“Dear Steve,
I’m struggling with whether to get debt free as fast as I can or use the equity in my home and invest. I’m in the process of refinancing and cashing out $40K. I don’t have any liquid savings. I do have a little in 401K. I’m in my mid 40’s. Some say get out of debt but other’s like Ric Edelman says to carry big long mortgages. I’m confused.
Is it better to get debt free then think about investing or invest now?
Thanks for your help. So many different views out there.
Carolyn”
Dear Carolyn,
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Nice to see my buddy Ric mentioned. I’ve never been a big fan of the big mortgage approach. I understand his logic and the math on that (borrow at low rates and invest the cash for higher rates) but for me there are things which are more valuable that the spread on borrowed money and investment. There is a tremendous emotional value to not having a mortgage at all or having a small mortgage.
This does not have to be an all or nothing approach. If it was a perfect world I’d rather see you not refinance and instead focus on taking your extra money each month and use half for debt reduction and the other half for putting away each month. With that half put half of that into a boring old savings account and the other half in investments. So of the 100% of the extra money you have each month, 50% used for debt reduction, 25% savings account, and 25% investments. You can use the debt snowball method to get out of debt faster.
I’m a fan of keeping the mortgage as low as possible so that in the event of an unexpected situation you do not wind up in a position where you can’t afford your big mortgage payment. This past unexpected economic downturn has been a great example of that.
If you look at the massive foreclosure rates you will find many people that had maxed out their mortgage in recent boom times only to lose their homes to foreclosure now when their income dropped or job was lost and they could no longer afford the big mortgage.
Think about it like this, a person with no mortgage can never lose their house to foreclosure.
I really hate to confuse you with an exact opposite position here but even though Ric is a friend, I just don’t agree with his approach.
Best advice would be if you don’t have an emergency account the last thing you should do is lock yourself into the liability of a home. Not the mortgage but the maintenance. That’s a big problem. if you can’t save for a down payment and an emergency account, how in the world will you deal with an unexpected home related issue. In my opinion if you can do both you are then ready to buy a house. But the problem with Ric’s advice is it ignores amortization schedules. They are not very friendly to the person taking out a loan. Particularly since most loans never fully amortize. That is a big flaw in his argument from an investment standpoint. For most people Ric’s adive is a losing proposition given that after 15 years in a 30 yr mortgage you still have 75% of principle to pay. In that 15 years you will NEVER make that kind of return you paid in interest vs your small principle. It does work however if you are very well off or have a paid for home. Example is take out a 200k mortgage. All the cash is now in your pocket. If you immediately put 1/2 or more towards the mortgage you have really scewed the amortization schedule and could actually beat the return from an investment standpoint without taking undue risk. In a perfect world Ric’s advice works, but it’s not a perfect world, loans for the most part never fully amortize and if in the end taking a big mortgage is simply a hedge for disater #1 you will default and that is breaking a contract and #2 you just shouldn’t being buying a house at all.
Ed and Steve,
I too am a mortgage originator. I recently got a letter from a client that I advised 2 years ago to not put all of the 200k she had gotten from the sale of her home down on her new home. When I did a review of her situation when doing her mortgage for her she had no emergency savings.
Thankfully she listened to my advice and put 50k of the 200k aside in savings. The letter she just wrote to me was to thank me since she just lost her job and would not be able to afford to pay her mortgage or anything else without her savings.
Rick
Rick,
Thanks for sharing this with us. Great example.
Steve
Rick,
That is what its all about. Great job. Again… Having your home fully paid for is of little consulation when you lose your job and still need to put food on the table, pay medical bills, put gas in the car, pay the property taxes and home insurance and maintenence and utilites on the house.
Ed
.-= Ed Conarchy´s last blog ..Must See Video Before You Have Your Taxes Prepared =-.
Steve,
Unfortunately that is just one of the sad stories I have personally witnessed over the last 2 years.
Yes, we can only give advice and hope they take it.
Think about this. Who is the Government helping? People who have mortgages, allowing then to modify them if they are behind. Problem is if you do not have a mortgage because you paid it off using a 15 year fixed and now have hit hard times, you are out of luck. you cannot have your mortgage modified if you do not have one.
Ed
Steve,
Yes, I agree! 🙂
We do agree more than disagree and we both care for what is best for the person we are trying to help. That is the most important point. Caring about the outcome for that person we are trying to help and advise. i will indded register and look foward to help.
Ed
.-= Ed Conarchy´s last blog ..Happy Holidays! Ed Has a Gift For You =-.
