I'm a big fan of debt-free living. Probably too big of a fan, actually. I know of at least one financial error I've made because of a general abhorrence of debt (can anyone say HPSP?) At this point in our lives we only have two debts. One is on an investment property (our last house.) I owe $91K at 5.3% (3.3% after tax) on that property. We refinanced into a 20 year loan when we moved out and we've been paying on that for a little over 4 years. We pay $300 a month extra on it, so we're probably 8 years away from paying it off if we held on to it. We probably won't have it paid off before we sell it. [Update prior to publication: It's now on the market.] Obviously, upon selling it, that debt will be gone. After transaction costs, we'll probably get $20-30K out of it and will need to decide at that point whether to put it toward our current mortgage or invest it.
We are 29 months into a 2.75% 15 year mortgage fixed mortgage on our residence. At this point, our loan to value is about 50% on the property. The payment is very affordable on our income, but it bothers me to have it. I would be making extra payments on it to get rid of it sooner if it wasn't so darn cheap. I mean, our marginal tax rate is 38% this year and the interest is completely deductible to us. So our after-tax rate is 1.7%. Given current inflation of ~ 2% right now, the mortgage is better than free on a mathematical basis. But it still bothers me for a few reasons, not all of which are completely logical.
Why I Want To Be Debt Free
First, I feel like I need to make hay while the sun shines. I still can't believe I get paid what I do to practice medicine. There are many pressures on physician incomes, and it would not surprise me to see my income decrease dramatically at some point during the remaining time on this mortgage.
Second, there is a very real risk of job loss for employee physicians. I'm not an employee, but with regard to job loss, my job isn't much more secure than an employee's would be. Like most hospital-based specialists, our group would essentially disband if we lost our contract with the hospital. Those contracts renew every couple of years but at this point in our lives, we'd rather not move if that contract were lost. We like where we live-the schools are great, we have family and friends here, and we love the area. But if our group were to lose its contract, it would be unlikely that I could easily find another full-time job in this area. However, if our expenses were low enough it would be relatively easy to pick up some prn (as-needed) work in this area, perhaps fly somewhere else to do a bit of locums for a few days a month, and combine it with the income from WCI to maintain our standard of living. Having a paid-off home gives us much more freedom to survive a serious job catastrophe.
Third, I don't plan on ever working more shifts or more night shifts than I'm working now. In fact, I'd like to cut back a bit already-both fewer shifts and definitely fewer of the overnight ones. After-tax, my mortgage payment represents about 2 shifts a month. If I paid the mortgage off, that's two shifts I wouldn't have to work without changing my “after-mortgage income” at all.
Fourth, we're starting to spend a lot more money on stuff we want (but don't necessairly need)-expensive vacations, optional house upgrades, fancier toys etc. Buying stuff we don't need while we still owe money on our house is an awful lot like buying stuff on credit.
Finally, as Dave Ramsey likes to say, a paid-off mortgage is a status symbol. I value it a lot more than driving an expensive car. I make a ton of money, why shouldn't I have a paid-off house? Mathematically am I giving something up by not keeping a low interest mortgage for decades? Probably, but it's nice to be in a position to not need to take that risk.
Finding a Balance
So I've been thinking a lot lately about how to balance my desire to be debt-free with the mathematical stupidity of paying off a mortgage with a negative real interest rate early. I think I've decided on a solution.
The Plan to Pay off the Mortgage
My current P&I payment is $2,445 per month. In order to pay the mortgage off in 5 years, I would need to increase that payment by $3,140 per month. If I instead invest extra money in a side account, I will still owe $202K of my current $313K balance after 60 months. So I need that side account to be equal to $200K. I'm going to have to invest quite a bit of money to get to that in just 5 years. This, of course, is all in addition to our other financial goals- retirement and college for the kids.
Step # 1 Invest a lot of money on the side each year
How much I need to invest really depends on what kind of a return I can get on the account. If all I can get is 1.7%, then it will require $3,140 per month, or about $38K per year. However, if I can manage 8% on it after-tax and expenses, and I front-load it a bit, it would be only $31,500. Even so, that's still a big chunk of money.
Step # 2 Add in windfalls
I could further lower the planned amount if I'm willing to add in any windfalls and “found money” I get in the next 5 years such as the equity we get out of our rental property when we sell it. There will probably also be other windfalls, including months when my pay is particularly high or when WCI does well.
Step # 3 Take significant risk
Obviously, in order to get 8% after taxes and expenses, I'm going to have to take on significant risk. I could probably get that kind of return out of Peer to Peer Loans, but those don't meet my requirement of being instantly liquid in order to pay off the mortgage. I could probably also get that out of a real estate investment, but that also suffers from a liquidity issue. I'm almost surely not going to get that return out of any kind of a mainstream fixed income investment. So that leaves equities.
Taking equity risk for a goal that is only five years out isn't the typical financial advice you hear out there. However, just as I do with my children's 529s, I also look at not only the likelihood of losing money, but also the consequences. What is the really bad thing that could happen if I use equities to fund this side account? The really bad thing would be that I've almost got my $200K and we hit a big bear market and that $200K is cut in half. What's the big deal? I can clearly afford the mortgage payments. Waiting a year or two (or ten) for the market to recover certainly wouldn't be a catastrophe, especially since I'm not even sure I would rather have the mortgage paid off than the side account. Sure, I'm investing “on margin” but there won't be any margin calls. As long as I can service the debt, I can just wait it out.
