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Flawed Thinking (Part 2)
By JLP | June 10, 2009
After posting Flawed Thinking a couple of days ago, I got to thinking about it. I left out one very important part of the story.
Re-read the commenter’s first sentence and you’ll see what I mean:
The money they put into their 401(k) was pre-tax. If they were maxing out their 401(k) at $15,000 per year and were in the 28% tax bracket, they were saving approximately $4,200 in taxes. When they stopped contributing that $15,000, they had to give $4,200 of it to the government. Yes, the market was horrible last year and they probably made some money on their gamble. But, long-term it probably hurt them from a purely financial standpoint.
They made a decision based on emotion. It’s funny to me how we always talk about keeping our emotions in check and then we applaud an emotional decision such as this.
If this couple had extra money that they wanted to put towards their mortgage, I could see that. But forgoing their 401(k)? That just doesn’t make sense to me.
Thoughts?
Topics: Investing, Mortgages | 19 Comments »
June 10th, 2009 at 9:45 pm
Humans are emotional beings, so it's no surprise that many decisions are made for emotional rather than purely logical reasons. I don't really have a problem with that, as emotional gratification is often quite rewarding, though the metric is different.
June 10th, 2009 at 9:53 pm
I'm not sure I understand your point about the taxes. Sure they paid $4,200 in taxes now, but the alternative is paying taxes on the money later during retirement. Are you assuming they'd be paying a lower tax rate then?
June 10th, 2009 at 10:54 pm
Another point is that they still have risk. Even though the house is paid off, which is a very good thing, there is still risk with this investment. They may have to move because of a job, resulting in moving to a higher priced location. Their current home could go down in value: economy, environmental issues (mold for instance-seen it happen), because neighborhood changes, etc.. Even the government could take the home to put a park or a mall in. Because their money is tied up in the house they could have cash flow problems. Although many of these things are unlikely to happen, there still is risk. They have just chosen that risk verses stock or other investment risks. It is not necessarily a bad decision. I wish I could pay off my home that quickly. But my decision is that I want to fund for retirement – so I have chosen that risk. I think a little more grace from all of us toward decisions others make would be beneficial.
June 11th, 2009 at 1:26 am
I think they did the right thing, without a mortgage now, they could take ALL that "mortgage payment" money and invest it in the market and they haven't lost a damn thing. I'm in the process of doing the exact same thing.
You seem to have left out the part where they save a ton of money on interest paid to the bank over the course of the loan. You don't ever want to hold debt during a deflationary period and we're in a hell of a deflationary period.
June 11th, 2009 at 3:23 am
The fact is, NOT regularly investing in the market the past couple of years was the smart move. The poster's reordering of his/her financial priorities to pay off the mortgage at the expense of funding the 401k turned out to be the investment of a decade. By sidestepping a devastating 40% decline in the S&P and paying off a 5-6% interest mortgage (to the point where the mortgage is nearly gone), the poster is in an excellent financial position: the balance sheet is devoid of all debts, and the absence of a mortgage payment improves cash flow for future investment. It's hard to be critical when the end result is so correct.
But that was then, 2007, when the country was just entering the throes of a powerful recession. Here we are two years later, and much has changed.
First, even though interest rates may stay low for the next several years (I know they are spiking, but for how long?), a 4.5% rate on a 30 year note strikes me as ridiculously low. Which means expect rates to climb steadily higher over the next 5 to 10 to 15 years (providing a massive headwind to future property appreciation). Some long term debt makes more sense today than it did in 2005-2007.
Second, stocks are down 40%. That provides a much better entry point for the long term investor, and returns on equity investments should outperform most asset classes — especially real estate — over the next 10-15 years. Maybe not over the next two years, but long term investors should be salivating at the chance to buy stock at such deep discounts.
(As an addendum to the above, I don't recommend piling into stocks HERE, at S&P 950. I would assign an 80% probability to the S&P selling off sometime in the next 6-18months, declining at least 20% to under 800. I would even assign a 20% probability to the market suffering a 50% loss from today's levels. But that would constitute the buying opportunity of a lifetime).
In other words, funding the 401k for the next several years is an absolute must.
The time to be fearful was in 2007 at S&P 1575. At 750, 650, or even (God forbid!) 550 by the end of 2010, I will be selling the kitchen sink, liquidating the furniture, and pawing the kid's toys to sink every last dollar into an emerging market fund, or a commodity fund (Jim Rogers, anybody), and lastly an S&P index fund.
