Who Cares About Debt I Only Pay 2% on my Mortgage

That was the gist of a comment left on my post Let’s Define Debt Free (which you might have seen yesterday on my Twitter Feed).

Interesting point of view that I don’t agree with for a lot of reasons, but mostly because rates are not going to stay this low for that much longer, but even with that aside, I have never been a big fan of borrowing money to make money.

I lived through the dog days of the 90’s in the High Tech World, where our CEO attempted to rationalize how for every dollar that Nortel borrowed they made $3 back, it never really made a lot of sense to me at the time, and at the end of it, maybe I was correct in my assumption that this didn’t make any sense. I realize that most businesses do have to borrow to get on their feet, but to continuously borrow without paying off debt has always seemed rather fool-hardy to me.

Yes, I could have made a crass comment about how one "poke" from debt could deflate this balloon

Yes, I could have made a crass comment about how one “poke” from debt could deflate this balloon

Getting back to the statement of why should I pay off debt when I can make more money investing, depending on what you are investing in, how long do you think the gravy train will last? If you have a Mortgage at 4% that you are simply paying down as needed, but you are investing that extra money in the Market currently, you most likely are ahead of the game (i.e. making more than 4% back on investments), but are you sure that is going to last, and are you taking your profits?

This is my other concern, I had many colleagues and friends who were “on paper” millionaires, but never took their profits (and jumped to the wrong conclusions). Many folks did one of the following:

  • Never took out their profits, and they kept thinking that the bubble would keep growing (it didn’t).
  • Borrowed against perceived profits, using their stock as collateral for loans to either buy oversized houses or extravagant vacations, those loans were called when those stocks went bust.
  • Fiddled while Rome burned (i.e. didn’t get out because they kept thinking things would get better) (yes I was very guilty of that too).
  • Sold, took their profits, but then invested in even riskier stocks (remember Pets Inc., or Groceries to the Door?). Some of those risky stocks burned through cash and then just shuttered the windows.

These are some of the reasons I am paranoid about Debt (yes I said paranoid) and feel it is a much better “investment” to pay it down, than invest in anything else.

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The Principal is always Your Pal

Last week I wrote a very flawed post about What would Happen if Interest Rates doubled. Luckily my sharp-eyed commenters called me on it.

First point, like in school the PrinciPAL in your Mortgage is your Pal, not principle, as I originally wrote it. Someone commented how would anyone take me seriously if I was unable to discern the difference, I pointed out as the “Clown Prince of Personal Finance” respect isn’t really that high on my list.

The other major blunder I made was in my spreadsheet. Let’s have a look at my first assertion from my mortgage table. What’s wrong here:

Payment Number Principal Interest Payment Principal Payment
1 $250,000.00 -$833.33 -$486.26
2 $249,513.74 -$831.71 -$485.31
3 $249,028.43 -$830.09 -$484.37

Take a look at the PrinciPAL payment column, somehow my weird calculations have the amount you pay down on the principal each payment, decreasing, which is just SO wrong (even wronger than saying Principle of your Mortgage (in my subtle opinion)). What was wrong with me? I don’t usually screw up that many things in one article (that often).

The mistake I made was relying on the Excel PPMT() function to figure this out, instead of doing a simple calculated version on the basis of the Interest payment from IPMT()

Principal Payment = Monthly Payment – Interest Portion
Principal Payment  = $ 1319.59 –  $ 831.71 = $487.88  (for Month 2) (it got Month 1 right)

So really what this should have looked like was:

Payment Number Principal Interest Payment Principal Payment
1 $250,000.00 -$833.33 -$486.26
2 $249,513.74 -$831.71 -$487.88
3 $249,025.86 -$830.09 -$489.51

Thus the table for the end of the 5 year term would look like:

56 $220,700.69 -$735.67 -$583.92
57 $220,116.76 -$733.72 -$585.87
58 $219,530.89 -$731.77 -$587.82
59 $218,943.07 -$729.81 -$589.78
60 $218,353.29 -$727.84 -$591.75

More importantly the overpayment option now looks much better too:

