I have been seeing similar questions quite frequently lately by email, comments, and forum threads. Here are a few examples:
Q. I am trying to decide between a 30 year and a 15 year mortgage. We would have no trouble making payments on the 15 year mortgage and would love to be out of debt in 15 years. In fact, we even hope to make extra payments and/or pay the 30 like a 15 but are concerned about something happening and want to have the lower mandatory payment, just in case.
Q. I am considering refinancing my student loans. I've been quoted a rate of 4% fixed or 3% variable for a 5 year loan on my $300,000 in student loans. But I'm hesitant to do it because if something happens, I want to be able to take advantage of the government programs that help in the event of hardship.
Q. I have $50,000 in savings at 1% and owe $125,000 toward my student loans at 7%. I don't want to put any of that money toward my student loans in case something happens and I need it.
You get the picture. In all of these cases, there is a smart financial move that is almost certain to help the person come out ahead, both behaviorally and financially, and then there is a fear keeping them from making that decision. Making decisions based on fear, especially irrational fear, and especially, especially irrational fear that can even be insured against, is a bad method. Let's look at each of these in turn.
The 15 Versus 30 Year Mortgage Dilemma
I see this dilemma appear in two different scenarios. The first is the somewhat reasonable “I want to borrow at a very low rate on a non-callable loan taken on an asset that will probably appreciate over 30 years and invest it elsewhere at something that will almost surely make more over the 30 years.” While I doubt most will actually do the investing from a behavioral aspect, at least the math is sound. The second is the less reasonable, “I want a 30 year because I'm afraid of income loss that would only allow me to make a 30 year mortgage payment.” Let's actually look at this. Now, I recommend you get a mortgage that is no more than 2X your gross income. I also recommend you put 20% of your gross toward retirement savings. Assuming you follow these two recommendations, this fear of something bad happening to your income is really irrational.
So let's say you make $200K and you buy a $500K house, putting $100K down. So your mortgage is $400K. Your Principal and Interest (P&I) payment on that $400K mortgage is the following:
- 15 Year Fixed at 2.75%: ~ $2700 a month
- 30 Year Fixed at 3.25%: ~ $1700 a month
Now, I agree with you that ~$1000 a month does seem like a large amount. Until you look at two other amounts in comparison.
- Gross Monthly Income: $16,700 a month
- Monthly Retirement Savings: $3,300 a month
Okay, now let's consider a hypothetical situation where “something bad” happens to your income. How bad would it have to be before that lower mortgage payment is really going to be required for you? (Remember taxes, insurance, maintenance and everything else is exactly the same, so we're just considering P&I.) Well, let's consider a few facts about an income decline.
# 1 If your income declines, so does your tax bill. In fact, due to paying taxes as you went along this year presuming a higher annual income, you may owe NO ADDITIONAL TAXES for the rest of the year now that your income is lower.
# 2 You can tap your emergency fund. A serious income decline is usually due to an emergency. An emergency fund is 3-6 months worth of expenses. How many months of a lower income will that last? Well, it depends, but it's longer than 3-6 months because you're only using it to supplement your ongoing lower income. In fact, a 6 month emergency fund may cover the difference for 3 or more YEARS if you run the numbers.
# 3 You can stop saving for retirement temporarily. That by itself erases a 20% drop in income.
# 4 You can stop saving for college and other smaller goals. That might erase another 5-10% drop in income.
# 5 We haven't even started on your lifestyle. A huge chunk of my lifestyle is discretionary. Our spending would be cut at least in half if we stop buying stuff we don't need and going on vacation. And much of what we need can be deferred for months or even years.
# 6 Insurance covers most significant drops in income that you can't cover with an emergency fund. Remember that disability insurance policy you spend so much on? And that big fat term life insurance policy? Yea, they frequently come into play simultaneously with a drop in income. All of a sudden that drop in income isn't so big, especially when you consider that the benefits probably aren't taxed.
So what kind of a drop would really need to happen in order for you to benefit from that ~$1000 a month lower payment? It would need to be 75% or more of your income, not covered by disability insurance, and lasting longer than a couple of years. How often does that happen to a doctor or similar high-income professional? Not very often.
The Student Loan Government Program Dilemma
Okay, let's move on to the next subject. What about the guy, planning to pay off his loans, that doesn't want to refinance because he won't be able to go back to a low monthly IBR, PAYE, or REPAYE payment if his income took a big drop? What would it take to get back into those programs? For sure it varies by income and student loan burden, but for a typical doc, we're talking about going down to a resident-like salary, and again, doing so for YEARS. Not very likely, especially something that isn't covered by insurance and is out of your control. Besides, many of the companies have programs to help you in the event of hardship. There is also another outlet….these are student loans. What's the consequence of not paying student loans in the event of terrible financial hardship? A bad credit score. That's it. If you're in this situation, you don't want to be borrowing more money anyway, so what do you need a credit score for? When you're back in the position to buy a house or borrow for an investment property, your credit will be repaired. (I actually think credit gets repaired way too easily, but that's another rant.) And there's really nothing else a doc should need a credit score for anyway. So refinance and get busy paying off the loan. Now, if you're holding off because you think you might change to a job eligible for PSLF, that's a different issue.
The Hold Cash Versus Pay Off Loan Dilemma
This one really bothers me. I'm mostly with the Dave Ramsey crowd on this one. An emergency fund is to help you avoid borrowing money when something really bad happens. If you owe somebody money, something really bad has already happened. You already have a debt emergency. So use the emergency fund to take care of it. That's what it's for. Not only is that smart mathematically (borrowing at 6% to invest at 1% is dumb) but it's smart behaviorally.
Does a small emergency fund make you uncomfortable? You bet it does, and that's a good thing. Just like dumping the safeguards of the government loan programs makes you uncomfortable. Or having to come up with a 15 year fixed mortgage payment every month makes you uncomfortable. Use that discomfort, or even fear, in a positive way. Use it to motivate you to earn more, save a higher percentage of your income, make extra payments on your debt, and manage your finances in a smarter way. Having trouble avoiding splurging on an expensive car or vacation? Would only having $1000 in the bank help? I bet it would. So would knowing you've got a $5,500 student loan payment due in two weeks. Plus, it will increase the amount of relief and satisfaction you will have in growing your wealth. You can't wait to pay off your debt so you can have a real emergency fund. You can't wait to be free of your mortgage or student loan so you can have additional cash flow each month. You can't wait until this gnawing feeling that you're not only broke, but worse than broke, leaves your gut. Get uncomfortable! Then use that discomfort to fix your financial mess.
What do you think? Do you subscribe to the 30 year vs 15 year philosophy “just in case?” Are you avoiding refinancing due to fear? Are you carrying low-paying cash AND high-interest debt? Why or why not? Comment below!