Paying Down the Mortgage or Investing for the Long Term? What Shall We Do?

As I mentioned a bit last week, we’re currently debt free except for our mortgage and a student loan with such low interest that it would be financially reckless to pay it back early. The CD in which we were keeping the money to pay for our Prius matured (it was earning a higher percentage return in a CD than we could get on a car loan, so cracking the CD early and paying a penalty just to pay cash seemed like a poor move), so we paid off the full balance of that loan and own both of our vehicles now free and clear (we paid cash for our 2004 Pilot a few months ago).

Right now, we’re sitting at a decision point. Should we start prepaying significant amounts on our mortgage or should we invest that money elsewhere? I think we’ve come to a decision, but I also thought walking through our decision-making process.

Our home mortgage sits at about 5.5%. We are looking into refinancing it at 4.75%, but we haven’t yet fully run the numbers to determine if it would actually save us any money or not because of the cost of the refinancing and because of our intent to pay it off quite early. We’re already making payments that amount to about 50% more than what we owe each month.

Our question currently is simple: should we raise those overpayments to 100% or more or should we be investing that extra money into stocks or something else?

If we increased our payments to 100% of what we currently owe each month, we would pay off our mortgage in about seven years. If we exceeded that amount, we would be paying for even fewer years than that.

We view money put into the mortgage as being an investment with a guaranteed return of 5.5%, because that’s the amount of annual interest we’ll save by knocking off some principal. If we pay $1,000 early, it’ll save us $55 in interest this year and about $57 in interest next year and so on.

On the other hand, we could invest that extra mortgage payment each month into something else. We could put it into a savings account that would earn us 1.5% or 2% or so, but it would be very liquid.

We could also invest it in the stock market. It would be very liquid there and it would also have the potential to greatly beat the 5.5% we’re making on our home loan.

Of course, “potential to greatly beat” reveals the hard truth. Stock market investing, particularly in the short term, implies quite a bit of risk. 2008 was incredibly painful, for example, as were 2000 and 2001.

The truth is that stocks only pay off as an investment over a long timeframe unless you’re banking on some luck.

So, what’s our timeframe here? Our plan after our mortgage is paid off is to buy a piece of land in the country and build a house on it (and likely a small barn as well).

If we put the money into our home, we would be completely debt free in five years, buying land a year or two after that, and building a year or two after that. Let’s figure five to ten years is our time frame.

Is that “long term” in terms of the stock market? Sadly, it’s not. As Warren Buffett so eloquently put it, “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” The simple fact is that over a period of time less than ten years, the stock market is notoriously volatile.

This becomes even more true when you consider that we won’t be investing all of it now and just waiting. Instead, we’d be investing small amounts regularly over the next several years. Large chunks of our investment would be in stocks for only a year or two.

That’s not the kind of fragile foundation we want for our next home. We’d far rather own our current house free and clear. It’s in a good location, rurally placed with great access to the Des Moines metro area, and similar houses have held their value or even gone up over the last several years. We feel, based on the evidence, that we’ll get out of it at least as much as we put into it when we sell it.

Thus, our extra money is going into our mortgage for the time being. I altered our automatic monthly mortgage payment to be 125% more than our normal monthly payment and may yet alter it again (I want to watch our monthly cash flow for a while). This leads us to paying off our house in just a few years and pushing us right towards the country home we’ve dreamed of.

Continue reading Paying Down the Mortgage or Investing for the Long Term? What Shall We Do? …

From The Simple Dollar.

What’s Coming Next?

Fifteen years ago, I didn’t believe I had the financial resources to go to college. Instead, I spent my time thinking about a future where I took a few classes at a local community college and worked at a local factory.

Ten years ago, I was a college student. I was working towards a degree in computer science and had dreams of working at Microsoft.

Seven years ago, I was working in a genetics research lab. I was single, living in an apartment, didn’t own a vehicle, and couldn’t imagine being married.

Five years ago, I was working for a nonprofit organization. I was married, living in a different apartment in a different city, and couldn’t imagine having a child. I also couldn’t imagine being debt free.

Three years ago, I had a child. I was also near debt freedom. I was spending most of my spare time writing, but I couldn’t imagine a situation where I would be able to make a full time career out of it. I also couldn’t imagine being able to manage more than one child or live anywhere other than the little apartment we were living in.

Eighteen months ago, I had become a full time writer. I had a second child. We had moved into a house. At that point, I couldn’t imagine writing a book, editing it appropriately, and getting it published – it seemed like an unimaginably huge endeavor. I also couldn’t conceive that we would have a third child, as two seemed to keep our hands full.

Today, I have a book already in print, a second book that’s finished and due out in a few months, and a third child due in just a couple of months.

What can’t I imagine happening next?

Here’s the truth: an awful lot of lives go through the same progression as my own. Not in the sense of the specific things that change, but in that the specifics of their life change so drastically in even a few years. And we don’t see it coming, either.

At each of those times above, I thought my future would go on more or less the same way that it was going right then. I was repeatedly wrong.

The best thing you can do with your money and with your skills is prepare for change. Why? Because things will change.

You’ll lose a job. You’ll change careers. You’ll find a partner. You’ll have a child. You’ll move to another state. You’ll find a new passion. You’ll get sick. You’ll get well. People will leave your life. People will enter your life.

Things will change.

It’s this simple fact of life that leads me towards believing that the best personal finance tool that people can have is a big, fat emergency fund.

With a nice, healthy cash reserve in hand, a person can roll through these changes with ease. A job loss doesn’t mean an apocalyptic disaster in your life. A choice to try a new career becomes exciting and fun instead of scary. Falling in love and moving across the country becomes a whirlwind adventure instead of an exercise in tightrope walking. Opportunities spring up and you can take advantage of them instead of having to run away in fear.

