Tuesday, March 18, 2008

Mortgage Interest and Tax Advantaged Investments

A few basic principles of personal finance apply to almost every homeowner. If money is not a concern these principles may seem less important because the water is deep, so to speak, and many of the hazards of life are covered over. The hazards are still there you just miss them. If, like most people, you are boating in shallower water the chance of hitting a hazard or two during your lifetime is greater. The closer these principles are followed the easier it is to get around hazards without sinking your ship.

  • Spend less than you earn. This may seem obvious, but in our world of have it all now and easy credit this rock sinks a lot of boats.
  • If you use credit cards pay off the entire balance every billing cycle.
  • Keep your home mortgage as high as you can for as long as you can. This may fly in the face of all you have been told, but don't dismiss the idea yet.
  • Build an emergency fund large enough to pay off your home mortgage.

Earning and Spending

I will only say here if you do not know how much is coming in and where it is being spent you can never spend less than you earn. Budgeting doesn't have to be elaborate or detailed, but you must understand where your money goes.

Credit Cards

Credit cards are a most useful tool if you have self control. Make all routine purchases using your cc. If you have the money then paying with your cc gives you a receipt and lets you postpone payment until the end of the billing cycle; essentially you're getting use of free money for up to 30 days depending on when your billing cycle ends. If you have saved up for a larger ticket item make the purchase with your cc for the reasons above. If you don't have the money for the purchase never use your cc to pay for it.

No self control? No credit cards. You must be honest with yourself on this one. Debit cards or cash also work well.

Home Mortgage

When we were just starting out together in life my wife and I bought our first house. The interest rate on the loan was 12%, ouch!

I majored in finance and thought I knew something about personal finance, and we knew all the cliches: Interest, those that understand it collect it, those that don't pay it; Debt is a strict task master it never sleeps, never takes a vacation if you can't repay it, it crushes you; You're never really free while your in debt. With a 12% interest rate those sayings seemed all too true; we wanted our freedom back. We decided to start making additional principal payments on our mortgage every month.

Since I was an employee I reasoned I would only earn a specific amount of money during my life time, I hoped to add to that some day with investment income, but at any rate a finite sum. The more we paid in interest during our lifetime meant less we had for other things.

Even though we were not bringing home all that much money, we faithfully paid extra principal every month. And not just a little, we made big sacrifices paying as much as $1,000 in extra principal each month. I spent hours with my financial calculator and graph paper (there were no laptops or PCs) mapping out how quickly we could get out from under that mortgage. We made extra principal payments for several years and I have to say it was exciting to watch the principal amount of the loan drop dramatically over that time.

Then we bought a new home. We had a large amount of equity--at least for us--to put into the new home, but the price was also much higher so we ended up with more debt than what we had started with on our first home. Fortunately by then interest rates were much lower, our new mortgage payment wasn't much different than the old payment.

By this time my wife was not working. They say most people are one paycheck away from being on the street; we had a small emergency fund so we were maybe four paychecks from the street. For me, being so vulnerable was not acceptable; we needed greater security. That meant not putting all of our money into paying off the mortgage.

I worried during those years of extra principal payments about what would happen if I lost my job and couldn't make next month's payment. For lenders the primary thing is that you make your next scheduled payment. How consistent you have been in the past means nothing if you cannot make your next scheduled payment. On our first mortgage we had paid enough additional principal to be about fifteen years ahead of scheduled payments, but if we missed the next monthly payment we were in trouble. No matter how far ahead you are next month's payment must still be paid.

We stopped making extra principal payments and built up our emergency fund. An emergency fund should be liquid--in very short-term investments that can be converted to cash quickly--and in safe types of investments; your emergency fund is no good if it's not available when you need it.


Before I go on I must give a caution: Too often we rely on our government and its programs to take care of us and bail us out if problems arise. First, relying on government is never a good thing because it generally requires giving up some of our freedoms (think taxes, and IRA and 401k requirements). Second, when we know the government is there and will take care of us we become lazy and do not exercise the caution we should in considering the safety of investments. What I am about to share I believe meets the requirements of safe and liquid, but should be considered seriously to determine if it is a strategy that will work for you.

Emergency Fund

Conventional wisdom says paying off your mortgage is the best thing to do. However, conventional wisdom never looses its job or has other real life catastrophes that might keep it from making a mortgage payment, and there are other factors to consider. Having enough money to completely eliminate your mortgage may be a better strategy. There is a tax advantage to having a mortgage and some disadvantages to having no mortgage or one that is small in relation to the value of your home.

Mortgage interest is tax deductible, this is powerful because it means the government is paying part of your interest expense (as an aside, one of the reasons you do not want credit card and consumer debt is because interest expense on these borrowings is not tax deductible). If you have no mortgage then you have a considerable amount of your money--equity--tied up in an asset that is illiquid and earning no income. Some people look at house appreciation and say their equity is earning a return, but think about it, whether you have one hundred percent equity in your home or none the appreciation is the same. So, equity taken out of your home can be invested to earn additional income and in safer and more liquid investments.

In the wrong type of real estate market you may wait months if not years to sell your home. We had a great real estate market for many years, prices usually went up and houses usually sold fast. Now things have changed and at the very time you may need to sell your home quickly you may not be able to.

You are more likely to be foreclosed on with a small mortgage and a lot of equity in your home if you get into trouble and cannot make your payments. Imagine you are a mortgage lender and you have two loans outstanding, one with a lot of equity and one with no equity. Both borrowers are having trouble making their payments. The house with a lot of equity can be sold--at a discount if necessary--the loan repaid and likely with enough equity left to cover the costs of foreclosure. If the house with no equity is foreclosed on and sold at a discount the proceeds will not even cover the loan on the property let alone the foreclosure costs. If you were the lender which house would you foreclose on first?

Building an emergency fund with the goal of having at least enough to pay off your entire mortgage puts you in a nice position. Let's say you are just starting and your fund is only $15,000 or $20,000, even with this much if you have a problem and cannot make your mortgage payments from your regular income you can make a lot of monthly payments from your fund while you resolve the problem or sell the home. With time your fund will grow and the larger it gets the more money it will earn each year. When you have enough in your fund to pay off your mortgage isn't that essentially the same as not being in debt? You could pay the mortgage off if you wanted to, but you would still have a large sum parked in an illiquid asset and not earning any return.

One final consideration is using investment vehicles that will allow your money to grow tax free and also be able to be drawn on and used without paying taxes. These vehicles exist and combined with tax deductible mortgage interest make it possible to accumulate a good sized emergency fund in less time than you would think.

If this makes sense to you there are people that can help you explore these options. I'm not one of them and I receive nothing from them for making this recommendation. Douglas R. Andrew has written four books: Missed Fortune, Missed Fortune 101, The Last Chance Millionaire, and Millionaire By Thirty. I highly recommend the first two, the third was not as good and the last one I haven't read yet. Doug's website http://www.missedfortune.com/ is the place to start. His staff can help you find someone in your area that understands these principles.

If you do what everybody else does--live from paycheck to paycheck with a lot of illiquid funds locked up in your house--you will get what everybody else gets. There are much better alternatives, take time to educate yourself and do what is best for you.

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