k (currently very low) to get the company match.

[BW]

@werty - That is a great idea and something worth considering.

@Mike Hunt - $10M by age 70. Growing career is a must.

@Ivy - I think you are correct on putting sinking funds in the market. All it would take is a short dip in the market to cause problems. For school choice, yes it is really to early to tell, but we like to plan ahead and you provide some good food for thought. I think the Roth is also the way to go and we are contributing enough to get the max at both of our works.

[Paul]

Roth versus PMI is good debate. At only $45/mo PMI, even though it's going to nothing, I'd probably fund the Roth. Part of the benefit of an IRA is time. Waiting to contribute more, robs you of that more than $45/mo PMI does.

[Old Limey]

You stated, "We live in a school district with great schools". Sending your children to catholic schools is going to have a huge negative impact upon your future finances so why do it?

I live in an area that has some great Catholic high schools but there are also great public high schools available. However you cannot pick and choose which public schools your children go to, you are limited to the schools in your school district. Hopefully the area that you live in publishes the test scores for the schools in your area which will give you a good idea which district you need to live in to take advantage of a great, free, public school education. Also you don't have to go to catholic schools to become a good catholic, your children's religious training is largely in your hands.

In the area I live in, Silicon Valley, what has been happening in the top scoring school districts is that real estate values are higher because they attract young couples like yourself who are looking ahead and want to live in those districts.

[Daniel]

I went to a private religious school, but only on account of a 75% discount. I think school is a pretty small factor in the outcome of your children, morally or academically. I know plenty of kids that excelled in public school and were much more grounded in their faith than kids I went to school with. It was primarily because of their family and the emphasis placed on those things outside of school. So, unless you have poor schools, I'd save the money.

You are definitely a CPA... first time I've seen someone use the term "sinking fund" in personal finance.

[Nick @ ayoungpro.com]

My experience with moving to one income has been very positive. I feel much better about having my wife at home with my daughter and it has freed me of a lot of stress. I believe that I am better able to concentrate on work and bringing in extra income.

If you want to try to do it I would suggest living off of your paycheck alone for at least 6 months prior to the change. You can put all of your wife's income into savings to boost the emergency fund. If you can do that, switching to one income will be no problem. I think there is definitely room to cut down your monthly expenses to make it happen, and in my opinion it is worth it.

[Pauline]

There are generally lots of positive comments on this blog about supporting a family on one income, but here's another 'cost' in the cost-benefit analysis of deciding that your wife will stay at home to watch the kids: your wife will be in her prime working years when you have children. When you make a decision to have your wife stay at home for childcare purposes, you're not only losing the income that she makes today, you're losing the investment she could be making in her career during her prime working years.

[BW]

@Paul - Thanks for the input and I am leaning more towards the Roth.

@Old Limey - I am with you. The school district is rated in the tops of the state and I think will do a great job with education. Now, how to convine the wife?

@Daniel - Thanks for the thoughts. And I really enjoy my sinking funds.

@Nick - Thanks for the suggestions.

@Pauline - This gives us another thing to think about on the childcare front.

[JNEW]

As usual-- the community has come forth with great advice.

Here are my thoughts:

You are a young man. Believe it or not that is one of the most compelling facts that will help you achieve your financial goals. $10 Million may be a lofty goal but... millions are not out of the question. Compound interest and time are a magical combination. To make it work-- you need to begin investing now.

-- consider reducing your debt as fast as you can. With rates as low as they are (historically low) you should consider a 15 year mortgage. I did it at your age and had the homestead paid off by 40. The result is greatly increased cashflow. That equates to more savings, faster accumulation of wealth and much stress lifted from your shoulders. By the way-- It also opens the door to having the old mortgage payment get funneled toward college tuition.

You may not need to have a separate college savings fund if you take the 15 year mortgage approach.

- I am a huge fan of sinking funds! I have utilized them my entire life. They help level the playing field by making sure you have the money when needed and that you don't raid your investment accounts for regular annual tax bills or car maintenance surprises. Keep that up-- it is a great way to go.

--The key to investing success IMO is patience and diligence for the most part. Starting young is a critical part. Sock away as much as you can. Live below your means. Strive to find ways to save more by increasing your cashflow. A side gig? Tax prep? or simply lowering expenses.

--You do not need to live like a hobbit-- that is not what I mean at all. But be prudent. Figure out your priorities and stick to them. Maybe most important of all--- do not get sucked into keeping up with the neighbors. Some day you will be driving your used car with a net worth of $10 Million while he drives his brand new Mercedes Benz with a negative net worth and debt through the roof. He will think he is a winner and you can just smile and feel bad for him.

Regarding the school stuff. My kids went to public school. They are good kids who hang out with good kids. The circle of friends is MUCH more important than the school. I know plenty of kids who are trouble makers and wild out of control that attend good private schools. I also see that private school is not a ticket to a better college. Or a better education. Having a parent with money does not mean that you are grounded. More times than not... the opposite can happen. But in the end that is my opinion only. As I said earlier-- go with your priorities. If its important to you and your wife... save so that you can make it happen without financial duress as a result.

If you can afford it-- go for it.
Good luck!

