Posts Tagged ‘working capital’

Paying off the mortgage is the American Dream and the first step toward retirement; it’s harder to retire with a mortgage payment blowing a hole through a fixed budget. Owning your home is the foundation of any vibrant financial plan. Until your home is unencumbered (without a mortgage) the bank still owns it in a manner of speaking (and they’ll remind you of it if you miss a payment).

Still, a home mortgage has its benefits. The traditional reasons to carry mortgage debt are bad reasons to carry the liability, but there are still a few good reasons.

We will review the traditional reasons for borrowing against your home and why the benefit is perceived rather than real. We will finish with the three reasons a mortgage can help you build wealth.

Revolving Mortgage

The debate is legend: should I pay off the mortgage faster or invest the extra instead? I recently finished that personal debate permanently.

In Accounting 101 they teach students how leverage (borrowed money) spikes investment returns. It all makes sense.  If I pay cash for a $100,000 home and it increases in price by $3,000 the first year I managed a meager 3% return on my investment (assuming you feel your primary residence is an investment). If instead you borrowed $90,000 and only invested $10,000 of your own money, the gain jumps to 30% ($3,000 increase in value divided by the investment of $10,000).

They also teach of the risks of leverage in the classroom, but it doesn’t feel as real as the real world will make it. Leverage is wonderful animal when your assets are increasing in value. When the inevitable decline happens real pain begins.

In our above example the 30% gain is an illusion. If you have a mortgage against your home you will pay interest and that reduces the actual gain. Let’s assume a 5% interest rate on your mortgage. This equals $4,500 in interest the first year without consideration for the principle payments on each monthly payment. Your 30% gain went south darn fast, taking a $3,000 gain and turning it negative!

But if I invested the $90,000 (assuming I didn’t need a mortgage) and earned a return there I once again should be popping some mouth-watering returns. Maybe.

We’ll return to this in a moment.

Understanding how leverage can spike investment returns, I always subscribed to holding a mortgage. I bought my first home in 1986 and had a loan against it. It was paid off when the home was sold. (I’m embarrassed to say it was a mobile home, but in my defense I was single and enjoying life to the max. I was retired at the time (turned out to be gap years only) and immersing myself in an endless supply of books.)

From the mobile home I moved into a three bedroom ranch in town (1989); full mortgage in place. Opting to invest every dollar I had, the mortgage was never paid a penny sooner. Then I bought the farm (sounds morbid, doesn’t it?).

The farm is my final resting place and — embarrassed as I am to say it — was used as an ATM since 1995 when I took ownership. The farmhouse was unlivable, but I wanted a traditional barn and the 10 acres also appealed to me. I coughed up a $120,000 hairball with a $100,000 mortgage. I handled some remodeling on my own to make the farmhouse livable until I was ready to seriously remodel with an addition.

A few years later (somewhere around the year 2000) the mortgage was down to $40,000. It was time for a serious upgrade.

My 900 square foot farmhouse swelled to 3,000 square feet and cost close to $200,000 to remodel and expand. (I still swallow hard when I think of that. Not to be outdone, the bank (Farm Credit; they have awesome terms and interest rates for farmers) allowed me to borrow 80% of the value of the finished home; $400,000. That means I was able to grab another 80 grand and drop it into the market.

By 2008 the farm mortgage was under $100,000 again as I paid extra in spurts. The market tanked and good credit came to the rescue; I was able to take another quarter million. Into the market it went.

Of course I look like a hero because the timing of my remortgages coincided with market declines. This wasn’t an accident. When the market died I wanted to add to the account and the ATM was cheap money. (You can read the prior article linked above for more. The ends do NOT justify the means so the increase in investment value is a poor reason to toot my horn.)

I tell you this story for a reason. I struggled with paying off the mortgage for decades as many readers also do. I had the funds to retire the debt a long time ago, but chose to keep the mortgage anyway. Until last month.

At the beginning of this year I had whittled down the mortgage to ~$100,000. I didn’t want to sell assets/investments to pay the mortgage, causing a taxable event. Hyper-frugality set in. By June the mortgage was down to $57,000 and the sickness set in. It was time to kill the mortgage forever!

And I did it! On October 5th I made a special trip to the bank to put the final nail in the mortgage. (Mrs. Accountant came with to experience the magical moment. Either that or she didn’t trust me and was worried I might chicken out and drop it all in an index fund.)

