Thursday, February 09, 2006

You Stupid SOB

Res Ispa disagrees with my mortgage theory:

Edited for formatting. I also dropped out his amortization table due to formatting problems. I wish Blogger would add a table formatter.

A disclaimer:
When you here people giving financial advice they are talking in generalities. This is true if it’s a national radio personality, or some guy you’ve never met on the internet. If you want advice on what you should personally do, in your particular situation, you need to hire someone who has a reputation as a solid financial planner.

Dif, I have exactly the opposite opinion that you expressed. I think you’ve put some thought into this but I can’t go along with your conclusion.

The Short Version:
My take on leveraging your house to the hilt, is to never ever do it. Don’t ever be in debt for anything ever. If you have to be in debt get out as fast as possible. Then you’re free to invest and prosper. This includes house debt.

The Long Version:
Some people live in areas where the real-estate market has been more akin to a loose Vegas slot machine than a traditional housing market. Dif lives in one of those areas. Since the 1970’s CA has been the best place year in and year out to make money in RE.

Houses are assets; they are not mutual funds or investment vehicles. A house is a place to live. If you own your house free and clear you can invest the money you would have made in PMT in other investments, or spend it or give it away.

And here is the beginning of our basic disagreement. Houses ARE investment vehicles for many people, or more precisely, in many area. The whole idea of flipping properties quickly for a high return has nearly stopped because growth has slowed even here in The OC. Whether you bought your house an investment or not, it is still useful for that purpose.

Dif used investment as the scenario for his argument so I’m going to do some math based on that.


House Value $500,000
Loan Amt $400,000
80/20, first position,
100% cash out for investment
No PMI required
5.875% Interest P & I only 30 year fixed rate loan
T & I don’t count in this scenario; they’re a sunk cost that would have been paid out anyway regardless if you had a loan.
Technically “I” would be optional if they didn’t have a MTG but most people still carry it.
4% front end points to the broker baby! All add on, no cash out of pocket.

PV = $416,000
INT = 5.875%
PMT = $2,460
Level of monthly income needed to qualify for the loan at 28% front end ratio = $8,786.
Actually the needed income is higher but I’m ball parking.
Federal tax rate before deductions etc. for a married couple making $105,432 per year is 28%
California tax rate on same income is: 10.3%
Some local governments also charge income tax too, for argument sake the borrower doesn’t live in one.

Dif's note: Res had a partial amortization table here listing 1, 5, 10, 15, and 30 year results. You can find an amortization table in MS Excel and various places on the web. The 30 results are below on a loan amount of $400,000 at 5.875% fully amortized.

Total Repaid: $885,888
Total Interest Paid: $469,888
Interest as percentage of Principal: 112.954%

My version of this scenario differs from Res in a couple of key points:

I would only take an 80% loan.
The loan would be Interest only (no principle payment) That makes the payment $1958/month

OK that’s the cost side, now lets examine the investment possibilities.

Using the 3 month T – Bill as the risk free rate currently 4.30% First year results:

Risk free rate: 4.3%
Return on $400,000: $17,200.00
Ann. Cost of Capital: $24,300
Profit/Loss: -$7,100
Taxes: $0
Profit After Taxes: $0

Not such a good investment after the first year I think we’d be looking for something with a better rate of return. Over the 30 year period:

Risk free rate: 4.3%
Return on $400,000: $516,000
Cost of Capital: $469,885
Profit/Loss: $46,114
Taxes: $17,661.98
Profit After Taxes: $28,452

Some of you are looking at this and thinking big deal no one would take the RFR on the entire balance if they could invest it as a lump sum. They’d invest in a diversified portfolio. True. In fact you can go to

And run just about every loan and investment scenario you can think of and the calculator will do the math for you. You do need to tax effect the annual investment which will reduce your return. Unless the cost of borrowing is higher than the rate of return you’ll make money.

Possible downsides are:
  • Investment risks will eat up profits.
  • Inflation won’t keep up with gains.
  • The market could tank and you could lose everything.

BUT if your 30 years old and own a $500,000 house free and clear and make over $105k per year you might want to cash out the house and invest the balance, before taxes you should net around $7 million when you retire.

That’s not a 100% accurate picture of what most people are looking at in this scenario. Let’s get real for a minute.

Same facts on the loan, same facts on income, same all around except were going to look at two borrowers with different debt philosophies. We’ll call them Difster and Res. We’ll assume that both of us are 30 (were really older, but it’s my scenario) and both are single with no kids and that we’ll never make the huge financial mistake of getting married and having kids etc. None of which is true BTW.