[Luis]

$4500 per year for private education will not buy you a better education. The best teachers will snag private school gigs whose tuition rates well exceed $15,000/yr K-8 and more for high school. The question your wife needs to ask herself is whether the quality is significant. Can the funds be used for other purposes? Piano, foreign languange, or even specialized services like extra help with weaknesses in math just as an example.

[Apex]

@JNEW,

Your reasoning on the mortgage seems a bit strange to me. Interest rates are at 50 or maybe even 100 year lows and from that you conclude the best thing to do is to have a short mortgage that takes advantage of that very cheap money for the shortest time period possible? There may be reasons to have a 15 year mortgage but from an argument stand point I don't see how cheap interest is one of them. Expensive interest is a great reason to have one. If interest is 12% then why carry that debt for 30 years. Stop paying that interest as soon as possible. But if interest is 3.5% why is getting a 15 year at 3% (minimal change in interest rates), a big boon? If he wants to hit 10 million he will need a lot better return than 3 or 3.5% to get there. So paying down that kind of cheap interest will not be what gets him there. Taking the money he was going to use to pay down 3.5% interest and using it to get a better return is what he needs to do if he wants to get to 10 million. Yes the 3% return is guaranteed, but if someone told you they would give you 3% on a CD for 15 years would you put 100K in that investment? That's what you are doing if you take a 15 year mortgage over a 30. I don't think there is hardly any investment adviser out there who would recommend a 15 year CD at 3% interest.

As a side note, for all the talk about being debt free, getting out of debt, and avoiding debt at all costs here in this blog's community, I find it interesting (and amazing actually since it is the community voting), that it appears the winner of the march madness contest here out of 64 articles is going to be an article that argues directly for more debt and in fact argues for the exact situation we are discussing here. Namely that a 15 year mortgage is often not a great idea especially at these cheap interest rates.

I would have to agree. Cheap debt on appreciable assets where the funds are used to grow something more valuable is a huge benefit. The paying off of that debt feels good, but that's an emotion. You don't get rich because you did something that feels good or right. The numbers say paying off cheap interest early is net negative to long term capital appreciation unless you have nothing else useful to put those funds into.

[BW]

@JNEW - Thanks for the thoughts and encouragement. It gives me a lot to think about. One question on sinking funds. Do you break them up into individual accounts, or do you just add them together into one big account? For example, all of the sinking funds total to $600/month, with X of $150, Y of $200 and Z of $250. When you spend the money, you spend for X, you take the value of X down. Or do you simply say there is $600 into the account for X, Y and Z and do not worry what the specific balance for each is?

@Luis - Good thoughts. Just because you send them to public school, the money that would have gone to private school can still be used to enhance educational opportunities.

[BW]

@Apex - Those are some interesting ideas on the 30 year vs. 15 year mortgage. Any other ideas for me?

[Old Limey]

@BW
This was your reply concerning education for your children. There's an easy answer!
@Old Limey - I am with you. The school district is rated in the tops of the state and I think will do a great job with education. Now, how to convince the wife?

Usually in a marriage one spouse or the other seems to end up with the major responsibility of managing the family finances. In our case it was me. My wife was awarded a scholarship to a very expensive girl's finishing school in England and received a great education in the humanities, arts, literature, and elocution, however developing mathematical skills was purposely neglected because in that class the wife was not expected to have to work. Rather she was expected to make a good marriage. In my case I started off as an aircraft apprentice and ended up with a BS and MS in aeronautical engineering and a strong Math background, so naturally I take care of all the finances and investments and even balance my wife's checkbook for her every month.

Thus to me it's obvious who should be the final decider concerning your children's education.

[Apex]

@BW,

I wasn't really going to go specifically into advice for you as I generally prefer to only comment on the big picture items in profiles but since you specifically asked I will offer a few things.

First we have to talk about the BHAG (Big Hairy Audacious Goal) that you threw out there .... 10M. That's a really big number. I am not sure if you can fathom how big that is. Perhaps as an RIA you are seeing some numbers like that so you might be tempted to think it's achievable with a little diligence. Now I am not saying it can't be achieved but I want to make sure you are aware how rare something like that is. In 2012 Money Magazine reported that there were 1.8 million people in the U.S. with a net worth of $2 million dollars or more. That is a little less than 1 in every 100 adults. If it's adults over 50 its about 2 in every 100 adults.

Your number is 5 times larger than this $2 million. Now by the time you are retirement age $10 million will probably be worth about $2 million, so perhaps that is a fair comparison. But you are still looking at a top 98 percentile type of number. Make sure you internalize that. Think of 50 random people you know. Only 1 of them, will make it to your BHAG. Will it be you? That number is not something to just throw out there and say maybe someday if we keep plodding along we will get there. You don't reach the 98 percentile by plodding along. If you truly want to reach that number, you better be aiming for it. Specifically. Directly. Regularly. If you are not, you will certainly not achieve it. The way you stated your goal seemed a little casual, kind of like a crap shoot at the moon. It did not seem very intentional. Perhaps you are being intentional about it but if not, become so. You will have to be intentional if you have any shot at reaching it.

So how to do that? 2 suggestions. One, run some scenarios: We will make $X amount each of the next 35 years. We will spend $Y. We will save $Z and get return R% and that will give us total dollars of $T .... tada. The BHAG. Make sure to account for kids cost, more than you even expect, wife working or not and day care costs if needed, college costs if you intend to pay, etc. What will it take to get to 10M. Plan this out year by year. Each year our Net Worth will be $W.