Ed,
When I used your example for my Dave Ramsey Twitter friend to see the dangers of the 15 year mortgage. Here was his response.
I guess all we can do is offer an opinion and let people decide their fate for themselves.
Steve
Hi Steve,
The comment section was closed so here is the answer to your question of someone getting into trouble handling their money emotionally.
This is a real life example/person. This is not hypothetical. It is important to note I have helped and continue to manage mortgages for over 2500 clients. So we see real life events shape their lives and follow them year by year to make sure their plan it is working for them over the long haul. We just do not give advice and move on. Success is a journey!
So, I have a client that was referred to me by a current client of mine. They are co-workers. This new client bought a home and put 40% down to get a small mortgage and took on a 15 year fixed to get rid of the mortgage as fast as possible. As he admits he was emotionally attached to the concept of getting rid of the mortgage as fast as he could. “How great he would feel the day he paid off his mortgage in full.”
But on his way to paying off the mortgage, life happened. He experienced the downturn in the economy and his hours where cut in half and therefore his pay was cut in half. He works in the automobile industry for a car dealership. So now the payment that was high to eliminate the mortgage fast was suffocating him. He could not afford it anymore. And because he put so much money down when he bought his home and was sinking all his discretionary money into the 15 year mortgage payments all his money was tied up into his home. So he was refereed to us by his co-worker to refinance to a 30 year fixed to get his payments down and maybe even get some money out. Makes sense right?
HERE IS THE MOST IMPORTANT POINT I SEE MOST CONSUMERS FORGET: A MORTGAGE IS NOT A LOAN AGAINST YOUR HOME, IT IS A LOAN AGAINST YOUR INCOME. And that is where it was really bad for his situation. With the 50% drop in his income he did not qualify for a mortgage now, not even a lower payment/lower rate 30 mortgage. It was a sad sight to see his face when I told him that. So what is his only option to avoid foreclosure and losing all the money he has and worked so hard for. To sell his home. But here is the other problem, the market to sell is terrible as you well know. In fact, in his subdivision there are so many homes on the market that are not selling that is not an option either. So either he takes a huge lose on the home to sell it and bring money to closing or misses 3 mortgage payments and will lose the home and all his money in it to foreclosure as well. Either way he is or will lose all the money he worked so hard for.
This all would have been avoided if he were to have just put 20% down and done a 30 year fixed mortgage. Focusing more on financial contingency plans and having rainy day funds vs. just focusing on emotionally being debt free.
I hope this shows my very deep concern for homeowners just focused on emotionally eliminating there mortgage at all cost. Even Carolyn sees the value of liquid cash for emergencies. See that is a financial decision she made there, not an emotional one. “Proper financial planning plans for the worst and hopes for the best” not the other way around. That only creates major problems like the example above.
Happy Holiday!
Thanks, Ed
Ed,
Well there is something we might agree in. I’m not a fan of locking oneself into a 15 year mortgage and getting trapped. I’d much rather see people go for the 30 and pay it off like a 15. That way if life happens they can drop back a bit.
You know, I’m not an all or nothing guy. Even when people are getting out of debt I like to see some amount of saving and investing. It might be just putting some money into an emergency fund and participating in the employer sponsored 401(k) program but it is something.
The point I was trying to get to is in every financial investment there is an emotional component that needs to be considered. And while that emotional component has a financial impact I would suggest that it also has a financial value as well.
Not everybody is made the same. For some, the emotional satisfaction of having less of a secured obligation like a mortgage, that gives that person more freedom in life than worry about the monthly nut. It may have significant value in less work, less stress, greater happiness, more satisfaction with life.
Actually a mortgage is a loan against future labor. The more you obligate yourself for the loan the more future labor you are pledging to repay. That is of course assuming that your income comes from working at a job. There is an excellent book on the subject that you may have read. It’s called Your Money or Your Life: 9 Steps to Transforming Your Relationship with Money and Achieving Financial Independence: Revised and Updated for the 21st Century.
I agree the guy in your example found himself in a bad spot. He somewhat took the Dave Ramsey approach of all debt is bad and boxed himself into a corner. Funny, I was having a lively discussion on Twitter just yesterday with a Dave Ramsey fan about the very same issue.
At the end of the day Ed, I think we agree more than we disagree on this and the good news is that we were able to help Carolyn find an answer to her situation that work for her with a balance of financial wisdom and emotional insight.
