May 6, 2005
Mortgaging Your Future or The Creative Road to Disaster
Back in the early 1970's I was doing some work at a model home in a new subdivision and struck up a conversation with the salesman on duty. "Things must be going ok for you right now", I remarked. "I always do well", he replied. "I have been selling real estate for 25 years." See, he was a professional agent. "The problem with a booming real estate market", he added, "is that during a boom every moron who can "scratch his butt" thinks he can sell real estate." Which, in his opinion, was bad for buyers, sellers and professional agents. This brings me to an ad I heard on the radio by a guy hawking mortgages. I'll just call his firm "Divinely Inspired Mortgages", or DIM for short, because he used the old Christian angle to lure us in. In the ad, this guy brags that a retired couple came in to see him and he was able to save them from themselves by selling them the proper mortgage. Proper mortgage? As old William Jefferson Clinton might say, "It depends on what the meaning of proper is." You see, these poor fools didn't have a mortgage and were, to quote the man from DIM, "being eaten up by taxes". According to the man from DIM, the real financial hipsters are mortgaged up to the hilt, leaving plenty of dough to invest. Not his exact words but I get his meaning. I disagree. My premise is that having any debt, including a mortgage, increases the risk to your finances. In most places when you own a home free and clear you will always have a roof over you head, no matter how otherwise screwed up things get to be. And taking out a mortgage in your retirement is very risky. Let's agree at the beginning here that, financially speaking, big reward generally means taking big risk. But I would submit that little risk does not necessarily mean little reward. To quote Bill again, "It depends on what the meaning of reward is." If your goal is to build a financial empire, then the "little risk" approach won't work. But if it is having enough to live a full life, then the little risk approach will do the job. Slow but steady makes millionaires that stay that way. Almost all titans of finance have made it big more than once by taking enormous risk. Of course in between the stays in the penthouse, they've had a stop or two at the outhouse. Donald Trump brags on The Apprentice that he is a billionaire, but not long ago The Donald was broke, relatively speaking. When Donald and I are both broke we are not equally broke. I am much broker than the Donald. The thing is when guys like Donald falls, it is from the 86th floor penthouse. Donald can fall 30 or 40 floors and still be pretty high up, metaphorically speaking. The rest of us fall from about the 2nd story and there is a pretty good splat when we hit. This is why most of us stay in the 90% between the extremes of fabulous wealth and living on the street. We don't have the risk tolerance or the backup plan of a Trump. We are not to quote the President "savvy investors". The sooner we recognize this and plan accordingly, the better off we will be. You cannot dabble in big risk. Either you're in or you're out. Lastly, these guys with the plans often have no money anyway. Anyway, back to our radio guy. His assertions are as follows; 1. The proper mortgage will cut your taxes. 2. Your home is rising in value whether you have a mortgage or not. 3. The interest earned on the principal payments on your mortgage is zero. 4. Take all that pesky consumer debt you have built up and slide it onto your swell new mortgage. 5. Get an interest only loan or an ARM because it allows you to buy more house now. These are all wrong and potentially ruinous to the believer. They work well only if everything else in your life goes nearly perfect. Those of with perfect lives can stop reading now. We will begin with the Book of DIM, verse 1, the proper mortgage will cut your taxes. This is true. A mortgage interest deduction will cut your taxes if you itemize. But at what cost? A tax deduction works like this. If you have a $200,000 mortgage at 5% you would pay about $10,000 in interest in the first year of the loan, which you could deduct from your taxable income. If you are in the 25% marginal rate, like a lot of folks, you would save $2500 in federal taxes. Toss in another $1,000 for state and local income taxes and your $10,000 interest payment saves you $3,500. Where I come from spending 10 grand to save $3,500 is not too smart. "But wait", DIM shouts, "you can invest the proceeds of the new mortgage to make some serious dough." Borrow money to invest. Ask someone who has tried it. So DIM 1 while strictly true is dumb financially speaking. Next we are told that your home appreciates, whether or not you have a mortgage on it. I suppose DIM's point is that the appreciation will justify the larger mortgage in the end. Perhaps. The problem for most of us with home appreciation is that it only benefits us when we sell. If you plan to live in your home long-term it matters little whether it is worth a buck or a million bucks. When we sell most of us have to turnaround and buy someone else's overpriced palace. Our profit needs to go into the new digs. Of course, DIM would tell you to invest the profit and get a bigger mortgage on the next joint. It should be obvious that this is a bad idea. About 15 years ago a novel idea swept California, where the west coast branch of the DIM family took it into their bosoms. It was the 125% first mortgage. The thinking went like this. California's real estate prices were rising and would do so forever, so no matter what your is mortgage today, the rising value would make it seem modest over time. Let me say this again. It doesn't matter what your house is worth or what you owe if you can't make the payment. People were loaned 125% of the value of their homes. This meant that if your home appraised at $200,000 you could get a first mortgage of $250,000, assuming you could qualify. Too often "qualifying" meant to be alive and to show up. Heck, with prices rising, the 125% loan would soon be a 100% loan or even lower anyway so why sweat it?. Plus with that extra dough you could get some cool stuff. Well, a funny thing happened on the road