Two, start tracking your net worth each year to see how closely you are coming to your estimates, you may have to adjust your projections to fit them to reality, or adjust your reality to fit them to your projections, or both. The good thing about this is you can start to ask questions about what happened. We came up 20K short this year, how did that happen? My salary was 5K less than I expected, we didn't expect the kids to cost that much, We kind of blew the budget on that vacation, holy cow kids cost a lot ... etc. And then you have to adjust your lifestyle or adjust your goals.

But if you are not tracking this stuff you won't know where you are at and most likely that will mean you are not anywhere in the vicinity of your BHAG.

As to Net Worth. The most important thing for you to do in everything you do financially is to ask yourself, how does this affect my net worth. Obviously not everything is about net worth. Vacations are about enjoyment. They don't build Net Worth. But if you are asking the question then you can decide if that extra $2,000 you were going to spend on that upgrade is worth the hit to your net worth.

The theme of this blog is growing your net worth. If you are not constantly thinking about growing your net worth, it won't grow very well. And untended field does not reap a bountiful harvest.

You already know I wouldn't pay down a cheap mortgage or go to a short term mortgage with interest so cheap. You are an RIA so I will leave it to you to decide how to grow your funds. I presume you expect to grow your client's money at a better rate than 3%. As an advisor I would think you would want to be able to show your clients when you are 40 how you grew your portfolio by doing the types of things you are recommending they do. How would you feel about an advisor who recommended you invest in a series of asset classes and when you asked him if he invested in those he said, oh no, I put all my extra money into paying down my 3% mortgage. Wouldn't that make you think he doesn't really believe in the investments he is offering you? Do you believe in those investments? If you do, why would you put your money into a 3% CD?

Last thing. I am reluctant to tell people how to spend their own money so if private school is important to you that's a trade off you make. However I will offer that my personal opinion is if you have a good public school system, then the private one is not really about getting a better education. From what I know of teachers in both public and private secondary schools in my area, most private schools pay their teachers less in overall compensation than the public school system. So they certainly aren't attracting superior teachers with higher pay. I am not exactly sure what you are paying for with a private school, other than choosing a select group of classmates for your kids and perhaps a particular religious instruction. That is just my two cents. But again, that's only my opinion. If private school is a priority then you make it work by fitting it in to your budget. It's just that the BHAG is already a reach half way to the moon. The more of those types of things you do the farther away the moon gets.

[BW]

@Apex - Thanks for the suggestions (and I like the Big Hairy Audacious Goal - Jim Collins reference). The $10M is $2M compounded at 3.8% per year for 43 years (age 70). It seems so large, almost to the point of being embarrassing to talk about since it is so large. I like the idea of tracking it out over time to see where I would need to be each year on the plan. I think I am capable of getting there, but it would require a sacrifice. Thanks for the suggestions.

[JNEW]

BW

Regarding sinking funds--I prefer to use a separate account for each sinking fund but there is a limit as to how many checking accounts are reasonable for one person. So the answer is I do it both ways.

@Apex

I certainly understand your comment about the 3% mortgage being cheap money. My point is, however, that we all have a limited amount of net income available each month. If a large percentage of the available net income is utilized to pay a mortgage payment (even at a great rate) then there is precous little money available to invest toward increasing your net worth. And-- a 30 year note pays almost all interest for the first 10 years ( no principal payment to speak of) furthering my argument that paying a significant sum each month toward a long term mortgage does little to help you increasr your net worth and reach your long term financial goals.

In order to increase your net worth-- you need to increase your assets and decrease your liabilities. Its that simple. Shorter mortgages decrease liabilities faster than long mortgages.

One caveat-- If BW already had his $10 Million dollar net worth and was looking to buy a home he might ask if it was better to pay for the home in cash or get a 3%/ 30 year mortgage. In THAT scenario I agree with Apex-- to take the cheap funds for the mortgage and use your existing funds to invest in a diversified portfolio that will likely get a return higher than the 3% mortgage rate. However, the difference in this case is that BW has limited funds to invest at this point.

My suggestion helps him to increase his cashflow so that he can increase his investments and savings rate and start the process to attain his $10 Million goal.

[Evan H.]

BW: "Anyone have experience with paying off house before kids go to college and using old house payment (and maybe even slowing or stopping retirement) to fund college?"

I'm in the camp where you should fund your retirement up to the level where you can afford (hopefully maxing 401k and Traditional/Roth IRAs) before funding 529s for your children.

BW: "What about 529 plan vs. taxable accounts?"

I'd go with the 529 plan. We just set up one in the Vanguard 529 Plan which is sponsored by Nevada.

[BW]

@Evan H. - I think we will fund retirement up to a certain level (appr. 20% of gross income) and then put some money in the 529s. Given that my state offers a tax deduction for money going into a 529 plan, I lean that way. The one thing I thought about was investing it in a taxable account for added flexibility, but I could always put half in a 529 and half in a taxable account.

[Luis]

BW

If your wife continues to work, you can put 11k into a Roth account per year. Assuming you stay within Roth IRA's eligibility rule, your dollar contributions should grow to over 200k by the time your future children reach college age. I think this method provides the flexibility you seek.

