Saturday, April 28, 2007

What is "normal" debt anyway?

Money magazine recently ran an article (May 2007 issue) "Why your planner wants you in debt" that made me think about my own recent encounter with my financial adviser. We were discussing investments and we went over our financial statements, and sometime during the conversation I mentioned that I was concerned about my outstanding debts and looked forward to dedicating a chunk of money to pay them down.

My debt consists of a small personal loan from our wedding, a small student loan, a car loan, and a mortgage. It's around $138,000 total, 90% of that the mortgage. My goal: eliminate the personal loan, then the car loan, then the student loan, then the mortgage loan.

The reason for this order is that the personal loan has the highest interest rate, 10%. The car loan the second, 7%, the student comes next at 5%. The mortgage is 8%. I decided the put the mortgage as the last priority simply because it is the largest loan and I believe eliminating all of my other debts first will give me a feeling of accomplishment. My planner disagreed. He didn't see any reason why I should pay down my mortgage or my car loan, and he called them "normal debts". What is a normal debt anyway? Any debt I have I am paying for the privilege of borrowing someone else's money. It's something I do out of necessity, not because I like owing money. If I pay my mortgage payments according to the terms of the 30 year fixed loan, I end up paying somewhere between 200-300% of the cost of the home. In other words if I had just saved up I could have bought the house in just 11 years.

Is that practical? Probably not, since I would have to be paying a rent payment as well as a house savings payment. But wouldn't it be in my best interest to pay the mortgage as quickly as possible to reduce my losses? I think so.

I don't consider any debt to be normal. It's a necessary evil, not a way of life. The Money article says

Most financial planners...say "An 8% mortgage costs you only about 6% after your interest deduction. I can do better than that in the stock market.

And it goes on to say that paying off a mortgage is guaranteed while investments are not. Good point, but I wanted to really crunch some numbers and see which one was better, just on paper. Are the financial planners right?

Using an online amortization schedule, if I pay just $50 a month extra towards my mortgage every month, I can shave 5 years off my loan. It may not sound like much, but it saves me $42,000 in interest. That's $140 a month in savings. If I put an extra $100 each month it brings it down to 21 years. Now I've saved myself $266 a month!

Now let's compare this to what will happen if I invested $50 instead. According to an online compound interest calculator if I save $50 a month for 30 years I will have $50,476.88 assuming a modest 6% return and compounded monthly. On the surface it looks like investing the money would be worth it.

But if I've paid my house off early I've got 5 years without a payment. So let's say I pay $50 into the mortgage and pay it off in 25 years, now I've got $900 a month laying around. Let's invest that ($900 plus my extra $50) for 5 years. Starting with nothing, investing the mortgage payment every month for 5 years at a modest 6% nets me $66,612.94. Subtract 5 years of higher taxes without my deduction (around $2k a year) and I'm left with $56,612.94.

If I pay myself off in just 15 years using an extra $294 a month (the same as, say, that car payment I've got) and invest after paying it off and minus my extra taxes I've got $318,973.73 as opposed to $296,804.06 if I had just invested.

My conclusion is that paying off the mortgage early and then using payment after it's paid off to invest is better than just investing from the beginning and letting the mortgage mature normally.

Maybe Money is right when they say most cases, the more money you let your planner manage, the more he earns. There is absolutely no money to be made from your thriftiness.

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