Never, ever let debts and a lack of money on hand keep you from jumping on board with your dreams when the chance comes along. You have the power, right now, to get things under control, eliminate that debt, pick up some new skills, and be ready for the inevitable changes that will come your way.

When that chance comes, you’ll be ready.

Continue reading What’s Coming Next? …

From The Simple Dollar.

Does a Credit Score Matter to Someone Living a Debt-Free Lifestyle?

Mary writes in:

My husband and I have been debt free for seven years. Hooray! We cancelled all of our credit cards in 2001 and paid off our home mortgage in 2002.

A few weeks ago, our homeowners insurance premium went up substantially. I called our agent to ask why and he told me that our premium was automatically raised because our credit score was low.

I got worried and checked our credit report at annualcreditreport.com (as you suggested before) and found nothing at all on our credit report. So, I called our agent back and told him the story. He did some follow-up and found that because we didn’t have any outstanding credit of any kind on our credit report, they couldn’t verify that we were responsible payers, thus we were placed into a higher risk category.

This seems nonsensical! I am shopping around for new insurance but I wanted to know what you thought of this policy.

Obviously, on an individual level, this is nonsensical. A person with no debt at all and a long history of never having debt is the type of person that ought to be considered a great client for an insurance company. I can’t think of anything that screams “stable and reliable” than a person without any debt.

Yet, if you step back and look at the broader view of society, this policy does somewhat make sense.

First of all, the insurance company has to have standard rules and practices for setting their rates. They have to know cold the risks associated with different factors, from the color of the car to the reliability of the driver. When they know these risks, then they can calculate the exact rate to charge to simultaneously be competitive with other companies and earn a profit for themselves.

Hand in hand with that is a society that lives and thrives on personal debt. Between automobile loans, student loans, consumer loans, mortgages, and credit card debt, the vast majority of Americans possess some form of debt in their lives. Given that as a baseline, it’s reasonable to argue that a person who pays their debts in a timely fashion is more reliable – and thus less of a risk – than a person who does not.

That information is packaged up nicely in our credit reports and usually calculated down to a single number that represents how efficient we are at paying our debts – our credit score. Insurance companies will often take this score and run with it, using it as a basis for determining our premiums.

Unfortunately, a person’s credit score is higher if they have small, reasonable debts and always make their payments instead of having no debt at all.

The next question, obviously, is how can a debt-free person improve their credit score without getting into additional debt? There is no easy answer to that question.

The simplest solution is to simply use credit for the most routine of purchases – groceries, gas, and so forth – and to pay off that debt in full each and every month. One way to do this – to keep things under control – is to simply get a credit card at your preferred gas station, use that card just to fill up on gas and nothing else, and then pay off the card each month. So, for example, you might have a BP card, and you would only use that card at BP.

A second option would be to stop by your local credit union and talk to a loan officer. They may be able to develop some form of no-risk personal loan for you based on using some of the assets you have as collateral. You then just leave the money at the credit union in an account and have all payments for your loan deducted from that account. If you have such assets, the actual cost of this would be minimal.

Yes, society has stacked the deck a bit against people with no debt, as there are many financial incentives to carry debt. With a little clever thinking, though, such risks can be pushed back.

Continue reading Does a Credit Score Matter to Someone Living a Debt-Free Lifestyle? …

From The Simple Dollar.

Consumption Smoothing and Why It Doesn’t Work

When I was a young professional, my income was relatively low – substantially lower than it was even five years later. I knew that over time, my income would go up; my career path offered lots of opportunities for growing one’s wage and I was dedicated to my career.

So, like many young professionals, I justified a lot of overspending with the excuse that I would be earning a lot more in the future and could make up for my spending then.

This is a well-known economic concept called consumption smoothing. In a nutshell, Consumption smoothing means balancing out spending and saving to maintain the highest possible standard of living over the course of one’s life.

The big reason in favor of consumption smoothing is that it in theory balances between the two extremes. On one end, overspending means that you consistently spend more than you earn, while oversaving means that you consistently spend less than you earn.

My argument, early on, was that I should overspend while I was a young professional and that I would spend less than I earned later on when I was earning more. This would allow me to have the same quality of living now that I would have later.

There’s a big problem with all of this, though: life happens. Seven years ago, I was unmarried. Five years ago, I was childless – my wife wasn’t even pregnant yet. Three years ago, I lived in a tiny apartment. Two years ago, I had a full time job with a large organization. Heck, three months ago we didn’t know we had a third child on the way.

Beyond that, I’ve watched my friends pretty much stumble onto successful dot-coms. I’ve watched other friends come down with life-altering illnesses. I’ve watched friends fall in love. I’ve watched friends get divorced. I’ve watched friends discover children they didn’t know they had.

Consumption smoothing only works if you can exactly predict the way your life will go. And you can’t. Life is too unpredictable for that.

My philosophy is much simpler: just consistently spend less than you earn and save the difference. If you’re early in your career and not earning much, these should be your salad years. When your life changes – you’re earning more and you have more responsibilities – spend more.

Spending less than you earn and saving the difference provides a much more important kind of smoothing, what I’d like to call “risk smoothing.” If you have money in the bank, it’s a lot easier to take a risk and start a new business. If you have money in the bank, you are much more likely to roll through personal crises.

This isn’t a call to “oversave” – that’s unhealthy. Just consistently save some percentage of what you earn – you can figure out what works in your own life. Then, when you need it to take advantage of the great opportunities life hands you or to deal with the problems that come up, it’s there for you.

Or, you can sit at home with your 72″ television while lamenting the fact that you missed out on the opportunity of your dreams.

Continue reading Consumption Smoothing and Why It Doesn’t Work …

From The Simple Dollar.