Flawed Thinking…

June 9, 2009

Check out this comment that was left the other day on one of my old mortgage posts:

Two years ago we stopped investing in our 401k and we began paying thousands against the principal on our home. We only have $1,500.00 left to pay and the property is ours and we didn’t lose our a$$et$ to the stock market. We don’t have to worry about losing our home to the bank.

Our money isn’t tied up in unstable companies that could fail in a second with no warning. We are debt free and will now be able to live comfortable lives without worry. There’s something to be said about that don’t you think? If all of your money is placed in the stock market, which most likely it is. You most likely are worried that you’ll never get back what you just lost in the latest crisis. I don’t have that worry and in 11 years, I will have saved approximately $500,000.00 that I probably would have sank into the stock market and lost. Now that is a $500,000.00 gain in 11 years.

Can you beat that?

I don’t think so…

Oh, and did I mention that God was in all of this? That is right! God. If we all would just obey the Lord and keep his word, “owe no man nothing” then we wouldn’t be in the situation that were in today.


Where do I start?

1. I NEVER said that going long on your mortgage and investing the difference was without risk. I do think that over the life of a 30-year mortgage, the risk is reduced.

2. Although you own your home you still have to pay property taxes. In some areas those taxes are small, but in other areas they can be quite high. Yes, not having a mortgage payment makes paying those taxes easier but you still have taxes to contend with.

3. Your money may not be tied up in “unstable companies” but it is tied up in your house and is quite illiquid. According to Jonathan Clements’ new book, The Little Book of Main Street Money, (review to follow soon) housing prices have increased an average of 4.7% over the last 30 years (through 2008). Inflation has averaged 3.8% per year during that same time period.

Chew on this…

EVEN WITH LAST YEAR’S -37% return for the S&P 500 Index, the index had a compound annual return over the last 30 years of 11%!

To put that in perspective, if you started 30 years ago with $100,000 invested in a house that appreciated 4.7% per year and $100,000 in the S&P 500 Index (minus 1% per year for fees), the house would be worth $396,644 at the end of 2008 and the S&P 500 Index account would be worth $1,744,940. And those numbers include some pretty dismal years for the S&P 500 Index. Even if you paid taxes at 28%, cutting your annual rate of return on the S&P 500 Index to 7.2% over the 30 years, you would have still had over $800,000 at the end of 2008—roughly TWICE what the house was worth.

4. I’m not sure where you’re getting the $500,000 in savings. Not including interest, you’re looking at having to save over $45,000 per year for the next 11 years to meet that goal. Surely I’m missing something here.

5. Lastly, you say:

“Oh, and did I mention that God was in all of this? That is right! God. If we all would just obey the Lord and keep his word, “owe no man nothing” then we wouldn’t be in the situation that were in today.”

If you truly believed that then why did you have a mortgage in the first place?

Seriously though, I think you are referring to Romans 13:8, which reads: “Owe no one anything except to love on another…” The notes in my Bible say that this is not a scripture against borrowing money, which the Bible does regulate and permit (Exodus 22:25; Leviticus 25:35-37; Deuteronomy 15:7-9; Nehemiah 5:7; Psalms 15:5, 37:21, 26; Ezekiel 22:12; Matthew 5:42; Luke 6:34). I think the virtue from the Bible that would have been more beneficial in preventing today’s circumstances would be not to love money (greed). Borrowing is both a tool and is necessary for an economy to function properly. It’s when the borrowing gets out of hand (usually due to greed) that we get into trouble.

Bottom line: you have to do what works for you. If the thought of owning your home is important to you, then by all means, own your home. But, that does not mean that it’s the best or most prudent decision for everyone else.


Also see: Flawed Thinking (Part 2)

20 responses to Flawed Thinking…

  1. My wife and I paid our house off 7 years ago. Looking back, we think it was a great decision. We also invested in the market and had cash put aside to handle any emergencies. You always need a place to live and you can get money out of your house if you absolutely need it by getting a home equity loan. You have to pay property tax whether you have a mortgage or not, so I'm not sure what point you're making there. Essentially we put extra money we would have spent on new cars, vacations and clothing into paying down our house instead. It is an appreciating asset we get to use everyday. I think Scott Burns wrote a column about the rewards of paying off your house. We have no debt and can accomodate changes in our cash flow due to the market gyrations.

  2. I think you make a good point. Over the long term, the annual rate of return on stocks beats out a primary residence. Just because you have a couple bad years on the stock market, doesn't mean that long term things are horrible. Your showing that a home would barely beat inflation. The stock market more than handily beats it. I'm glad I have my home, but I see it as a long-term purchase — not an investment. Even with the stock market down, my retirement account as appreciated more in the last two years than my home has. Short term and long term, I'll take the stock market…

  3. On a different note,


    Granted, I am not a particularly religious guy. While I am Christian (Greek Orthodox to be exact) I couldn't imagine running my financial life pursuant to the rules of the Bible; yet, so many PF Bloggers do. I don't care how people are motivated to put themselves in a better situation, as long as they are motivated to do so.

