Why is Paying Off Your Mortgage a HUGE Mistake? |
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Moti Levi
Moti Levi and his wife, Kate Levi, started Life Group, LLC, which focuses on transforming lives and creating wealth for families, companies, and organizations along all dimensions of life, not just the financial ones.
Dr. Levi had been on the faculty of Penn State and Tulane after receiving his Ph.D. from The Wharton School, and currently teaches at Temple.
Dr. Levi writes for www.TheStreet.Com about Personal Finance and Investments, and his blog can be found at www.LifeGroupLLC.com.
He is also writing a forthcoming book, “The Funnel of Life: Why Our Dreams Shrink and Die, and How We Can Make Them Grow Again,” in which he provides a framework for achieving success, fulfillment, and happiness in a unified and consistent way, as well as showing why there is failure and how to overcome it.
Life Group, LLC uses an 8 step process to bring clarity, confidence, and direction to people, and take them on the road to lasting wealth, by optimizing their assets. The process starts in discovery and learning, and culminates with implementation of the plan, including the financial elements.
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The common advice you receive is to use a fixed (15 or 30 years) amortized mortgage, and pay your mortgage as fast as you can. Unfortunately, while it sounds like good advice, it is wrong due to both risk and return issues. This article explains why it is more risky to pay off your mortgage and create a financial loss at the same time.
The problem is that the common “pay it off” advice assumes you would not save except by paying money into the house, and focuses solely on the debt side without considering alternative usages of the money. If, however, you save the money you would otherwise put into the house, you are better off NEVER paying the house down, and in fact, keeping the mortgage balance as high as possible. Naturally, the savings should be in a safe, liquid, and good return side fund or it won’t work well. Safe means you cannot lose the principal. Liquid means you can always access it if you need to. Good return means your return is higher than the net costs of the mortgage.
The most elemental and powerful definition of risk is “Not having what you need or want when you need or want it.” Everything else is an application of it, or a factor that drives it. In real estate there are three drivers of risk. To illustrate the principles, we use Jim, who paid off his $400,000 house, and Jenny, who has a 100% mortgage but put the $400,000 in a safe, liquid, good return, side fund.
Risk 1: Inability to make payments
The first driver is job loss, or other unexpected event (e.g. health, accident, family, and legal related) that results in loss of income. While Jim doesn’t face foreclosure, he is in difficulty because he cannot borrow now, but is still straddled with bills and taxes on the house. Per the definition of risk above: “He doesn’t have what he needs, now that he needs it.” It is extremely difficult for him to sustain the transition period. Interestingly, and counter intuitively, the higher Jim’s income was, the more at risk he is, because his base life-style expenses are higher. I have several clients who came to me due to this situation and I am helping them reposition their assets and liabilities to counter those effects.
Jenny, on the other hand, can easily pay the monthly payments and expenses required until she finds a new source of income. After all, she probably has much more than $400,000 in the side fund, because she is getting compounded return there. Even in the worst case (foreclosure) she walks away with $400,000 and credit in need of repair but no real loss!
Risk 2: Falling prices
The second driver is falling real estate prices, as we’ve seen recently. If the house price fell to $350,000, Jim has net worth of $350,000 and potential access to $350,000 only. Jenny also has a net worth of $350,000 but access to $400,000, and therefore more flexibility. If Jim and Jenny have to move, Jim has to sell his house for $350,000 or below because he needs the money. Jenny, on the other hand, can offer a lease-purchase contract or seller financing to prospective buyers who do not have the ability to get a traditional mortgage, thereby increasing the number of potential buyers, which results in faster sale (especially in a down market!) and higher sale price, as documented by studies.
Risk 3: Damage to the House
The third driver is any event (e.g. fire, flood, tornado, a falling tree) that damages the house and results in a loss or reduction of its value. Jim, even if he has comprehensive insurance, and often we don’t, has to sustain a transition period until the insurance company pays the money. Jenny has no problem because she can draw on her side fund and rebuild immediately, and therefore minimize both her monetary costs and, more importantly, the disruption to her life.
The Lesson: Having your money in the house exposes you to risks. Having the money outside protects against the consequences of those events.
Returns
We compare Jim and Jenny 30 years later and we assume the house is now worth $1 million. Jim has a net worth of $1 million. Jenny invests the $400,000 in a safe and liquid side fund that returns an average of 8% and is tax-free (yes, there are such options!) for 30 years. She pays the 6% interestonly- mortgage cost from the interest gained on the side fund, and reinvests the tax refund on the mortgage deduction (assume a 30% federal & state tax bracket). Jenny’s net-worth 30 years later is $2,172,905 or $1,172,905 more!
To learn more about this and understand how it works – call or email Moti Levi, PhD at 215-854- 6418 or moti@LifeGroupLLC.com.