[getagrip]

Lots of good points so far and I'll just add a few personal notes.

Staying at home versus working, I've seen good and bad kids come out of both situations so IMHO its how you parent and deal with it more about whether you're both working or not. My wife took a year leave without pay with our first to see if it was something we could handle, both financially and emotionally. Perhaps that option may be available for your wife through her work and something you folks could consider.

With respect to kids and schools, don't always believe the neighbor's gossip or the local paper. I live in a county with good public schools. But even among the public schools there are differences. People loved our elementary school but bad mouthed our middle and high school, some to the point of moving out of the district to avoid them and most without ever having visited the schools. Their opinion was all based on gossip, prejudice, and poor media reports in the local paper. When the time comes for your children to attend, consider but look beyond the internet, performance on charts (which can only take so many variables into account), and biased opinions. Visit the schools during the day, see what happens between classes, how are kids behaving and what teachers are doing. Check out police reports or talk to officers about various schools and you'll find out some interesting information one way or the other, things the local paper tends not to report, especially about the more affluent school districts.

My opinion on the private schools where I currently live is they are more about being "elite" in social class than about being better academically or even morally (I've lived elsewhere where that isn't the case). I like to keep in mind that when $7 wine was put into a $100 dollar bottle and vice versa, the large majority of wine drinkers picked the less expensive wine from the expensive bottle as being better. Paying more is perceived as getting more especially by the people currently paying (who will pump up how great what they're paying for is), but it may not be so. You have to look carefully there as well before making a final call. In the end, I've also seen bad and good kids come out of the less and more affluent areas of the county. IMHO it's more about parent involvement and who your kid hangs with than the school in the end.

With respect to saving for college, I'd think you'd be better with a Roth IRA until you actual had a child. You could always take out some of the money to start a 529 later, as long as you don't touch earnings. Of course if you're doing something like that I wouldn't consider the Roth IRA as a critical component to my future retirement.

[Apex]

@JNEW,

I am going to deconstruct your comment because I think many people think this way. Namely that paying down a mortgage early is saving you money. It will get you money ahead. It will free you up from the burden of the payment in 15 years which will mean life will be easier, simpler and have more cash available. The problem is all of those are wrong. I will lay out why I believe so below.

"In order to increase your net worth-- you need to increase your assets and decrease your liabilities. Its that simple."

But it's not that simple. That's simply wrong.

You can increase assets AND INCREASE liabilities and still increase your net worth. Sometimes drastically. My net worth has grown faster in the last 4 years than at any time before it, and my liabilities went from 200K to 1.3 million. My liabilities will be growing to close to 2 million by the end of this year. And I will increase my net worth more than ever and my annual repeatable cash flow on returns from that debt will go over 6 figures for the first time (that's in addition to my day-job) If you are focusing on debt that will tell you very little about net worth or cash flow.

"My point is, however, that we all have a limited amount of net income available each month. If a large percentage of the available net income is utilized to pay a mortgage payment (even at a great rate) then there is precous little money available to invest toward increasing your net worth."

Exactly, and if you take out a 15 year mortgage your payment will increase by 50-70%. That means for the next 15 years you will have little if any money left over to invest. Yes in 15 years your cash flow will increase greatly, but at that point in time you will have a paid for house and little else. The magic of compounding is time. This strategy just lost 15 years of time. And the most important 15 years, because the earlier you start the longer you have to compound. What is magical about increasing cash flow 15 years from now? The time value of money says the cash I have today is far more valuable than cash 15 years from now. A 15 year mortgage has you cash poor and investment poor for 15 years. I don't see how that is a benefit when the interest costs are so low.

"And-- a 30 year note pays almost all interest for the first 10 years ( no principal payment to speak of) furthering my argument that paying a significant sum each month toward a long term mortgage does little to help you increasr your net worth and reach your long term financial goals."

This is irrelevant and does not further your argument. Everything is an opportunity cost. Remember the payments are not the same size. The 15 year payment is considerably larger. The extra money you are paying towards principal with a 15 year is the extra cash flow you would have available if you had a 30 year. That money paid into your house is getting you a 3% return. Invested elsewhere it's getting you whatever return that is getting you (20% for me in my leveraged real estate right now, but whatever else it is, presumably over time you are expecting to get better than 3%). The buying home equity mindset being superior to putting your money elsewhere is a fallacy. It all depends on the interest rate of your mortgage and the expected returns elsewhere.

This is not an emotional exercise. The numbers a very hard and very straight forward. If you invest the money elsewhere at higher than 3% you will come out money ahead. If you need to account for tax benefits of the mortgage then you might argue 4% return is needed elsewhere but if you are investing in something that is a capital gain asset you are not paying tax along the way anyway. Money is fungible, it can go anywhere. If you choose to put it in a place that has a lower return due to whatever reasoning you use, you will have less of it than you could have somewhere else. The math doesn't lie.

"One caveat-- If BW already had his $10 Million dollar net worth and was looking to buy a home he might ask if it was better to pay for the home in cash or get a 3%/ 30 year mortgage. In THAT scenario I agree with Apex-- to take the cheap funds for the mortgage and use your existing funds to invest in a diversified portfolio that will likely get a return higher than the 3% mortgage rate. However, the difference in this case is that BW has limited funds to invest at this point."