I suppose I could take even more risk by getting a home equity loan and investing the proceeds. However, not only does that increase my debt (what I'm trying to get rid of) but I also probably couldn't get anywhere near the terms I've got on my mortgage debt. Besides, I can't legally deduct the interest on more than $100K of that anyway, further increasing the effective interest rate.
Step # 4 Flush out the capital gains using my charitable contributions
8% after expenses and taxes is no easy goal in a taxable account. Not only will I need to use equities, but I may even need to use relatively risky equities, like emerging markets stocks, microcaps, or small value stocks. It is relatively easy to keep expenses low using ETFs and mutual funds from companies like Vanguard, but keeping taxes low in a taxable account can be tricky. However, I've got an advantage and I plan to use it.
I make sizable charitable donations each year. This provides me the opportunity to flush the capital gains right out of my portfolio. Let's say I put $25K into this account in year 1. It increases in value over the next year to $30K. If I were to sell that, I would owe capital gains taxes (18.8% LTCG rate for me) on that $5K, or about $1000. However, if I transfer those shares to charity, and then take the $30K in cash that I would otherwise use for a charitable contribution and buy more shares with it, then those gains are flushed right out. I've essentially reset my basis to $30K. Although I'll still have to pay annual taxes on any distributions, this will dramatically lower any taxes due. Even better, unlikely with tax loss harvesting, there are no wash-sale rules.
Step # 5 Tax loss harvesting
I can further increase the tax-efficiency of this account by tax-loss harvesting. Since I'll be using relatively risky equities, I will likely see quite a bit of volatility over the next 5 years. By exchanging shares with a loss for a highly correlated fund or ETF, I can book that loss and deduct $3K a year against my regular income (at 38%, that lowers my tax bill by $1,140 per year.) If I can book even more than $3K in losses per year, I can use those against the distributions, or even save them up for future years. Between donating appreciated shares and tax loss harvesting, it's even possible that the net effect of taxes on this account is positive. Tax loss harvesting isn't that useful for most people, because you're just delaying taxes to when the replacement investment is eventually sold for a gain. However, if you have a way to flush those gains out of the portfolio, tax-loss harvesting is a much better deal.
Getting out of debt isn't all about math, it's also about behavior. While 5 years isn't forever, it is still a long time to stay motivated to work toward a goal. So it would be a good idea to have a carrot hanging out there to provide the motivation. So here's my carrot- when my side fund equals the mortgage debt I'm going to drop the three overnight shifts I work each month. Trust me when I say I'm highly motivated to quit staying up all night 3 times a month. And I'm going to use your assistance, dear readers, in staying accountable by periodically posting about how I'm doing toward this goal. Perhaps others with low-interest mortgage or student loan debt and an interest in being debt-free might like to play along. Before you decide to do so, however, please give proper consideration to the three issues below.
Avoiding Being House-Poor
Paying off a mortgage early brings up the issue of having too much of your net worth tied up in your home. I saw a good rule of thumb recently that you should have twice as much in retirement savings as in home equity, and I think that's pretty reasonable. Paying off my mortgage today would probably drop me below that amount, but 5 years from now I should be well above that ratio.
What About Asset Protection?
There is also the issue of asset protection. In some states, your home equity is well-protected by homestead laws and “tenants by the entirety” titling. Unfortunately, Utah is not one of those states. My retirement accounts are well-protected here, but I'm already maxing those out. Any additional home equity I get will be no more protected from my creditors than a taxable account, so there's really no advantage one way or the other for me from an asset protection perspective. This might not be the case for you.
What Does Your Spouse Say About This Plan?
I decided to ask my wife what she thought about this crazy scheme. Here's what she said:
“You listen to Dave Ramsey too much. You just want to call in and scream that you're debt free.”
That is not true, but she thinks my concern that our income could dramatically drop and put us into financial difficulty due to the mortgage payment is an awfully small risk, especially given the side income from WCI, my disability insurance, and our sizable emergency fund. (She's right, of course.) But she reluctantly said,
“Okay, you can save up this side fund, but not if it delays doing some of the house improvements we've agreed upon. It doesn't seem that paying off a loan that is less than inflation should be our highest priority and you have to be willing to make other sacrifices if you really want to do it.”
Then she suggested that if we didn't buy this fancy new boat I've been eyeing [update: and recently purchased] that we would have two years worth of extra housing payments right there. Ouch. Nevertheless, we're keeping the goal. It should be an interesting study in personal finance (which is both personal, and finance) to see how we do toward it.
My First Report
So here's my first report on The Great Mortgage Pay-off Scheme:
- Month 2/60
- Outstanding Principal: $313,465.18
- Value of side account: $0
- Basis of side account: $0
- Positive or Negative taxes generated from account: $0
We're obviously not making much progress so far, but I'm confident we'll catch up!
What do you think? Do you plan to pay off your mortgage early? Why or why not? Do you have a low-interest debt dilemma? What do you plan to do about it? Would you like to play along and post your progress? Comment below!