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Monday, September 27, 2010

The Total Money Makeover: Pay Off the Home Mortgage

This is the tenth of twelve parts of a “book club” reading and discussion of Dave Ramsey’s The Total Money Makeover, where this book on debt reduction is teased apart and looked at in detail. This entry covers the eleventh chapter, finishing on page 202. The next entry, covering the twelfth chapter, will appear on Tuesday.

Is It A Crazy Goal?

My friends parents recently finished off their home mortgage after paying on it for thirty years. They’re pretty much debt free at this point for the first time in their marriage. So, for me, I have a great example in front of me that you can get rid of all of your debt. However, many people don’t have that example and it seems like an impossible goal. On page 186:
Anytime I speak about paying off mortgages, people give me that special look. They think I’m crazy for two reasons. One, most people have lost their hope, and they don’t really believe there is any chance for them. Two, most people believe all the mortgage myths that have been spread.
The “hope” factor is something I see popping up over and over again whenever I talk to people about money. Many people I talk to view their mortgage as simply a fact of life. If they were ever in a position that their mortgage became really easy to pay, it wouldn’t be time to double-up on the payments – no, no, it would be time to upgrade their homes.

I think this points to a prevalent mindset out there when it comes to debt. Many people simply view debt as a way to leverage the lifestyle they want now. It comes from a lack of patience – people don’t want to live in a small apartment watching their savings grow slowly when they could just get this loan and be in that house now – even if it costs them hundreds of thousands of dollars.

I think patience is one of the biggest tools a young professional can have when it comes to his/her money. Just wait for a while – you’ll be way better off over the long run.

The Tax Deduction Myth

Owning a mortgage just to get a tax deduction is something of a fool’s game, as outlined on page 187:
If you have a home with a payment of around $900, and the interest portion is $830 per month, you have paid around $10,000 in interest that year, which creates a tax deduction. If, instead, you have a debt-free home, you would, in fact, lose the tax deduction, so they myth says to keep your home mortgaged because of tax advantages. [...] If you do not have a $10,000 tax deduction and you are in a 30 percent tax bracket, you will have to pay $3,000 in taxes [...] According to the myth, we should send $10,000 in interest to the bank so that we don’t have to send $3,000 in taxes to the IRS.
All the tax deduction does is lower the effective interest rate you’re paying on your home loan a little bit.
In fact, Dave doesn’t even make the case as well as he could. If you’re using your mortgage interest on your tax return, that means you’re foregoing your standard deductions because you have other things to deduct. So, take a typical situation – you have two adults in your home. your standard deduction in 2010 is $11,400. If you choose to itemize your taxes (which you would have to do to deduct your home interest), you have to have more than $11,400 in interest on your home mortgage (or other deductible expenses) to beat what you would already get.

So, if your only significant deductible expense is your home mortgage – and your mortgage isn’t gigantic – you’re not actually gaining much of anything at all in terms of taxes.

The Risk of Having a Mortgage

Another disadvantage of holding on to a mortgage is the risk – if something goes wrong in your life, it’s a lot better to not have a mortgage payment than it is to have one. On page 189:
If I own the home next to you and have no debt, and you (because of your investment adviser guy) borrowed $100,000 on your home, who has taken more risk? When the economy moves south, when there is war or rumors of war, when you get sick or have a car wreck or are downsized, you will run into major problems with a $100,000 mortgage that I will never have. So debt causes risk to increase.
I think this is a vital, overlooked point. Having a mortgage – or any debt – is a type of risk. You’re gambling that your future will be stable, no different than putting cash down at the roulette wheel. With a mortgage, your life is simply more at risk than it was before.

I have a teenager at home. Risk stares me in the face every day. I encourage my son to push his limits a little, but I still stand very close by when my fifteen year old does wild skateboard tricks. Having a mortgage is something like telling my fifteen year old to jump off of a rail for the first time while I stand far away. Sure, he might jump for a while and then drop without a problem, but my distance increases the chance of a hurt elbow or a broken arm.

