A financial epiphany

[glockmail]

I reckon I'm pretty smart about technical matters, and know as much as anyone about interest rates and basic finances, but I also know what I don't know. My dad is an engineer also and way smarter than me and I've seen him make some poor financial decisions. Because of that my wife and I have had a fee only financial advisor working with me for coming on 15 years, and he's really helped us with retirement planning, taxes and the like. I've taken his advice on nearly everything except real estate.

When we first started working with him he was adamant that we buy a bigger house. "It's a hedge against inflation." The reason is that he has a formula, basic percentages of the optimum balance of your portfolio, depending on income, aversion to risk, and other factors. We only took his advice partially- instead of a larger home we built a second, vacation home about two hours away. My 'cabin in the mountains" has been much more enjoyable than living in some McMansion somewhere, so much so that we're looking to retire there as soon as possible. (The technical advisor to his association is Burt Whitehead, and he's written some easy-reading books for us lay folk.)

The other thing that we haven't been ready to accept is the value of keeping a mortgage after you retire. Shouldn't the goal be to own your home outright so you're not paying the bank monthly?

I understood the "hedge" part of the equation quite well. During times of inflation, real estate values increase, much more so that the interest rate on savings. What I didn't understand was the value of a mortgage as the real hedge against inflation.

Two weeks ago it finally hit me. If the value of the dollar goes into the toilet, my cash savings is worthless, but so is the value of my mortgage. I can simply use the cash to pay back the loan.

Therefore it is financially wise to have more debt than cash, CDs, savings, or other similar investments.

[Drummond]

I reckon I'm pretty smart about technical matters, and know as much as anyone about interest rates and basic finances, but I also know what I don't know. My dad is an engineer also and way smarter than me and I've seen him make some poor financial decisions. Because of that my wife and I have had a fee only financial advisor working with me for coming on 15 years, and he's really helped us with retirement planning, taxes and the like. I've taken his advice on nearly everything except real estate.

When we first started working with him he was adamant that we buy a bigger house. "It's a hedge against inflation." The reason is that he has a formula, basic percentages of the optimum balance of your portfolio, depending on income, aversion to risk, and other factors. We only took his advice partially- instead of a larger home we built a second, vacation home about two hours away. My 'cabin in the mountains" has been much more enjoyable than living in some McMansion somewhere, so much so that we're looking to retire there as soon as possible. (The technical advisor to his association is Burt Whitehead, and he's written some easy-reading books for us lay folk.)

The other thing that we haven't been ready to accept is the value of keeping a mortgage after you retire. Shouldn't the goal be to own your home outright so you're not paying the bank monthly?

I understood the "hedge" part of the equation quite well. During times of inflation, real estate values increase, much more so that the interest rate on savings. What I didn't understand was the value of a mortgage as the real hedge against inflation.

Two weeks ago it finally hit me. If the value of the dollar goes into the toilet, my cash savings is worthless, but so is the value of my mortgage. I can simply use the cash to pay back the loan.

Therefore it is financially wise to have more debt than cash, CDs, savings, or other similar investments.

CAN the dollar 'go into the toilet' .. ? I have my doubts. Consider the Fannie & Freddie problem back in 2008 .. and the dire financial crisis that just THAT sparked off. The dollar is into so very much in the global market, that it seems to me that nobody DARES see it fail. If the dollar fails, that'd be way, way more major than anything we've seen. This planet's entire financial system would go into meltdown.

Possessions would then become all-important.

[fj1200]

Therefore it is financially wise to have more debt than cash, CDs, savings, or other similar investments.

Not sure I agree with that. Certainly Dave Ramsey would not. If you have more "house" than you need then you are paying more in taxes, more in insurance, more in maintenance, more in interest than you would have otherwise. You are also tying up net worth in a sector (real estate) that typically under performs other asset sectors (equities) not to mention paying more in interest on a mortgage than you would be earning in interest on savings, CDs, etc.

It doesn't seem to make sense if your bailout plan is to pay off a "worthless" mortgage with "worthless" dollars. I don't think the historical rates of real estate appreciation make up for the downsides.