You are falling victim to the debt trap mindset. Debt is bad because it requires payments and reduces cash flow. But that is irrelevant. The return is the same 3%. You admit that if you have the cash you should not invest in a 3% returning asset, you should actually borrow money and use your cash to invest in a better returning asset. That's exactly what a 30 year mortgage does, it gives him more cash now to invest in a better returning asset just the same as if he had a lot of cash now. He has less than a lot but the 30 year gives him some. The 15 year gives him almost none. It's the same concept, its just the dollar amounts that are different but percentages and returns work the same on small numbers as they do on large ones.

"My suggestion helps him to increase his cashflow so that he can increase his investments and savings rate and start the process to attain his $10 Million goal."

This comment here is the most important one. I am not sure if you haven't tried to run the numbers or just assumed this was true or have been taught this is true or what. But in fact your suggestion does the exact opposite of what you said above. If we assume he can get a better return than 3% elsewhere, then your suggestion ensures that at every year along the path he has a lower net worth and less cash available assuming his other investments can be easily converted to cash (which they could if they are traditional market based investments).

For example, year 1 he pays down an extra 1K of house mortgage and saves $30 in interest because of it. He has increased networth an extra $1030. But if instead he took that same $1000 and put it into an investment returning 8% he has now increased his other networth by $1080. Due to compounding, this gap will grow larger every year and by year 15 the gap will be quite large. And while his payments will completely go away at that time, he will have no investment asset base that is getting him any kind of return, but with the 30 year mortgage he will have multiple 10s of thousands of dollars in investments getting him good returns that could be easily converted to cash if he needed to. Yes his cash flow will be higher in year 16 with the 15 year mortgage but he could easily convert the entire investment to cash, pay off the remaining house in full, have cash left over and still be money ahead of the 15 year mortgage strategy.

There is simply no way the 15 year mortgage can come out ahead. Not in net worth, not return, not in cash available, not even in cash flow. If the return on the 15 year mortgage is lower than the return elsewhere, it will lose in every financial metric possible. The only benefit it has is that it is a guaranteed return. And that was my point. If a 15 year 3% guaranteed return is appealing, then that is the best way to ensure it. However if you do not find those returns appealing then you should not drop a single extra dime into the mortgage and you should run it as long as possible. An interest only mortgage where the principle never came due would be the most optimal investment option to take if you want to maximize net worth by investing all available extra dollars.

If he wants to hit 10M, a 15 year mortgage provides him no benefit, it simply hurts him in every way.

[Apex]

People who want to understand how debt works in business should get The Farming Game.

This might seem like a strange comment but I mentioned The Farming Game in a comment about Monopoly a few weeks ago. Anyone who doubts the power of debt to grow a business or assets or investments should really get this game, play it, and try to understand what is going on and why debt works.

The game is a good approximation of reality. As good as you can expect from a game. I really think it would be extremely instructive for anyone who doubts that debt can be a positive growth tool.

Get The Farming Game if you want to understand how debt is supposed to work.

[Jonathan]

Apex you should turn your awe-inspiring talent at deconstructing financial myths into a book sometime!

[Apex]

@Jonathan,

I can always use extra cash flow. You buying the first copy? :)

[AA]

@apex:

Very helpful insights, thanks for the detailed explanation.
One question: what if a house should be sold in 3 to 5 years ? Will a 30 year mortgage still comes out ahead?

[Apex]

@AA,

Both could come out behind due to transactions costs in such a short window, but between the two if the interest rate is low and you have productive things to do with the extra cash flow that exceed the returns of the interest rate on the mortgage then yes, the 30 year will still come out ahead.

Now one caveat that has to be said to this whole situation is it depends entirely on you doing something productive investment wise with every extra dollar of cash flow you have from the 30 year. If you instead use the cash buffer to get some extra clothes, take better vacations, etc and only invest some of it, then you are going to come out way behind.

The benefit for most people in the 15 year mortgage is that is exactly what happens. Most people don't have the discipline, so instead of saving and investing all of the extra cash flow then find that the buffer it gives them makes it easy to live a little larger.

If you do that the 15 year mortgage is going to kick the 30 year mortgage's butt. The Math can't overcome you stealing the money from your investments to blow it on yourself.

[Luis]

@ Apex

It's ok for people to have debt but wrong for our government? Please if you have been arguing for debt and spending to come under control as it appears to be then how do you rationalize this disparity?

[Jonathan]

Apex - yes, sign me up. I'll even prepay for the book now if it means you'll start writing it! Most of what you say I already know and practice, but you articulate it so well. Thanks for all your input here!

[mysticaltyger]

@Luis.

I'm sure Apex will answer...but I'll take the bait...Most of what government spends money on are not true investments. Our biggest upcoming expenses are for a bloated Medicare/Medicaid system that provides mediocre care at very high cost. There is a lot of bloat in the care itself (as in up to 35% of treatments are not necessary...even medical experts admit this)...but the biggest costs come from a lack of emphasis on preventing diseases that are very preventalbe, but expensive to treat (diabetes, cancer, & heart disease being the big 3).

[Sarah]

Cancer is very preventable? Sign me up!