The risk of owning a fat mortgage is much like the risk of putting your child on a bike for the first time and shoving them down the sidewalk. Sure, they might ride like the wind, but they might also fall flat on the pavement. Instead, it’s better to do a bit of planning (like saving for a home) and then let go when they’re ready (like when you have enough saved up for a house). No broken bones, no broken lives.

Thirty Years Versus Fifteen Years

Many people advised me to get a thirty year mortgage instead of a fifteen year mortgage, arguing that I could make an extra payment each month and get the same speed benefit of a fifteen year without the risk of the larger minimum payments. That’s a bad idea because something will often come up, as is spelled out on page 190:
A big part of being strong financially is that you know where you are weak and take action to make sure you don’t fall prey to the weakness. And we ALL are weak. Sick children, bad transmissions, prom dresses, high heat bills, and dog vaccinations come up, and you won’t make the extra payment. Then we extend the lie by saying, “Oh, I will next month.”
A higher minimum payment is actually a good idea, because it forces us to work with what we have left over. A lower minimum payment means that we just have more to work with – if that extra payment isn’t required, it’s easier to argue that something else is more important for the moment.

With expenses like prom dresses, heat bills, bad transmissions, and dog vaccinations, you can always find ways to make it work. If you have a decent emergency fund, it shouldn’t be too tough at all.

What do you get in exchange for these little sacrifices? Your mortgage goes away in half the time. You find yourself free of that load much, much faster. Plus, the interest rate on a fifteen year loan is lower, meaning your payments won’t actually be anywhere close to double what they would be for a thirty year mortgage.
The New Rules for Mortgages

Home Equity Loans Make Poor Emergency Funds

One common question I get from my clients is whether or not they should take out a home equity loan to deal with some problem in their lives. My feeling is that if you’re in that situation, you need to rethink about your emergency fund. Sure, the home equity loan might be the right solution for right now, but if you’re living your life in such a way that it has to be used, you might want to rethink how you’re managing your money.

On page 197, Dave dips his toes into this idea:
Even a conservative person who doesn’t have credit card debt and pays cash for vacations can make the mistake of the HEL by setting up a loan or a “line of credit” just for emergencies. That seems reasonable until you have walked through an emergency or two, and you realize very plainly that an emergency is the last time you need to be borrowing money. If you have a car wreck or lose your job and then borrow $30,000 against your home to live in while you make a comeback, you will likely lose your home. Most HELs are renewable annually, meaning they requalify you for the loan once a year.
Think of it this way. You’re using your home equity loan as an emergency fund. You lose your job, so you take out $30,000 to live on – it’s fine, since you have tons of equity in your home, right? Well, the end of the year comes and you still don’t have a job. The bank says, “Sorry, we’re not renewing your loan,” and they call in the $30,000. You don’t have it. They repossess your house. Any equity you built up is gone.
An emergency fund needs to be cash, period. If it’s not liquid or it puts you at risk to get it, then it’s not an emergency fund.

Paying Cash for a Home Is Impossible

I agree with Dave that it is indeed possible to pay for your home with cash. So why don’t people ever do it? It’s not easy. It’s a lot harder to go this way than it is to just go get a mortgage.

On page 198:
Paying cash for a home is possible, very possible. What’s hard to find is people willing to pay the price in sacrificed lifestyle.
I think the problem is that many people view their home as more than just living quarters. They view it as a status symbol – they need a house they can show off to family and friends. It’s more impressive to live in a house than an apartment, isn’t it? So, if you back up and think about it, you pay hundreds of thousands of dollars in interest, home maintenance, and other costs – not to mention time – in order to impress others.

Again, the only people impressed with such things are people that you never speak to, who don’t matter in your life. They look at you and admire your home, but they don’t build a relationship with you. The people you build lasting relationships with like you, not your house.

Do you have any other thoughts on this chapter of The Total Money Makeover? Please share them in the comments – and feel free to respond to any of my impressions as well. After all, a good book club is all about discussion!

On Tuesday, we’ll tackle the twelfth chapter – Build Wealth Like Crazy

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