Traditional Benefits of a Mortgage

Mortgages have been touted for a variety of reasons with promises of helping the economy, providing liquidity to the housing market and offering tax advantages to some. We’ll now run down many of the most popular traditional mortgage advantages and why it’s best to avoid the boondoggle.

 

1.) Tax Advantages. This is the most popular reason given for having a larger mortgage. Banks and other financial institutions have a vested interest (pun intended) to get you to borrow more. You know the advertisements: Mortgage interest may be tax deductible. Consult your tax professional. Rarely do people consult with their tax professional and the bank is counting on it. All people hear is mortgage interest is tax deductible.

Why this is bad advice. 

Every lie has a grain of truth to it. Mortgage interest is deductible. Unfortunately many will not benefit from the deductibility of the mortgage interest they pay because they don’t itemize. Also, paying the bank $10,000 in interest just so the IRS might give you up to $3,000 back is a really stupid move.

 

2.) You can afford more house. Yes, the more you borrow the more house you can buy. If every home was required to be purchased with cash the price of homes would drop precipitously.

Why this is bad advice.

Just because you can dig a deeper hole doesn’t mean it’s a good idea. Dig a deep enough hole and it’s called a grave.

 

3.) You can invest the difference for a higher rate of return. Fair enough. If you borrow the maximum you free up capital for other investments.

Why this is bad advice. 

This concept is fine as long as you don’t take on more house than you can afford. And you have to actually invest the difference. After 35 years in the tax profession I can count on one hand with fingers left over of people who invested money earmarked for additional mortgage payments into an investment account. Sure, some may have invested the money without a formal accounting. But my suspicion (gather from decades of experience) is that people tend not to save the money; they just increase lifestyle spending. All is fine until storm clouds appear.

 

4.) You don’t have to sell assets triggering a tax event to put more down on the house. Once again, fair enough. I used the same philosophy when paying my home off faster (fast!). Selling assets to put more down on a property can cause a serious tax issue. A larger mortgage (temporarily) makes a lot of financial sense.   

Why this is bad advice.

The larger the mortgage (the more leverage) the larger the risk something can go wrong. The investments you didn’t sell could decline in value. Selling to have a reduced mortgage means you forgo future gains on the sold investment. By keeping the asset and acquiring a larger mortgage you take on market risk while paying additional interest to boot.

 

5.) Investment gains. I hear it all the time, “The market goes up 10% a year while I’m only paying 5% interest.” It is true the market averages gains of about 10% per year on average. Some years the market increases more; other times the market gets cut in half! 

Why this is bad advice.

As we noted at the beginning of this article, leverage seems like a great idea. . . until you look under the hood. It might be easier to see with an income property.

The choice is to pay cash for the property or mortgage it to the hilt. If you mortgage the property you can invest the difference.

Let’s assume you purchase a $120,000 property for cash. If the value increases 3% the first year your net worth has increased $3,600, plus any profits from renting the property. Sound good, but the real estate agent introduced you to his banker friend and he says you can borrow $100,000. This means you can buy more properties (now you know why the agent recommended his banker) or keep the money in an index fund or other investment.

A good banker can make the numbers look compelling and this banker is gooood. You decide to borrow $100,000 for 15 years at a fixed 5%. We’ll use simple interest to keep this easy to follow. The value increased the same 3% as above (and also a common annual increase in value for real estate). The value of the property increased $3,600; the mortgage interest amounted to $5,000!

Yikes! You actually lost on the deal!

Maybe not. The property in a vacuum with the mortgage appears to have lost $1,400 the first year. Hopefully you didn’t invest in 5 more properties with the same mortgage deal because then you are hurting. The $100,000 you left invested earned, let’s say, the average 10%, or $10,000. Added together you made $8,600. It seems the mortgage was a good deal after all.

Buuuut. . .  You have to assume a good market (or a pretty good return on whatever investment you made) to justify the out-sized mortgage. If the investment under-performed, or, {gulp!} declined in value, you not only suffered a loss on the investment, the property has interest expenses in excess of the gain in value, increasing the total loss from the investment.

 

 

The above traditional advantages are not bad in and of themselves. Most people don’t decide between paying cash or a mortgage; they don’t have the money to pay cash so a mortgage is the only choice. Home ownership, especially as you begin your financial journey, almost always requires a mortgage.

Now we turn to non-traditional reasons to have a mortgage; reasons that might actually make sense.