I benefited immensely from a private school but I do think it tends to be like colleges: there are a really impressive group at the top worth the investment, then there is a significant group that overcharges for only okay results. The problem is that both groups are very expensive. Tuition for boarders at the school I graduated from is now $40K! You don't want to sink a lot of cash into a school that's not worth it.

Apex: I think over the shorter term this is less certain. I wouldn't buy a 15-year CD right now with a 3% rate, but I would buy a 1-year, or even a 2-year...

[Apex]

@Sarah,

That is a good point. The alternative investments have more risk in the short term. If they outperform you will still come out ahead but you are correct that the odds of them under-performing increases in the short term.

Of course that depends on what those alternative investments are. Real Estate for me right now gives me a leveraged 20% return, repeatably guaranteed but that is likely to get harder to reproduce as time goes on so in the short term it is an even more certain bet for me. But in general it is true that time lessons the risks of the other investments.

[Apex]

@Luis,

I am trying to decide if you have not read what I said in enough detail and thought through it carefully or if you are simply blinded by a Keynesian ideology that has to defend govt debt at all costs. On the assumption that you are honestly not seeing the distinctions I will lay them out.

To state it directly, there is no disparity between what I discussed about using debt positively and govt debt being generally negative.

First of all be careful with how your paraphrase what I said. I did not say or imply that "It's OK for people to have debt," like any kind of debt is ok. The discussion about mortgages is a very specific kind of debt and it is related to a trade off between paying that debt off early or doing something more productive with it. Every argument I made must be interpreted only within the context of that scenario.

There is no such thing as one broad kind of debt. There are many different categories of debt. But lets talk about two in particular. Consumption debt which is horrible for one's financial health in all its forms and investment/business debt which can be quite good if undertaken by a prudent investor/business person.

I was talking about paying cheap debt down slowly to get a better return elsewhere. That's investment debt.

In order for the equivalency you are trying to draw to make any sense the govt would need to have surplus funds that they were deciding to invest elsewhere for a better return rather than pay down debt. But we are running trillion dollar deficits so there are no surplus funds to debate about paying down debt versus investing elsewhere.

Furthermore what return exactly is it that the govt could get elsewhere if it did have surplus funds? Govts don't get returns. They spend money on their citizens. That's consumption. Consumption has no returns. There is nothing wrong with consumption. We all consume and enjoy doing so. But there is no instance in which consumption debt is ever beneficial to your long term financial health. It makes life more enjoyable in the moment but it is destructive to long term financial health. See Greece / Cyprus.

Now I will grant you one Keynesian point. The Keynesian argument is that spending in a downturn improves the economy which would result in higher future govt revenue from increased tax receipts. That could be viewed as a return on investment. Fair enough. But Modern day Keynesians who I have heard talk about the topic never talk about the other half of Keynesian economics. Namely what should a Keynesian plan do when an economy is booming and in surplus. Answer, it should pay down debt like crazy and build a surplus. That is what Keynes himself advocated. But no one does that or even advocates for it.

So even if I conceded that stimulus spending could be viewed as an investment with a return, that is only valid in the down turn. Once the economy turns, the return on investment has already been realized and is no longer giving you additional returns. Thus the money should be piled back into paying down debt.

That is why there is a big distinction between what I was talking about with a longer mortgage and the govt just running deficits, in good times and bad, for as far as the eye can see.

Investment debt always makes sense as long as you can get a return that exceeds your cost of capital. Has the govt been getting a return that exceeds its costs of capital? Is it now? Will it in the future? Recall that returns are monetary. The only valid return for the govt would be an increase in revenue receipts. All the benefits of govt spending may be nice, important, even essential in some cases, but they are all consumption. Only new revenue can be considered a return on investment.

Very little of govt debt is financing a return on investment via increased revenues into the US Treasury. So there is no comparison at all between govt debt and the usage of debt I was discussing and there is no disparity between arguing for one and against the other. They are as different as night and day.

[GP]

I was going to opine on JNEW's 15-year vs. 30-year mortgage comment and explain why his statements are so wrong, but after reading Apex's comments I realized I couldn't have explained it better than him so I'll stop lol

[JNEW]

All:

I am not feeling much love here!

Yes, I agree--if you have $200 left after paying your 3% -30 year mortgage-- and you invest that in Vanguards Total Stock Market fund and get an 8% gross return--you end up with a net return of 5% (after offsetting the 3% paid for the loan). I agree that is better than just 3% you get by paying down the mortgage. No argument there. But that was never my point.

I was simply trying to state that one of the biggest drains on discretionary/ investable income is debt. No matter where you live, or how much you make, debt is an obligation that cuts into your financial freedom, and limits what you have available to invest.

If you have a small amount to invest-- even if you get a large percentage return-- it most likely equates to an insignificant amount of money. Thus, I was suggesting one approach to move toward an increase to his monthly investable/discretionary income.

IMO it is financially prudent to consider paying down debt so that you have greater financial freedom, and more discretionary income.

Best,

JNEW

[Jonathan]

JNEW,

Unlike most of the PF blogs around the web, the readers (or at least those who comment) on this one tend toward the financially savvy and love to help educate those who hold common money misconceptions. Obviously nobody is attacking you personally, just pointing out that from a logical basis, your arguments are incorrect.