    I see you quoting some scripture, but do you run your financial world that way? Thoughts?


  4. In response to this part of your post: "4. I’m not sure where you’re getting the $500,000 in savings. Not including interest, you’re looking at having to save over $45,000 per year for the next 11 years to meet that goal. Surely I’m missing something here."

    I think you have to consider the interest you would earn. If you saved 19,971 per year (or $1,665/mo which might be what their mortgage is) at a rate of 11% and assumed a 3.5% rate of inflation you would have $500,000 in 11 years.

  5. Interesting verses since most of them deal with lending for little or no interst. With BOA and Chase both recently increasing the credit rate on my cards to 29% and 24% (even with no payments missed) I could really use a lender as described in Leviticus. (yes, I know I shouldn't have any CC debt, but until then…)

    35 " 'If one of your countrymen becomes poor and is unable to support himself among you, help him as you would an alien or a temporary resident, so he can continue to live among you. 36 Do not take interest of any kind [a] from him, but fear your God, so that your countryman may continue to live among you. 37 You must not lend him money at interest or sell him food at a profit.

  6. MJTM,

    Yes, I am a Christian.

    I quoted those scriptures in response to the commenter's use of scripture claiming that God tells us not be in debt.


    I noticed that too when I was looking up the verses. I too am against usury.

  7. I have a somewhat similar situation that I just started thinking about lately. I am drawing money out of my retirement (403b), in the form of a loan, for the closing costs of my wife and I’s first house. I am only doing this because I have a relocation package with my company and will be able to recoup the closing costs as long as I pay them out of pocket. I will then be able to put the money back into my retirement. Essentially it is giving us more buying power by being able to offer closing costs to the seller with the only costs being money lost for the month or two it is out of my retirement account. ____

  8. This got me to thinking though. I still have student loans of about 70k which I have been paying extensive amounts to for about 4 years. The interest rate on these loans is variable and is linked somehow to the LIBOR. Once I get the money back from closing costs (or maybe in a few years) does it make sense to put money, again in the form of a loan, from my retirement to pay off the student loans. A few considerations are: that the loans average about 5% and before the short terms rates dropped had been as high as 10%, the costs of taking the loan out against my retirement is a $50 fee and of course the 3.25% paid back to the account, and I now make too much money to actually deduct any interest paid to the student loans.

  9. So I guess the question is, is it a simple matter of the difference between the percentage of increase in my retirement investments plus $50 versus the interest rate of the student loans. If that’s the case and I expect the market to do around 8 or 9% in the next couple of years and I expect my interest rate of the loans is going to remain below 7% for the next couple of years (cross my fingers) then I would be better off not doing this. Or does the 3.25% that I pay back to myself have anything to do with this decision?

  10. Your primary residence is not an asset because it cannot generate income for you. So what if the price appreciates 50%, if you sell it and take the profit where will you live?


    Not to the detriment of cash reserve accumulation but stick to a fairly short term plan (10-12 years) to be completely debt free on your primary residence. Stuff happens; serious disability, loss of spouse (and 2nd income) to divorce or death, extended unemployment, and having a place to live without a potential foreclosure is a great strategy. Yes, property taxes and insurance will be ongoing costs, but the bank will throw you out in a few months if you cannot pay the note. Don't take the chance.

    The "investment pros" want you to limit debt repayment so they can reallocate your cash flow to buy stuff like insurance or securities. Don't fall for it!

  11. I'm jealous — a paid for house. The poster should be commended, not criticized. Doubly so for pulling this off in the past two years — great market timing. Instead of investing into a falling market — they got a guaranteed rate of return equal (the interest on the Note). Good job!

  12. LOL,

    The commenter made an allocation choice by paying off his house. Yes, he could have done worse things with the money like spending it on conspicuous consumption. He didn't do that so he should be commended for that.

    I'm just skeptical of his strategy for everyone.

    • JLP (sorry for this long post): I understand the math in the original article, and on a spreadsheet I agree with you completely. But the real-world is not a spreadsheet. The poster talks about "don't have to worry", and "debt free", and "unstable companies", and "fail without warning" and "crisis". This is all about risk, which your formulas completely ignore.