Good Reasons to Have a Mortgage

Real, or good, reasons to have a mortgage are few. The risks of leverage are higher than most people anticipate. The odds are virtually 100% the economy will decline one or more times during the lifetime of a mortgage. Job loss or disability further add to mortgage risks. Rare is the person who doesn’t have a few times when the mortgage payment is a challenge.

All the negatives of the mortgage doesn’t mean the liability is totally worthless. There area a few reasons I can think of to have a mortgage, reasons worth their weight in gold.

 

1.) Free up capital. Leverage entails risk; no working capital can be a greater risk! If you pay cash for a property and have no working capital to deal with maintenance, insurance, property taxes or other expenses you can find yourself in just as deep as if you have a large mortgage.

Landlords should be acutely aware of this issue. Vacancies early in property ownership can cause serious financial harm. Without a mortgage the landlord should have a really good cash flow. But, you need a maintenance fund and resources to cover insurance and taxes should the property refuse to rent early in the ownership cycle.

The same can be said for those buying a primary residence. Without any emergency fund, a minor unexpected expense can create hardship.   

Solutions to potential problems. 

Up till now I’ve used the all-or-none approach. Taking out a small mortgage can free up capital to deal with any of the problems listed above.

Another very low-cost solution is a home equity line of credit (HELOC). For a couple hundred dollars you can secure a line of credit against the property. If things go well you have no additional mortgage expenses; if cash gets tight you have a resource to manage the bumps.

 

2.) Working capital. In business, investment properties and even your personal life, working capital is necessary to achieve your financial goals. Being property rich and cash poor means you have to pass on obvious opportunities for financial gain.   

Solutions.

When I bought my office building I didn’t want a mortgage. Profits are really nice when you don’t owe anyone anything. However, the seller wanted to spread his taxes out so I accepted a land contract (7 year amortization; seller allowed me to make a final lump sum in the fifth year).

But owning my office building requires ~ $200,000 of my net worth to be tied up in real estate. If an opportunity comes along I might have to pass and that would bother me. (It really would!) So I’ve always had a line of credit in my business. Originally it was attached to the building; now I have an unsecured line of credit. This allows me to smooth out the lumpiness of my business income (spring is good; year-end not so much).

I haven’t used the LOC for a few years so the only cost in $150 per year. Still, if I ever needed funds I can dip into the LOC for a very short term. This allows me to invest excess capital more quickly without fear I’ll need it before the good times return the following tax season.

 

3,) Motivation. This is the reason I wrote this post. I knew from the beginning if I ever paid off my mortgage, to be totally debt-free top to bottom, I would no longer have a financial motivation to get out of bed. And just as I predicted, I’m feeling the slump.

Financially I had the money to pay the house off decades ago without even a minor hardship. My logic was that I invested the extra money I borrowed so it was okay to keep the spur of a mortgage in my shorts.

Don’t worry too much, kind readers. I still roll out of bed around noon and put in an hour or two before calling it a day. (I’m joking, guys!)

Financial independence is different from debt-free! A mortgage always focused my attention. It helped me push my frugality (defense) while encouraging more income growth (offense). The frugal part has been good since the mortgage is gone; good habits continue on.

However, I find myself thinking more and more about how much I don’t have to do now that I’m mortgage free. I need $2,000 a month to live without a mortgage payment (a bit more during the winter heating season; a bit less in the summer). The nice thing about a mortgage is I needed lots of income to fully fund retirement accounts, add to non-qualified accounts and then pay extra on the mortgage. Without the mortgage money is no longer a driving force even on a minor scale!

 

And this is where we stop for now. My next post will deal with finding motivation when money is no longer an issue. Debt creates (or at least should) a crisis environment. As my good friend Mr. Money Mustache says, “It’s not a debt emergency; it’s a DEBT EMERGENCY!!!

I used a DEBT EMERGENCY to prod me in the past. Now I need to grow up and find motivation from other places. While debt can focus one’s attention, it is a poor way to achieve a goal! I used it way too long.

Debt is a tool with serious risks. Debt in and of itself isn’t bad, but it can create the illusion it is making things better when all it is really doing is increasing risk. We can do better than that.

Paying off my last liability has been liberating. I’m glad I did it. There are many ways to refocus attention so you can continue to create value in the world around you and in your life.

I think you’ll enjoy the answers I publish next week.

Happy Thanksgiving, American readers!

 

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