to riches. The aerospace industry didn't get the memo. Cut backs in aerospace caused mass layoffs and forced relocations. California was quickly awash in homes for sale. The law of supply and demand says when supply goes up, prices go down. And that's what happened. Suddenly many of the owners of those 125% loans were out of work and looking at not 125% loans but 150% or more loans because their homes had depreciated 10-20%. Can you say foreclosure? Many of these unfortunate souls found themselves living with the wife and 3 kids in a 2 bedroom apartment with the mortgage holders bugging them. To pour salt on their wounds, once the homes were foreclosed upon, sold at a loss and the mortgage holders gave up chasing, the IRS stepped in to demand the tax on the amount the mortgage companies had to write off. It seems the IRS viewed this as income. Now the former owners had a giant tax bill on a home that was long gone. So my advice is if you take out the biggest loan you can, you do so at your own peril. Point three by DIMmer is that you earn no interest on the money that you use to pay down your mortgage. Hogwash. Take your 30-year fixed rate loan of $200,000 at 5% interest. It has 360 principal and interest payments of about $1074. But pay an additional $100 per month on the principal and it pays off in 297 months (24.75 years) rather than 360 months, or 63 months early. 63 months of no payment times $1074 is about $68,000. The extra $100 per month time 297 months equals $29,700. So we spend $29,700 to save $68,000. If you wanted to save $100 per month and turn it into $68,000 in 24.75 years you would have to get 12% interest. That's serious interest to me. Even if you pay no extra principal you reduce the balance and thus the interest you pay each year. That is the same as having money in the bank that earns interest. DIM is just wrong on this one too. The old DIMster would also like you to finance that pair of zorries you got at WalMart on the way to the lake for the next 30 years or so. Take those credit cards and move the balances to your mortgage, he says. It is just smart financial thinking. Lower payments, tax deductions, a frickin bonanza, just there for the taking. Well, first of all if you carry a balance on credit cards you are buying stuff you can't afford. Beyond that though, moving balances to your mortgage is admitting that you will never pay them off. Take a $7000 balance from your car loan and put it into a mortgage for 30 years and it costs you about $14,000. This for a car that is gone and dead. Those zorries, that triple latte mocachino you charged at Starbucks and your last carwash are with you forever because the old DIMster says only suckers pay down their loans. The real problem with this idea though, is that most people don't change their ways. If you ran up credit card or other consumer debt before you moved it into your mortgage, statistics say you will do it again. Take for example a couple with a mortgage of $120,000 at 7%, a 5-year, $15,000 car loan at 8% and $10,000 of credit card debt. They would have total monthly payments of $1200 bucks or so principal and interest. Along comes DIM with a nifty plan to roll it all into a $150,000 (including refinance costs) 30-year 10 year interest only loan at 5%. The new payment would be only $625. An apparent savings of $$575 a month. What a cool deal. The problem is that statistics show within a year or two that savings will be consumed by a new loan of some kind. The past is the best predictor of future financial behavior. The DIMster would say invest that money and you'll be flush in 10 years. Most folks just aren't going to do it when there are Ski Doos to buy. Get that new mortgage for sure, but don't roll in the extra debt. Then use the savings to get rid of your consumer debt quicker. That $120,000 7% loan can be refinanced to a $125,000 5% one with a monthly reduction in payment of $120. Use that to pay off the credit cards. It may be more painful in the short term, but it is much better in the long run. DIM and his ilk also think an ARM (adjustable rate mortgage) is a swell idea because heck people don't stay put anyways. But why would you take out an adjustable rate loan in the midst of the lowest interest rates ever? Do you think that they might just head higher? What if the company you work for cuts off overtime or lays you off just as your payment adjusts up? Could be trouble. Or better yet, they say, get an interest only loan. The "magic" of an interest only loan is that you can get a $250,000 home for the payment of a $200,000 conventional 30-year loan. More house, same payment. A dream come true. Just don't pay the principal for ten years. By then you should be able to sell the place for a bag-o-cash. That is unless the housing market is stagnant or you lose your job. What if you die and leave your family to figure it out, or something else happens that forces you to sell at the worst possible moment? What if interest rates go to 12% like they did in 1983? Want to be forced to get a new loan then? No, getting into the maximum mortgage possible is inviting disaster. So here is what you do. Copy the millionaires. Millionaires don't generally have a lot of personal debt. Get smallest mortgage you can by making a good down payment and don't load it up with extra debt. Get the shortest term you can swing on a fixed rate. Preferably a 15-year loan. Remember this is where your family lives. Don't buy crap just because you can make the monthlies. It is the road to financial mediocrity or worse. That $250 dollar boat payment for ten years is your retirement funds. Don't take out big car loans. The average millionaire hasn't had a car payment in 15 years according to the book, The Millionaire Next Door. The line that everyone always has a car payment was made up by car salesmen. Car payments are the ruin of the middle class. An undeniable rule of physics is that any car that runs will get you there. The rich don't do these things because they are rich. They are rich because they do these things. Try this. Go into your kids room and watch them sleep, oblivious to the financial pressures of life. Worry-free. You can sleep just like them if you just stop being so DIM.