And by 2020, I will be rich, retired, and teaching the virtues of financial intelligence to children all over the world (and if not all over the world, at least to my son and daughter.)
Sorry for the wordy post.
June 11th, 2009 at 3:23 am
Rich, yes we are in a deflationary period now or at least we were until the recent jump in oil prices and long term treasury rate. How long do you think this deflationary period will last? 2 years? 5 years? Do you really believe we'll get Japan-like situation and prolonged deflation of 10 years or so? What happens when the deflationary period ends? Do you really believe the government will be able to take this extra money they printed from circulation before it causes inflation? How will they do it? They will have to raise rates. The banks will raise rates as well. When it happens, people who are paying 4.5% on their mortgages may well be able to earn more on regular CDs.
The mortgage is for 30 years or 15 years. If we end up with a high inflation 5 years from now, people who locked 4.5% on their mortgages will feel very well as they will be able to earn more than that on a regular CD.
Also, we may get higher interest rates even without inflation. The long term treasury rate is already up. OK this may be temporary appetite for risk, but how long do you really believe these low rates will last? With our government borrowing like crazy and printing money.
if we end up with high inflation down the line with higher interest rates than having paid off mortgage would not seem like such a hot idea.
BTW – I am really torn on it. I am looking at various investment options – no, I have no debt and my mortgage is paid off (did it a while ago; not sure if I'd done it now) – and the question of betting on inflation or deflation is an important factor. I think if I had really known for sure the answer of whether we'll get inflation or deflation, I'd not have to work
So I am honestly interested in what you think.
June 11th, 2009 at 4:11 am
Kitty, I think the jump in bond yields has more to do with the free markets shrugging off Fed interventions in the MBS and treasury markets, pushing yields to where they should go, rather than to where Bernanke wants them to go. The game of printing dollars to buy our own debt is getting old, and bond investors are demanding greater compensation for taking risk.
While I agree that massive printing of dollars can be an inflationary force down the road, it's hard to see inflation taking hold when consumer demand is so weak, and looks to weaken further as job losses grow (even if they seem to be decelerating). The government prints dollars, but these dollars are not finding their way into the economy. Making credit available is one thing; getting people to actually borrow — and credit expansion is the root cause of inflation — is quite another.
Our collective balance sheet remains in the toilet. We are still choking on debt, and lack the income to pay for it. Credit money is being destroyed faster than the Fed can replace it. Deflation still rules.
For now, the dollar remains the world's reserve currency, even if we all know that it's toast down the road (2-4 years).
By 2012, I plan on converting all my dollars into Yen, Yuans, and Rupees.
Seriously.
June 11th, 2009 at 5:46 am
James, tell me more about how you (logistically) do this conversion…and the (tax/reporting) repercussions. I admit I'm ignorant when it comes to foreign currency stuff…Thanks.
June 11th, 2009 at 3:21 pm
JLP: As a response to your original question about the tax incentives — isn't it better to pay taxes now while they are at historically low rates, than put them into a tax-deferred 401k where in the future rates must be higher? If someone can't max out both a 401k and a Roth IRA, my bet would be to max out a Roth IRA (or the new Roth-401k) first — pay the taxes now while it is cheap.
Another reason to pay taxes now is that someone probably has more deductions while they are working, than when they will be in retirement (kids for example). Paying into a tax-deferred 401k right now kinda feels like getting an ARM loan when fixed interests rates are at 4%
June 11th, 2009 at 3:39 pm
JD: I couldn't disagree more. You have to live somewhere, so a house with a mortgage versus one without have the exact same 'risk' that you mention (house losing value). As someone else pointed out earlier, that risk is assumed when the decision to purchase the house was made.
As for cash flow problems — not having a mortgages actually frees up cash-flow (not reducing it as you seem to think).
How does paying a bank hundreds of thousands of dollars in interest, somehow make YOU rich? The financial industry has convinced the American public that we can't retire without giving them both interest payments on massive debt, plus management fees for mismanaging money in risky stock investments — the only winner here was the financial industry.
June 11th, 2009 at 4:37 pm
"If this couple had extra money that they wanted to put towards their mortgage, I could see that. But forgoing their 401(k)? That just doesn’t make sense to me."
Really? What do you know about their financial circumstances? What do you know about their 401(k) plan? What do you know about their life goals/desires? You claim that they made a decision based on emotion, but it is possible that their decision was based on evaluation of their risk tolerance (which may have changed or been misevaluated in the first instance).