U.S. Census data
The price of new homes increased by 5.4% annually from 1963 to 2008, on average. (U.S. Census (http://www.census.gov/const/uspriceann.pdf), PDF) New homes aren't the best yardstick -- we'd really prefer to see sales of existing homes. But if new homes are all the U.S. Census gives us, then that's all we have to go on.First, let's account for the fact that the average new home size exploded from 983 s.f. to 2349 s.f. from 1950-2004, or about 1.6% per year on average. (NPR (http://www.npr.org/templates/story/story.php?storyId=5525283)) So a big chunk of the increase isn't inflation, it's that bigger homes cost more money. O nce we factor that in, the price of new homes per square foot went up by only 4.2% annually from 1963 to 2008.
And now let's compare that rate to the general rate of inflation, which was 4.4% for the same period. (CPI, BLS (http://data.bls.gov/cgi-bin/cpicalc.pl)) As predicted earlier, the rate of real estate inflation and the general rate of inflation are almost identical.
National Association of Realtors
The price of existing homes increased by 5.4% annually from 1968 to 2009, on average. (Natl. Assoc. of Realtors, p.1 (http://www.realestateabc.com/graphs/natlmedian.htm), p.2 (http://www.realtor.org/research/research/ehsdata)) Notice that this is the same figure as new homes by the Census Bureau for a similar period. Once we adjust for the fact that homes get bigger over time, the annual rate is 3.7%. The general rate of inflation during this time was 4.5%. So here again, homes didn't appreciate faster than inflation.Case-Schiller Index
The price of existing homes increased by 3.4% annually from 1987 to 2009, on average. (Wikipedia (http://en.wikipedia.org/wiki/Case-Shiller_home_price_index)) We don't adjust for houses getting bigger, because the Case-Schiller Index tracks repeat sales of the same homes. (They might get a little bigger from remodeling, but so few of them will get bigger, and by such a small amount, that we can safely ignore that.) The general rate of inflation during this time was 2.9%. So again, the appreciation rate for homes was very similar to the general inflation rate.
http://michaelbluejay.com/house/appreciation.html

That's not to say it isn't nice to have a cabin in the woods. :)

[glockmail]

Not sure I agree with that. Certainly Dave Ramsey would not. If you have more "house" than you need then you are paying more in taxes, more in insurance, more in maintenance, more in interest than you would have otherwise. You are also tying up net worth in a sector (real estate) that typically under performs other asset sectors (equities) not to mention paying more in interest on a mortgage than you would be earning in interest on savings, CDs, etc.

It doesn't seem to make sense if your bailout plan is to pay off a "worthless" mortgage with "worthless" dollars. I don't think the historical rates of real estate appreciation make up for the downsides.


http://michaelbluejay.com/house/appreciation.html

That's not to say it isn't nice to have a cabin in the woods. :)I don't advocate owning more house than you need, just a benefit of keeping it mortgaged.

[tailfins]

If you want a more expensive house without additional space to maintain, why not move to a more expensive zip code?

[glockmail]

What?

[fj1200]

I don't advocate owning more house than you need, just a benefit of keeping it mortgaged.

Your FA advocates owning more house than you need. Nevertheless I don't see the benefit of keeping it mortgaged if your intent is to pay off "a worthless mortgages with worthless dollars." You're also paying more in interest than you'll earn vs cash and missing out on the opportunity costs of holding cash. Unless your leveraging your mortgage to invest in higher earning instruments, i.e. equities, which is a different discussion and should include a risk calculation.

[glockmail]

Your FA advocates owning more house than you need. Nevertheless I don't see the benefit of keeping it mortgaged if your intent is to pay off "a worthless mortgages with worthless dollars." You're also paying more in interest than you'll earn vs cash and missing out on the opportunity costs of holding cash. Unless your leveraging your mortgage to invest in higher earning instruments, i.e. equities, which is a different discussion and should include a risk calculation.

Yes he did, and as I stated earlier I disagreed with that, and instead bought a vacation home that we use all the time.

I'm not sure why you don't see the advantage in paying off a mortgage with useless dollars. If you did you would no longer have a mortgage. You would then able to get a new mortgage and take a much larger amount of cash out.

With regards to cash in your portfolio, you should only have enough to act as a 'cushion' of several months expenses, in case you lose your job, had some kind of emergency, etc. Anything over that amount you should invest into other areas of your portfolio, hopefully some that grow faster than the mortgage interest rate that you are carrying.