If you get a chance, register in the forum section of the site and offer up your advice. People can benefit from what you have to say.
Steve
Carolyn,
I am happy to hear that you see the financial value in having liguid cash. This is not my website so I will not ramble on. But be careful of handling your money emotionally. I have seen so many people get in trouble doing that. I advise my clients to handle their money financaially, not emotionally.
Ed
.-= Ed Conarchy´s last blog ..New IRS ruling on the Homebuyer Tax Credit =-.
Ed,
Are you suggesting that important life decisions should not involve any emotional component or consideration?
Can you give me an example of how someone got into trouble as you mentioned.
Steve
Thanks for all the responses. I really appreciate them. I’m actually relieved that I did a cash out refi simply for the fact that I now have some liquid cash for emergencies. Like Ed said, I would be in trouble if I lost my job without any liquid cash. Steve, thanks for pointing out that debt reduction/wealth building doesn’t have to be an all or nothing approach. I am still weighing my options but I am likely going to take your advice. Up until this point, I was only considering the numbers and ignoring the emotional value of not having a mortgage.
I currently have 2 mortgages; one on my primary home and one for a small investment property. I am going to concentrate on paying off the investment property mortgage first. It has a smaller balance and a higher interest rate. If anyone sees this as a bad approach, please feel free to let me know why.
Steve, thanks for offering this free service! It helps me to keep the faith that there are good people in this world who truly do want to help others without expecting anything in return.
Gratefully,
Carolyn
Steve,
Yes, I totally agree that Carolyn should not take 40k out to invest.
But she said one thing that makes me really nervous for her: she has no liquid savings. And I am assuming she still has a mortgage when she says she is refinancing. So if Carolyn loses her job tomorrow, how does she get by with no liquid money? Probably liquidate her 401k she mentions and that would be disastrous after penalties and taxes she could lose up to 50% of the value that’s in her 401k.
Not having a mortgage is not a bad thing. The danger point for consumers is when they are on their way to getting rid of that mortgage and having a life event happen before the mortgage is completely paid off. Not having money to get through that life event and therefore losing it all. It is a Catch 22. Once you are there, no mortgage, it is great. It is the risks of not having liquid money to back you up on your pursuit to getting there that I am worried about for most consumers.
Ed
.-= Ed Conarchy´s last blog ..Vital Info about Mortgage Escrow Accounts =-.
Hi Steve,
I am a big fan of Rics. Ric is #1 focused on liquidity when it comes to carrying a mortgage. He would NEVER condone anyone to invest until they have maxed out 401k/IRA contributions, paid off all high interest/non-tax-deductible debt, and have a 12 month fixed expense liquid cash rainy day fund. So I think when you say Ric is saying borrow at low mortgage rates and invest that money, it is very inaccurate.
Having money liquid and available in case something happens is the main reason he is saying carry a big mortgage. Being a mortgage advisor for 19yrs I have seen the other side, especially during this recent downturn. Wonderful well-intentioned people that have paid down their mortgages over the years and now have small or no mortgages and a lot of equity. But they cannot get at it since they have lost their jobs. As Ric says “A mortgage is not a loan against your home; but a loan against your income.” If you do not have income (verifiable, stable and consistent) you will not be able to get a mortgage or a Home Equity loan. Therefore one would be forced to sell their home to get at the equity to make ends meet and get them through their current financial crisis. We all know how hard or impossible selling a home is in this environment.
Ric also has another great saying: Having your home fully paid for is little consolation when you lose your job and still need to put food on the table, put gas in the car, pay for prescriptions, pay the home’s utilities, pay the home’s property taxes and homeowners insurance. See getting rid of the mortgage payment only gets rid of the P&I payment, property taxes and homeowners insurance are still there and always will be there.
That leads me to one final point you made about not being foreclosed on if you have no mortgage. That sounds great, but we have all forgotten about one thing in that example: Property Taxes. See if we do not pay the property taxes we will lose our home and all the equity that is in the home will be gone as well.
Just wanted to clarify and show everyone the other side of the coin.
Ed
Ed,
True, without a mortgage there are still obligations. But I’ve had no mortgage and I have to tell you it feels GREAT! I would much rather be on the hook for $2,000 a year in property taxes than $3,000 a month in a mortgage payment.
Tapping equity at a time when times are rough just isn’t a long term solution for many. It only prolongs the underlying issue, not solve them.
I think if you go back and look at Carolyn’s situation you might agree that tapping the equity to invest, as she wanted, was not the right course of action.
Steve