      I wish there was a quantifiable way to show how bad a ROR would be given all of the risks against your strategy: risk of not sticking to the savings plan, risk of job loss (and not able to find an equal paying replacement), risk of divorce / death of spouse, risk of large medical expenses, risk of markets not matching historical returns, tax consequences and the list goes on and on. Any of these things would easily force someone to sell equities at potentially the exact worse time to do so.
      Even worse is that the odds of these things happening are increased in your 30-year window (it's nearly guaranteed), with the end result being: your plan will not look as rosy as you make it out to be — meaning you are showing the "Best Case" scenario for your side — where is the "Average Case" and the "Worst Case"?.

      With a paid off mortgage, this risk window is reduced to 15-years, or even a 4-year window, depending on how fast you can get out of debt. There is still the same odds of being laid off (for example), but the consequences are not as devastating for someone with a paid for house.

      I will agree that if you have a large enough cash account (emergency fund) it helps to reduce some of these risks, but your formulas never show this account — having this account will lower the ROR for the 30-year mortgage side. We can all agree, that someone with a mortgage needs a larger emergency fund than someone without.

      Even the size of this cash account needs to be based on the 'risk' of needing liquid cash. What are the odds of two or more really bad things happening simultaneously — how much should be in the cash account then? This is especially true for the 30-year scenario, because of the longer time frame, the odds of two-or-more 'really bad things' happening during the window increase dramatically.

      I can't quantify and put into a spreadsheet hard numbers for this stuff, but people know what I say to be true — as a lot of your (older?) readers are either paying extra on mortgages, or have finished paying them off early, while at the same time saying that they agree with you but just can't commit to your plan.

  13. My thoughts: money in a retirement fund offers some protection against creditors/lawsuits, right? However, anyone can go after your house, although it's a little more difficult if held Tenancy by the Entirety. IMHO it's good to eliminate some risk by having the funds in the retirement plan and not all in the homestead.

    @ Jarrett, I can relate to the dreaded "can't deduct the interest on the student loan" situation. In one of our previous refinancings on our former house, we rolled DH student loan balance in and thus it became deductible interest. However, one case for NOT rolling your student debt into a mortgage/equity line: if you die, your heirs are not legally responsible as you were the only one to sign the loan paperwork. However, if you roll the loan balance into your mortgage…your spouse will be stuck paying for it in the event you die. Besides, what tax rate are you at? Sometimes you just have to suck it up and and have less write-off…

    BTW: I would NOT take money from retirement…you'll obviously lose the magical compounding from a nice long time horizon of investing. Just do your best to pay it down as fast as you can.

  14. Stacey: I'm sure this varies by state, but in Texas, creditors can NOT touch: $125,000 worth of home equity (homestead exemption), and 100% of qualified retirement accounts. Of course, if you are defaulting on your mortgage lender, then they will foreclose on you.

  15. @Milo. Regarding these verses "Do not take interest of any kind [a] from him, but fear your God, so that your countryman may continue to live among you. 37 You must not lend him money at interest or sell him food at a profit."

    This excludes all modern banking as well as investing in bonds. When you put your money in a bank, you really lend your money to the bank. At low percent, yes, but it is still a loan. Now, the banks take this money, put a certain percentage – normally around 10% but in this times it's higher as a cushion towards future losses – and lend the rest at higher percentage. So by giving banks your money you enabling these higher rates.

    If you invest in government bonds, you lend money to the government. If you invest in municipal bonds, you lend money to municipalities. If you invest in corporate bonds, you lend money to corporations. So if you think that you shouldn't be charging interest you shouldn't put your money in a bank or invest in bonds or bond funds. Of course then businesses will not be able to borrow money.

    How many people will lose their jobs without lending? I guess we see this now.

    As to usury, do a little elementary math. At this moment the default rate on credit cards is around 10%. This is unsecured debt, so there is no recovery in default unlike with mortgages. Now, let's say you give your own hard earned $1000 to 10 people for a year, $100 to each. Let's say 1 person defaults i.e. you lose $100. What interest rate do you need to charge other 9 just to break even i.e. to get your $100 back? Hint: you need to get $100 in interest on $900. Unless are you just prepared to lose money, but then this will be charity.
    Yes, the interest is considerably below your rate. But this 10% is average and it includes both low risk and high risk borrowers. So for higher risk borrowers, the risk of default is higher. Being late or defaulting on another bill corresponds to higher risk. In a riskier group more people default. Let's say 2 out of 10 in a group will default. I.e. you lose $200 out of a $1000. What rate do you need to charge on $800 you gave to other 8 people to get $200 in interest? Close to the one you are paying, right? I'll leave the calculations to you as an exercise.

    Keep in mind that this little exercise implies that you got your $1000 for free and you lend all of it. But in case of banks, you have to consider a) the interest paid on deposits b) money left in reserve i.e. you can only lend $900 out of a $1000 in normal times, more now, but you still have to pay interest to your depositors on the full amount c) business operational expenses i.e. lease, furniture, salaries. And yes, banks are supposed to make profit. Oh I forgot, your verse said that they should all operate as charities. But then, what about all the people who work for banks, where will their salaries come from? What about shareholders? Further investment to expand and hire more people?