Difster keeps his House PMT and doesn’t pay off debt, but he uses the difference in his income to invest in mutual funds, over the 30 years he averages 8% return. For argument sake both men have the same amount of income after taxes $5775.

Basic finances for Dif and Res look something like this:

Disposable Income: $5775
House PMT: $2460
Taxes and Insurance: $500
Living Expenses: $1500
Net Disposable Income: $1315

Difster invests his $1315 each and every month for the next 35 years his return after taxes and inflation is: $835, 694 based on an average return of 8%.

Res takes his $1315 and pays off his mortgage 16 years and 9 months early. Then he takes the entire $3775 and puts it into the same investment Difster is using. He makes $1,746,762 over the exact same time period. Effectively kicking Difster’s misguided hind end to St Paul and back. That’s $910,798.00 or nearly ONE MILLION bucks over the same time period. If you cost effect for raises and other economic factors, Res Ipsa ends up with more than ONE MILLION bucks after taxes over the same period. For your own amusement run scenarios at

Using the same assumptions of a home worth $500,000 owned free and clear, let's what I can do using the scenario that I've now spent countless hours pouring over.

Loan amount: $400,000 (leaving 20% equity)
Interest Rate: 6.125% Interest Only
Payment: $2041/month

Investment Rate: 12% (current trust deed rate - California REIT's have paid about that on average over the last 20 years).

Rather than make your mortgage payment out of your income, we're going set aside 1 year of payments from the loan proceeds or $24,500 to make the mortgage payment for you. That $24,500 goes in to a series of 3, 6, and 9 month CD's and earns an additional $716.00 for the year. The CD's mature in time to make your payment and you always have a 90 day buffer.

Now, you don't have a payment going to your bank out of your income. Your house is simply paying for itself at this point. Because of the change in loan amount, you now have $3775 in disposable income per month. Let's take half of that ($1887)and roll it each month in to our investment fund. The rest you can put in a savings account for a rainy day.

What do we have at the end of 30 years? Res used 35 years but the complex calculator I've put together is only designed for 30 and I'm not about to redo it for a blog.

Assuming that you don't refinance to take advantage of higher rates or increased equity, at the end of 3o years, you will have $10,800,000. No, those decimal points are not out of place, that's $10,800,000. I haven't taken taken in to account taxes, inflation or rising wages. My scenario is based purely on today's dollars. The mortgage interest deduction stays constant over the life of the loan also because the principle is never reduced.

At the end of that 30 years, you will still owe the principle balance of $400,000 assuming you have not refinanced over that period of time, taken more cash out and reinvested it (or spent it). With my theory of remaining heavily mortgaged and having the rest invested, you would even be in better shape that what I've shown you so far if you take advantage of the cyclic rate of interest rates, rising home values and watching the market. The beauty of the whole thing is that you can simply pull back at any time and pay down your mortgage. When the conditions are right, insert your equity back in to the market mechanism of your choice.

Another disclaimer: Dif and I have both made lots of money off of dumb people just like you poor bastards reading this blog. If you come into our office/bank and say I want to cash out $50,000 grand (or more the amount doesn’t matter) we are required by law to let you fools have every cent the lending policy says your entitled to: regardless of the financial havoc it will wreck on your life.
Read my e lips:

Borrowing money is now and always has been a bad idea. The salesman who is going to make lots of cash off your sorry butt isn’t your friend when he tells you that the bank will let you buy the house or you can afford the car.

BUT: You making payments has always made guys like me money, so be a dumb SOB and stay in debt. You will never get rich making payments, unless its to yourself.

Borrowing money isn't always a bad idea. Equity in your house is D E A D money. If you can't make your mortgage payments, the bank take your house, you don't get that extra equity when they auction the place off; it's gone. The more equity you have in your home, the more risk you are carrying. When you are heavily mortgaged, the bank is taking all of the risk (or whatever portion of debt it's carrying for you).

What happens if proprty values plummet? Great! You already have your equity out and working for you. Wait for the market to bottom out and transfer some of that equity you already have out in to those lower value houses and wait for the market to bounce back (it always has).

I do see what Res is trying to say but I have searched and searched for a downside to my plan and I can't find one. There are some tradeoffs but if you leave the equity in your home, there are tradeoffs there too. Lost opportunity cost is hard to calculate sometimes but it is very real.

I'm looking forward to all of your comments.