Sunday, June 17, 2007

Lessons from dad's generation

Well it's Father's Day today and of course that made me think about my dad. A lot of people (including me) look to their dads as an example of financial responsibility. He worked hard for his whole life and even though he started off without a whole lot, he's always provided for his family and made it comfortably into the middle class. A person like that can really change the course of a family line's destiny. If I had been born poor, would I have made it as far?

One of the bits of advice from his generation that I'm a bit conflicted about is with regard to debt. They don't like it. Maybe it's a result of *their* parents' generation growing up with things like WWI/II and the Great Depression or just a generally more conservative outlook. In any case, the people I'm talking about are characterized by: making extra payments on their mortgage; putting as much money down for a new house as possible; saving up cash in a special savings account to buy a car with a huge down payment; getting life insurance for their kids when they're like 5 years old.

I see the value in owning your own house, of course. But making extra payments on your mortgage is not good I think! It doesn't reduce your future monthly payment, it just makes the payments end more quickly. If you lose your job or otherwise can't make payments anymore, the bank doesn't say "Oh well you paid extra so we'll let it go for a few months!" For security it would be better to put whatever extra money you would pay towards your mortgage and put it in a high interest savings account. Then towards the end of your mortgage pay it off early if you really want.

With cars, if you can get a special APR from the manufacturer, I think the interest rate is too low to justify putting down more than the minimum. For instance, Honda is having a special right now for APRs from 2.9% to 4.9%, depending on the length of the loan. Hyundai is offering 1.9%. I'm looking for a new car right now so this is an important issue to me -- should I put $5000 down and get a 3 year loan, or put $2000 down with a 5 year loan and leave the remainder in AAV earning a 15% return? I'm leaning strongly toward the latter.

I feel the same way about a mortgage. Rather than pay $200 extra each month, I would stick that $200 in my IRA or regular stock trading account and watch it grow. When you're talking about mortgage time spans, money will REALLY grow. $200 a month has a good chance of being worth more than your entire house after 30 years. That way after 30 years I'll have the house paid off, plus a huge chunk of cash. If I paid $200 extra a month, I'd have the house paid off after maybe 25 years, but I'd have no extra cash. Right now I rent so it's more of a hypothetical issue, but I want to buy a house in the next few years. Wow, I just found a mortgage calculator which lets you test this hypothesis. Indeed, it looks like investing rather than prepaying is the way to go for the situations I tested. Another advantage I didn't even think of is when you prepay you lose a bit of the tax advantage a mortgage gives you, since the extra money you pay goes toward principal and not interest (so it's not tax deductible).

The issue of the down payment is as true of houses as of cars. Let's say you save up for a few years and you expect to get some cash from your parents (and inlaws if you're married). Let's say $15000 total. Then at the last second you say, hey I'm going to just put this money in the stock market for 30 years, and use no money down for the house. Ignoring the ethical implications of re-routing gifted money, what would happen? I don't know. I guess some banks require a minimum down payment so it's a non-issue. I talked to Bank of America recently about the mortgage process and they suggest about 5% down. Let's look at what would happen to the $15k being used on a $120k house in two ways: the minimum down payment and the maximum. We'll assume a 6.4% interest rate (the current average for a 30 year fixed loan according to a Google search I just did). 5% down would be $6k, so the loan amount would be $114k. The monthly payment would be $713.08 a month, for a total payment (after 360 months) of $256,758.80. (Yes, compounding sucks when it's working against you!) With your down payment, the total cost of the house is almost $263k.

In the meantime, the extra $9k that you didn't put towards the down payment has been growing... and growing... let's say at 10% a year (under the long-term average of the stock market, but oh well). We never added anything else and let's say we just put it in an index fund so we never had to manage it or worry about it. After 30 years you would have $157k! So since that money basically came from the house we'll say the net cost of the house is 263k - 157k = $106k. So we got a $120k house for only $106k! Plus the house has probably appreciated since then. Not bad.

Now if we took the entire $15k and put it towards the down payment, what would happen? The monthly payment would be $656.78 and the total payment would be $236k. Add in our down payment and the total cost of the house is... $251k!

So blowing all your cash on a down payment is not a good idea. In this case it more than doubled the net cost of the house. We've also ignored the increased tax deduction that the higher payment gives you, yet another benefit of the first scheme. (But we've also ignored the tax on the investment, which would probably make a huge difference unless it's in a tax-deferred account.)

What I really like about it is that if you lose your job after 10 years and have trouble finding another one for a while, you'll have a nice stockpile of $9k * 1.1^10 = $23k, which, even if it's in a tax deferred account and you pay a penalty to get it out, will definitely give you a nice cushion for those monthly payments.

21 comments:

JonathanRaleigh said...

interesting...thanks for using examples with numbers, it makes it easier to understand...I may back off on overpaying on my student loan.

stat said...

Here's a few more scenarios.

Anonymous said...

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