The real irony in all this is that your conclusions regarding “flawed thinking” and “emotional decision” are based upon one unsupported assumption piled on top of another. Talk about the pot calling the kettle black.
@JD yes they still have asset price risk (assuming they haven’t hedged it). But what they don’t have is LEVERAGED asset price risk.
June 11th, 2009 at 5:20 pm
Don't think the thinking was flawed at all. They were guaranteeing themselves a 5 to 6% return by paying off the mortgage and will not wind up paying twice the original cost of the house or more as you do with a 30-yr mortgage.
The 401(k) contribution is only a deferred savings as some have pointed out and the value of the 401(k) is debateable, particularly for big-time savers. Many will pay more in taxes with a 401k in the long term as Scott Burns has pointed out with more than one article.
It was a rather conservative move but there is nothing wrong with being conservative. The only way it was a poor decision was if they decided to forgo a matching contribution. Otherwise, I give them a thumbs up.
As for the God part, I'll leave that to the holy rollers to debate.
June 11th, 2009 at 5:33 pm
For those interested in the marginal value of a 401(k) contribution, check out "Tax-Favored Savings Accounts: Who Gains? Who Loses?"
http://www.ncpa.org/pub/st249/
June 11th, 2009 at 5:41 pm
kitty · 14 hours ago
Rich, yes we are in a deflationary period now or at least we were until the recent jump in oil prices and long term treasury rate. How long do you think this deflationary period will last? 2 years? 5 years? Do you really believe we'll get Japan-like situation and prolonged deflation of 10 years or so?
The recent jump in oil prices is rumored to be none other than Chase Bank pumping up the oil futures market now that they've freed themselves from the TARP rules. The price of natural gas hasn't moved up in unison so it's not energy driven demand. Oil will come crashing down in a few weeks or months in my opinion.
Let's look at all the factors on the future of the US economy and please feel free to provide an alternative view point if you can:
1. Various agencies have already reported that the US budget deficit will grow from anywhere from 30% to 100% of GDP over the next few years.
2. Social Security & Medicare are in pre-insolvent stages right now.
3. A large percentage of the population (about 1/3) will either retire or will no longer be able to work. Let me spell it out: P R O D U C T I V I T Y .
4. The US Trade deficits continue to grow out of control with the help of China and Japan. Every one believes that these two countries won't ever stop buying US Treasuries but never say never.
5. There is a wide move by China, Russia, Brazil and other industrial countries to move away from the US Dollar as the reserve currency. Go to news google and type currency and read to your hearts content.
These are just some variables to consider so why is every financial adviser and pf blog like this keep telling people to do more of the same with their investments when clearly the circumstances of our economy are quickly changing. Every one keeps talking about looking at things from a rear view mirror but I'm not (see above). I'm looking at what's ahead down the road and it doesn't look pretty.
June 11th, 2009 at 5:56 pm
In JLP's defense, some assumptions can be made based on where the original posting was made — it was on the article discussing whether someone should have a 15yr or 30yr (and invest the difference). Any discussion there kinda assumes that one is young enough to even have a 30-year mortgage. Also, the wording of the posting clearly shows massive risk-aversion (at least now), as well as significant cash flow to direct extra "thousands" a month to paying off mortgage debt (versus 401k investments).
JLP makes very valid and academically accepted points against emotional investing, staying the course, gains over very long periods of time, etc
The only point I truly disagree with JLP on is that perhaps when publishing an investment strategy — instead of pointing out how much money that (potentially) could be made, point out instead: exactly where the weak (and risky) spots are. For example: the risk of having to sell stocks at a loss plus eat a 10% penalty for early 401k withdrawal — and how to hedge those risks to make an investment less risky while increasing a ROR.
Personally I'm torn between investing in equities and paying off the mortgage and it IS an emotional decision for me now (trying to rationalize both sides) — and I still don't know what I'm gonna do. I do know that inaction on my part is the wrong choice.
For the record, to clear up any assumptions about me: I'm 32, investments are 50/50 stable_value/equities and have been that way since Sept 07 (was at 100% equities before that time), and I have a 15-yr mortgage that I currently do not pay extra on (10yrs left), with a 9-month emergency fund in a 2-earner household. I have no other debt except the mortgage. I still contribute into my Roth-401k up to the company match.