Above, you claim that a 5% net return is better than the 3% you get by paying the mortgage. You are short-changing the investing side of the argument by 3%! If you have choices for some cash, one in which you earn 8% by investing it and the other in which you earn 3% by paying off cheap debt, there is a 5% spread there.

You say it is prudent to pay down debt to have greater financial freedom and more discretionary income. We all agree on the goal - financial freedom and extra income. But paying down debt is not always the fastest, smartest, or most effective (or even most sure!) way of getting there.

In its simplest form, a fixed-rate debt obligation is simply a recurring expense of equal payments for a set length of time. Your financial freedom and discretionary income is based on your ability to earn - through whatever legal means - more than your expenses. Apex's argument is simply that, by putting your cash to work more productively than rapidly paying down a 3% mortgage, you can increase your income (whether through cash flow or through equity) far faster. Looking at two future scenarios, one in which you put all your cash toward paying off a cheap mortgage and another in which you paid the minimum on a max-length mortgage and put all the savings toward productive investments, the investing option makes you far wealthier, with far more financial freedom and discretionary income. Those are your goals, after all, aren't they?

[Apex]

@JNEW

This is going to be my last attempt. I think I laid out the reasons pretty clearly but you are still making a similar argument that debt hurts your ability to invest and paying down debt helps your ability to invest. This is completely false and entirely backwards. Please don't just respond from the mentality that has been drilled into so many that debt is bad without thinking through the arguments. You can't be doing that and yet making those statements because the math doesn't support you. It's like you are saying not eating makes you fat. It's that backwards.

Paying down debt can of give you funds to invest. It takes them away. Now what you might mean but aren't saying is that debt service, namely the monthly payments, hinders your ability to invest. And that is true. But that is an argument about not taking on the debt in the first place which still might not be correct depending on what the debt is for. But once you have the debt and the known debt payments it is a very simple calculation to determine which is better if you can project a reasonably accurate level of returns on the alternative investment.

So here is my one last attempt at making this clear.

Say that you borrowed 10k from Jonathan at 3% last year for whatever purpose you like. He is a good guy so he tells you that you can pay him back anytime you want before he reaches age 65. You just have to pay the 3% to him every year.

It turns out you now have enough to pay him back and then some.

However i approach you and say I really need funds for my real estate business. It's booming. I tell you I will give you 7% return on as much money as you will give me for as long as you can give it to me. You trust me and are confident it's as safe as any investment out there.

If you are paying Jonathan 3% and I am paying you 7% when should you pay Jonathan back ? The question is laughable right? It's so obvious. You make a 4% spread on the money every year. You should pay Jonathan back when he is 65 because that's the latest date he gave you to pay and not a day earlier.

The reasoning and the math work out the same on the 15/30 year mortgage debate.

Please tell me you wouldn't pay Jonathan back early in that scenrio?

[Luis]

@ Apex

It wasn't that I misread your posted comment; I intended to link your well articulated concept of leveraged debt, like mortgage debt, and move the discussion more to government debt because I believe there are a lot of misconceptions out there in this country about that too. For the sake of this argument and to clarify your question I was interested in comparing consumer and government debts specifically within the confines of our current economy.

You partially admitted that spending during economic downturns are important if not essential to a recovering economy. No doubt some readers here are disturbed to "learn" that government spending isn't all bad. You explained this half of spending so well again and perhaps more of those around us will rethink how they feel about their heretofore held beliefs and positions on such a complex subject.

The comforting news about Keynes theory is that government spending returns to normal, surpluses during boom years will see to it that debts are paid down (the 1990's are a great example), and further reduced spending by cutting inefficient government programs are all mutually desired by true Keynesians. To embrace Keynes model would not be a complete release of everything you have believed to be true heretofore and in no way does it have a unified embrace by the Democratic party. Those who you say do not advocate for doing so are not modern day Keynesians. Who you’ve identified is probably a Dem who either is not Keynesian or thinks they are and haven’t a clue.

You mentioned in a previous post titled "Social Security Q&A" that the primary reason US credit downgrade from AAA to AA+ had to be caused by some type of reckless spending, or "government consumption" as you coin it. I had to do some background search on this term because frankly I had never heard of it and even now I cannot find anything that subcategorizes government purchases. As we all know Y=C+I+G where GDP is the sum of consumer consumption, business investment, and government purchases. Any kind of “stimulus” whether it is mailing checks directly to everyone’s home (as President GW Bush did) or infrastructure they all net positive GDP. I will concede there have been the rare “bridge to nowhere” project here and there but those are rarities. I digress.

The reasons to the downgrade were purely political. If you look at what happened immediately after the downgrade you will see that there was an influx of bond purchasing. Obviously, this is the complete opposite of what one would expect to see when rating agencies lower the confidence rating of the US Treasury.

Spending aside, debt also has its misconceptions. Examples of which include ideas that debt suppresses economic activity, or that debt is so large that it will burden future generations who will have to pay it down, or that taxes will rise unbearably, or hyperinflation will occur, or currency will collapse, and lastly the likelihood that there will be a stampede of bond sell offs.