Payment Number Principal Interest Payment Principal
Payment
Overpayment
37 $231,433.88 -$771.45 -$548.15 -$610.00
38 $230,275.73 -$767.59 -$552.01 -$610.00
39 $229,113.73 -$763.71 -$555.88 -$610.00
40 $227,947.85 -$759.83 -$559.77 -$610.00
41 $226,778.08 -$755.93 -$563.67 -$610.00
42 $225,604.42 -$752.01 -$567.58 -$610.00
43 $224,426.84 -$748.09 -$571.50 -$610.00
44 $223,245.34 -$744.15 -$575.44 -$610.00
45 $222,059.90 -$740.20 -$579.39 -$610.00
46 $220,870.50 -$736.24 -$583.36 -$610.00
47 $219,677.15 -$732.26 -$587.33 -$610.00
48 $218,479.81 -$728.27 -$591.33 -$610.00
49 $217,278.49 -$724.26 -$595.33 -$610.00
50 $216,073.16 -$720.24 -$599.35 -$610.00
51 $214,863.81 -$716.21 -$603.38 -$610.00
52 $213,650.43 -$712.17 -$607.42 -$610.00
53 $212,433.00 -$708.11 -$611.48 -$610.00
54 $211,211.52 -$704.04 -$615.55 -$610.00
55 $209,985.97 -$699.95 -$619.64 -$610.00
56 $208,756.33 -$695.85 -$623.74 -$610.00
57 $207,522.59 -$691.74 -$627.85 -$610.00
58 $206,284.74 -$687.62 -$631.98 -$610.00
59 $205,042.77 -$683.48 -$636.12 -$610.00
60 $203,796.65 -$679.32 -$640.27 -$610.00

Remember, it’s OK to point out my mistakes, but don’t be a comment troll about it either. Thanks to Michael James for pointing out the folly of my arithmetic.

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What If: Your Mortgage Rate Doubled ?

So while I was ruminating about what would happen if Mortgage Rates increased violently, I came up with a very interesting exercise to try out for those with mortgages that allow them to make over payments when they wish.

If I assume that current mortgage rates can be achieved at around 4% annually, using the PMT command in most spreadsheets, you can do a very quick comparison to come up with the following simple table.

Interest rates 4.00% 8.00%
Years of Mortgage 25 25
Amount of Mortgage $250,000.00 $250,000.00
Monthly Payment $1,319.59 $1,929.54

Given Canadian mortgage rules are a bit different, and interest rate calculations are not quite right, let’s just use these numbers as an interesting basis for our model.

The question is, can you afford if your mortgage rate suddenly doubled when you had to renew your mortgage? Maybe it’s time to find out if you can. From the above simple table, the difference is about $610 a month, so why not simply increase your Mortgage payment to that amount for a period of time? Maybe experiment and try it for 6 months to see whether you can live with this extra pay out, and if you can, then continue to pay this for the rest of your term, thus lowering your principal?

What might this cause? So at the end of your first five year Term your mortgage schedule for the last few payments might look like:

Payment No
Principal Interest Payment Principal Payment Overpayment
56 $224,613.20 -$748.71 -$436.88
57 $224,176.32 -$747.25 -$436.03
58 $223,740.29 -$745.80 -$435.18
59 $223,305.11 -$744.35 -$434.34
60 $222,870.77 -$742.90 -$433.49

So after five years you will have paid off about $27,000 from your mortgage, a good start, but then if interest rates have somehow jumped to 8% your monthly payment now are $600 more (ouch). (by the way I used the iPMT and pPMT spreadsheet functions for those calculations).

What would happen if at the start of year 3 of your term you started making a $610 overpayments on your loan, what might the end of your 5  year term look like?

Payment No. Principal Interest Payment Principal Payment Overpayment
37 $233,077.61 -$776.93 -$453.34 -$610.00
38 $232,014.26 -$773.38 -$451.28 -$610.00
39 $230,952.99 -$769.84 -$449.21 -$610.00
40 $229,893.77 -$766.31 -$447.15 -$610.00
41 $228,836.62 -$762.79 -$445.10 -$610.00
42 $227,781.53 -$759.27 -$443.04 -$610.00
43 $226,728.48 -$755.76 -$440.99 -$610.00
44 $225,677.49 -$752.26 -$438.95 -$610.00
45 $224,628.54 -$748.76 -$436.91 -$610.00
46 $223,581.63 -$745.27 -$434.87 -$610.00
47 $222,536.75 -$741.79 -$432.84 -$610.00
48 $221,493.91 -$738.31 -$430.81 -$610.00
49 $220,453.10 -$734.84 -$428.79 -$610.00
50 $219,414.31 -$731.38 -$426.77 -$610.00
51 $218,377.54 -$727.93 -$424.75 -$610.00
52 $217,342.79 -$724.48 -$422.74 -$610.00
53 $216,310.05 -$721.03 -$420.73 -$610.00
54 $215,279.32 -$717.60 -$418.73 -$610.00
55 $214,250.59 -$714.17 -$416.72 -$610.00
56 $213,223.87 -$710.75 -$414.73 -$610.00
57 $212,199.14 -$707.33 -$412.73 -$610.00
58 $211,176.41 -$703.92 -$410.75 -$610.00
59 $210,155.66 -$700.52 -$408.76 -$610.00
60 $209,136.90 -$697.12 -$406.78 -$610.00

Interesting, isn’t it? Now you are $13,000 farther into your principal, and when the bank comes back to figure out your new 5 year term, you end up with the following:

Interest rates 8.00%
Years of Mortgage 20
Amount of Mortgage $209,136.90
Monthly Payment $1,749.30

Your monthly payment is actually lower than it would have been, and in fact if you kept up your $1930 monthly payments, you’d still be paying off the principal of your loan by about $185 a month (more than you would normally), not a bad thing either.