I'd like to publicly thank JLP for providing us with this forum to have open and frank discussions on these topics, and also putting himself out on the line for criticism (and taking it so well
This is a great community he has pulled together.
June 11th, 2009 at 7:18 pm
Perhaps they expect to be very wealthy in retirement and in a higher tax bracket as a result. Then it could make sense. More sense than those who expect to get rich and fund a retirement account at the same time. They may be deluding themselves, but there is no shortage of that around.
June 11th, 2009 at 7:59 pm
LOL: You do have to live somewhere, but you may want to rent versus buy – sometimes renting is a better decision. As far as your other points, you are right, my examples were not the best. My main point was that every financial decision involves risk. You then choose the risk-reward option that you believe is best for you. Stocks are down now, but I do not believe they will be long term. Housing is also down now, but there will probably be an upturn in this area also. I just think in the long term stocks will outperform my mortgage expense (4.75%). If they do, then my one dollar invested in stocks will have been better spent than an extra dollar toward the mortgage. If not, then like the original poster it would have been better to pay off the mortgage. Both are financial decisions with risk.
June 12th, 2009 at 10:32 pm
Were they also forgoing an employer match? That is a pretty significant guaranteed loss if they were actually attempting to time the market. They timed the market correctly whether they planned to or not this time. In my book that makes them lucky, not good planners.
I don't know of any way of improving my luck… but do I want a good plan. I don’t see a likely scenario where prepaying my mortgage (5%) is a good plan compared to contributing to a 401K.
The 401K gives you a lot: an employer match, a tax deferment, and a rate of return that is likely to be 8% or greater over the long term. Deflation is the only possibility that comes to mind. Unless the government runs out of paper I think they will continue to print enough cash to overcome deflation and then some. If they DO run out of paper, then they will just print larger denominations!
-Rick Francis
June 14th, 2009 at 1:08 am
Rich, I am not disagreeing with what you right about the economy. But some of the factors you mention are inflationary – falling dollar for example or huge government debt. You yourself said in 2-4 years you plan to get out of dollar. Mortgage is in dollars. As the dollar falls so will the real value of your loan and your premiums. What do you think is going to happen if other countries stop buying treasuries? Wouldn't it result in interest rates going up? If your mortgage is at 5% while the bank rates go up from todays 1-2% to 6% we saw on some high yield savings just a year ago or heaven forbid the double-digit rates of the early 80s, would you still think "guaranteed 5%" is a good investment? Especially if 5% is tax deductible.
Low dollar is not necessarily bad for the stock market. There are a lot of companies that benefit from low dollar – virtually every tech company, commodity-related companies and all US exporters. My employer likes low dollar – all it needs to do then to show great profits is to convert profits from abroad. Sure high DOW is not going to be that high in purchasing power if dollar is worth little, but it'll be worth more than the mortgage at 5%.
The money you haven't invested in your mortgage you can invest elsewhere. Not necessarily in stocks and not even necessarily in 401K : you can keep them in short term CDs, for example, then as the risk of deflation lows and the risk of inflation increases, you can move them to inflation protected treasuries or commodities or foreign currencies or even stocks of companies that benefit from low dollar. Even in CDs, today the rates are low, but if you keep them short-term, you'll be able to take advantage of higher rates when they become available.
I also don't see 401K as necessarily stock investments. Most 401Ks have stable value, for example. Sure the interest there is low, but if you get company match, it is a lot of free money; if you expect lower income in retirement or plan to move to a state with smaller income tax, tax deferral is an advantage.
This doesn't mean that I agree with JLP about the particular situation. We don't know much about this family: did they have company match? how good was their employer's 401K? what is their tax bracket? could they deduct all of the interest? do they believe they'll pay higher taxes in retirement? Personal preferences are important as well and, yes, the feeling of not owing anybody money is great. I have a paid off mortgage, and yes, it feels great. But a) it wasn't a choice between 401K or mortgage for me, I simply cleared a large amount of cash from the sale of another property and paid off the whole thing b) my rate was at 7%; sure I could've refinanced, and some time I wonder if this was what I should've done, but refinancing costs money too c) this was 2003 (or 2004 – don't remember) and I was still upset at "missed opportunity" of paying off my mortgage by selling stocks in 2001, so this was partly an emotional decision. d) I was in mid- to late- 40s at the time, and I don't want mortgage when I retire.
I don't believe there is one right or wrong decision here. I think it depends on individual situation and personal preference. Only future will say which decision results in higher return.