The last five years have all been proof that the Keynes model holds up to the test. Austerity failed miserably and in current news one will find that all the academic papers Paul Ryan and others trumpeted supporting austerity have been debunked by a math error. Basically the conclusions drawn by said error was based on a purported "90% rule" where they said that if debt exceeded 90% of GDP then it reflected a great chance that the US government economy would collapse. Imagine now there are no scientific papers to support any of the Austrian positions at this moment, none!

So what are the lessons of the last five years? How has Keynes failed? Was it hyperinflation? no. Bond sell-offs? no. Debt overhang? no. Rising interest rates? no. Screamingly high income taxes? no. What about unemployment? The Keynesian answer is that there wasn't enough stimulus spending. The unemployment numbers did come back down to below 7% but much slower than if there had been more stimulus! Not to mention the jobs bill got voted down in Congress. Simple dig ready projects were put on hold that could have figuratively dug us out of high unemployment. Think about it….the interest on infrastructure spending would have been less than the 3% inflation rate. A no-brainer decision was frittered away because of our country's inept ability to discern right economic policy from wrong.

Let's not forget that the trillions of dollars of US debt owes have to be compared to its relation with GDP. Let's also not forget that these debts are "good" in that most debt is debt that we owe ourselves -- or that the debt we owe to foreign countries is not routed by the debt that other countries owe us. Think about this for a second, World War II as your example. After the war ended in 1945, our debt to GDP was over 150%. Now almost 70 years later those debts were never paid back and today our debt to GDP is well below 100%. This is like owing Jonathan money but never having to pay back to meet a specified deadline.

Thus the answer to the last question "Are we burdening our children's future?", and the answer to that question is also “no”.

[Apex]

@Luis,

Good response.

A couple points back.

I did not partially "admit" that spending during a down turn was important if not essential. I conceded that it was possible. That is not the same as admitting. It is saying that I am not convinced that the Austrians are 100% correct, but I am not convinced the Keynesians are either.

Our credit rating was downgraded because of a fear about our ability to pay it back. Whether that is an inability to tax enough or an inability to cut spending, or an inability to grow the economy enough or a growing future liabilities problem or a combination of all of them is not exactly known but not really relevant. I am not trying to make an argument about govt spending. We can spend as much as we want. But if spending is not balanced with revenues on some level over the long term it creates a mismatch and an inability to pay it off. That is what happened in Greece and Cyprus. That is what some are concerned about in places like Japan. That is all I am saying. If Keynesian spending works, and we return to surplus and the debt goes back down, then all good. If it doesn't then not so good. Sooner or later increasing debt does become a problem.

5 years really isn't a long enough window to prove Keynesianism works. We have come out of every recession this country has had since WWII and come up stronger than ever. Even 1982 which was pretty bad. We are slowly coming out of this one too. Slowest recovery since WWII though. But also the deepest recession. So how does one compare those. I don't know. But I don't think you can make any kind of historical comparison and say Keynesianism is what saved us. It could have, but it could be that we would be in the same position without it or perhaps even better. There is not conclusive way to answer the question.

As to the debt surpressing economic activity being debunked and everything that was against it being based on the 90% of GDP magical point in the Reinhart and Rogoff paper and their mathematical error, there is an article out just today on Market Watch addressing that very issue which I think does a good job of deconstructing the ideas. People have held the view that high levels of govt debt were harmful well before that paper. The mathematical error in the paper made the results look more dramatic than they really were but the results were still real, just less so. And this is trying to argue that we can prove one way or the other based on a few decades of study over things that are very different.

For example, the WWII debt you talked about. The article I am going to point to talks about how personal debt was very low at that time and people used their surplus assets to purchase US govt bonds and then inflation came at a higher rate and ate away a good portion of the returns. The people financed away the debt. Inflation eroded the debt and that's why it came down. And I actually think that is a viable way to deal with the debt, its likely to happen again if we keep running debt at these levels. In my opinion that is preferrable to what is happening in Cyprus right now.

Anyway, here is the article:

http://www.marketwatch.com/story/why-everyone-is-wrong-about-austerity-2013-04-26

Luis, I am not trying to stand with a party or pick a side in this fight. I am not interested anything other than what actually works. If Keynesianism works then great. And I am not opposed to trying a little bit of it when times are tough. But lets do the other half and pay down some debt when things get better. The path we are on it's tough to see how we get to that other half of Keynesianism. I know in the late 90s we had a couple year of very moderate surplus but there are a lot of things that came together to make that happen. Unprecedented dot com boom that brought in so much revenue that it swamped the budget. Tons of companies producing fraudelent earnings reports to boost stock prices on fake earnings, earnings on which taxes had to be paid by the way. Y2K money pumping that doubled the NASDAQ in 9 months due to easy money needing a place to find returns which also brought in tons of new tax revenues. And a fight between Clinton and Gingrich to do things like Welfare reform etc to hold govt spending down just a tad. And that gave us about 2 years of very modest surplus. I hope we could get to something like that again and on a more sustainable level but it is hard to see it when you look at our current levels of deficit being so much higher as a percent of GDP than any time since WWII and our future liabilities for the baby boomers via SS and Medicare.

Anyway, I would encourage you to read the article. The best answer is the right one, whichever side or idea that happens to be. Unless we have solid proof of which one that is like we do for things like Gravity, its probably best if neither side professes be 100% correct.