    Back on topic. I think paying or not paying mortgage is a very personal decision. I paid off my mortgage and, yes, it feels great. After all had I not repaid with the money I got from the sale of the condo I was renting out, I would have invested at least some of the money in stocks and lost some of it. Not only that, back in 2000 when I had all these insane gains, a friend suggested that I sold stocks and pay off my mortgage. I told him I was earning higher rate on stocks… Then the market crashed, my gains evaporated, but I still had my mortgage. This was probably one of the reasons while I choose to pay off my mortgage when I got a second chance.

    On a flip side, I now have a large chunk of my net worth in my home. At the same time if I were to decide to "upgrade" now, I'd probably take a mortgage even if I could pay cash for the difference. One reason is that rates are low and there is a great chance with the current government spending that at some point within next 10 years of so they will go significantly higher. I am still not convinced on inflation scenario near term as there are still some deflationary pressures out there, but there is a good chance of high inflation later on. If we do see high inflation and/or higher interest rate, a low fixed interest loan is an advantage. Think early 1980s – banks' paying over 13% on regular CDs, even short term CDs, while people who took mortgage in the 90s paying 9%.

    There are other factors as well – your age, since you probably don't want to be paying mortgage in retirement; whether or not you can pay it off completely with one lamp sum or not – if not, maybe putting this money in a bank in case of a job loss or a really serious emergency would be more useful.

    As to 401K vs mortgage, there are other considerations. First of all, stocks is not the only option in 401K. There is stable value, for example, or at least in our 401K government inflation-protected bonds. So if you are averse to risk, you can put your money there. If your company matches some percentage, this is often 50% return on your investment. Yes, you can lose it in stock funds, but who says you have to invest it all in stocks? Stacey made a good point about bankruptcy as well.

    • When responding to Milo, you left out the part that said…. 35 " 'If one of your countrymen becomes POOR AND IS UNABLE TO SUPPORT HIMSELF among you, help him as you would an alien or a temporary resident, so he can continue to live among you.

      Banks and Governments that you loan to (Bonds) are not poor…

  16. @Jim – your house certainly is an a asset by any common definition (I realize there is a particulary famous Guru out there who claims otherwise but he simply redifines "asset" to suit his purpose). And it produces income (tax free income at that) it's called imputed rent.

    Paying off your mortgage versus investing in other assets is a complex decision with numerous variables and a great number of unknowables. But people need to realize that if you alternatives are pay off mortgage vs stocks/junk bonds then you are comparing a low risk investment vs a high risk investment (so you better be very comfortable with the implications of that).

    And for those who think time somehow cures the inherent volatility of the stock market, I suggest you consider the following: http://knowledge.wharton.upenn.edu/article.cfm?ar… The point is there are NO guarantees in the stock market (even over a thirty year period)

    • @Bender – I thought the "not an asset" comment might lead some to think of the famous "Guru" you mention. LOL.

      Of course your home is considered an asset in many discussions, I just think it's one to ignore in the context of wealth building. I'm suggesting that we can paint many scenarios where on paper it seems to make sense to pay mortgage interest while investing cash flow elsewhere. These strategies are generally made by those who either have a bias towards investing in securities or (mostly) those who SELL them.

      Of course if you own your home free and clear, you have no variation in the amount due each month (excluding taxes & maintenance), it's ZERO. Thus begins the conversation about how we might do better with that capital:

      If I can earn x % in say porcelain dolls over x years, with inflation at x %, and with my earning power increasing at a x % (exponential) rate I'll have one ZILLION dollars at age x.

      A nice exercise but I think most folks are best served with a more conservative approach. Most do exactly what you describe; ignore the risk.

  17. @Andy J. Since banks are not charities, I didn't think this was applicable. The "usuary" quote said no charging interest of anybody rich or poor and this is what I was replying to. Incidentally when you deposit money in the bank you might be lending your money at low interest and to a 'rich" entity, but you also enable the bank to use your money and to lend it via mortgages and credit cards. If nobody charged any interest on loans, we'd have no modern banking at all. Then you'd have to pay the bank to keep your money safe for you rather than them paying interest to you.

    Additionally – banks aren't individuals. Banks have employees – IT, secretaries, cashiers, many of whom aren't rich at all. Not all shareholders or bondholders are rich either as these include retirement funds of many middle class people.

    I am sure some of the banks' shareholders give money to charities to help poor people. But if they had given all money to their borrowers for free especially with the default rates they have, they'd have to fire some of their employees. Then their employees would become poor.