Anybody thinking of trying this idea out?

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The 4% Draw Down Theory (again)

On Monday I asked about the 4% Draw Down Theory for retirement savings planning, and what readers thought, and as usual there were some very smart responses, and because of that I have come back with a better model for your perusal.

The major comment was that the model didn’t take into consideration Inflation, and that is an important thing to consider in your future. The other important thing to remember is not to retire carrying a large debt load (if any, really).

Our new model is a bit more conservative, where we only have $1M “nest egg” and assume we grow our nest egg by a generous 2%, however, this time assume an inflation rate of 3% (which is comparable to now, unfortunately). With inflation, you need to adjust your withdrawal to compensate for your shrinking spending capabilities, so you increase your yearly “allowance” by 3% (unfortunately each year).

Spoiler Alert: Note the red numbers at the bottom of the table, no you don’t make it to 25 years.

Also note that your withdrawal doubles in about 24 years following that rule of 72 as well.

Savings Amount at 65 $1,000,000.00
Savings Growth assumption after 65 2.00%
Assumed Inflation 3.00%
Initial Amount to draw every year $40,000.00
Age Amount Left Inflation Adjusted Withdrawal
65 $960,000.00 $40,000.00
66 $938,000.00 $41,200.00
67 $914,324.00 $42,436.00
68 $888,901.40 $43,709.08
69 $861,659.08 $45,020.35
70 $832,521.29 $46,370.96
71 $801,409.63 $47,762.09
72 $768,242.87 $49,194.95
73 $732,936.92 $50,670.80
74 $695,404.73 $52,190.93
75 $655,556.17 $53,756.66
76 $613,297.94 $55,369.35
77 $568,533.46 $57,030.44
78 $521,162.78 $58,741.35
79 $471,082.45 $60,503.59
80 $418,185.40 $62,318.70
81 $362,360.85 $64,188.26
82 $303,494.16 $66,113.91
83 $241,466.73 $68,097.32
84 $176,155.82 $70,140.24
85 $107,434.48 $72,244.45
86 $35,171.39 $74,411.78
87 -$40,769.32 $76,644.14
88 -$120,528.16 $78,943.46
89 -$204,250.49 $81,311.76
90 -$292,086.62 $83,751.12

{ 19 comments }

Pay Day Loan Mortgages ?

After reading about an amazing new movie that premiered in the U.S. called Sharknado (yes it is sharks inside a Tornado) I wondered what would be the most ridiculous (yet remotely plausible) financial idea I could ever think up, and I came up with a Mortgage Company but that uses Pay Day Loans methodologies.

It’s a Tornado with Sharks!

Why would you go to a Pay Day Loan place to finance your house? How should I know, the premise is the dumbest financial idea that is slightly plausible (where slightly plausible should read impossible). OK, so we go down to the BCM Shyster Loan store front and decide we want to buy our new house and get all the capital from the Pay Day Loan store, however, we really only need the money for 2 weeks (as we plan on winning the lottery by then). We have found the home of our dreams, but we need $300,000 to close the deal (luckily when we win Lotto Max that will easily cover this cost), so we wander into the BCM Shyster Loan store and ask for this loan.

Naturally the droid behind the counter is completely thrown aback by this request but goes and asks her “manager” (actually it’s her older brother Ryan, but we won’t go there), and for some reason Ryan (the manager) decides that we have an honest face, and we seem to have a credit card with a credit limit of over $400,000 (which has no balance now), so the “loan” can go through.

So after two weeks when I go back to BCM Shyster Loan store, all I need is $30,000 to pay back this loan (which I easily have from winning the Lotto Max), so the story ends happily, I have the house of my dreams, and there are no sharks in tornadoes flying around my house.

I am planning a sequel post about financing a leveraged stock option short sell using Pay Day Loans.

Any other great financial success stories like Sharknado out there?

I thought Mother F’ing Snakes on the Mother F’ing Plane was the oddest movie idea ever, I stand corrected.

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