There are also ways to reduce the impact of low interest savings accounts in your "cushion". Several years ago I took half of it and purchased four (relatively) high yield CDs that had a penalty clause if withdrawn prior to a one-year term. The idea being that if I needed them, I would withdraw the first one after I went through my savings, then one at a time to reduce the overall penalty. The interest rates of these certificates grows a certain amount for every year that I leave them alone, and over time that rate has approached the rate that I pay on my mortgages.

Once I retire I'll sell my main house, pay off that mortgage and move to the mountains. I'll continue to need a cash cushion, so I will maintain mortgage debt on my cabin as a hedge against hyper-inflation. As the mortgage gets paid down I'll take out no closing cost home equity loans, probably to finance cars, that basically do the same thing.

[fj1200]

Yes he did, and as I stated earlier I disagreed with that, and instead bought a vacation home that we use all the time.

I'm not sure why you don't see the advantage in paying off a mortgage with useless dollars. If you did you would no longer have a mortgage. You would then able to get a new mortgage and take a much larger amount of cash out.

With regards to cash in your portfolio, you should only have enough to act as a 'cushion' of several months expenses, in case you lose your job, had some kind of emergency, etc. Anything over that amount you should invest into other areas of your portfolio, hopefully some that grow faster than the mortgage interest rate that you are carrying.

There are also ways to reduce the impact of low interest savings accounts in your "cushion". Several years ago I took half of it and purchased four (relatively) high yield CDs that had a penalty clause if withdrawn prior to a one-year term. The idea being that if I needed them, I would withdraw the first one after I went through my savings, then one at a time to reduce the overall penalty. The interest rates of these certificates grows a certain amount for every year that I leave them alone, and over time that rate has approached the rate that I pay on my mortgages.

Once I retire I'll sell my main house, pay off that mortgage and move to the mountains. I'll continue to need a cash cushion, so I will maintain mortgage debt on my cabin as a hedge against hyper-inflation. As the mortgage gets paid down I'll take out no closing cost home equity loans, probably to finance cars, that basically do the same thing.

I don't see the advantage of carrying a mortgage if you have "useless dollars" in the first place especially when it's costing you more than you earn in interest. I just don't buy the hedge argument.

[glockmail]

I don't see the advantage of carrying a mortgage if you have "useless dollars" in the first place especially when it's costing you more than you earn in interest. I just don't buy the hedge argument.

Your dollars aren't useless in the first place. In this scenario they start off usefull, then due to high inflation become useless over time.

[fj1200]

Your dollars aren't useless in the first place. In this scenario they start off usefull, then due to high inflation become useless over time.

They're not living up to their full usefulness if they're earning you less than you're paying on debt. Considering the scenario you're planning for has happened once since WWII it doesn't seem worth the trouble. Debt adds a level of risk that does most people more harm than good; finance is more behavioral than head knowledge.

[glockmail]

Debt adds a level of risk that does most people more harm than good; finance is more behavioral than head knowledge. A home mortgage has to be the least risky debt one could do. It is very difficult for a bank to repossess a home.

[fj1200]

A home mortgage has to be the least risky debt one could do. It is very difficult for a bank to repossess a home.

It likely has the lowest interest rate but the bank has a direct lien on the property.

[glockmail]

It likely has the lowest interest rate but the bank has a direct lien on the property.

HUD requirements make it very difficult to foreclose on a mortgage for a primary residence. The process takes months, and by law the bank has to give back what's left of your equity. It's not at all like a secured loan like, say, a car loan where they can tow your car away a month after your last payment that you missed.

[fj1200]

HUD requirements make it very difficult to foreclose on a mortgage for a primary residence. The process takes months, and by law the bank has to give back what's left of your equity. It's not at all like a secured loan like, say, a car loan where they can tow your car away a month after your last payment that you missed.

It is exactly like a secured loan because it's a loan secured by an asset and foreclosure proceedings are done according to state law. It is well nigh impossible for a bank to foreclose on a home that is not encumbered by a mortgage. Of course this is not relevant to the question of the "wisdom" of holding a mortgage in the first place.