My motto has always been, “All my life I’ve been good with numbers. I like it when people ask me to multiply things in my head”. O.K., that’s not true. However, I did smile when I first heard that statement.
I enjoy trying to “quantify” the benefits of different opportunities. I suspect that every day you quantify one option versus another in your everyday life. Do you sometimes compare taking the toll road which might save you ten minutes in driving time but cost you two dollars? Do you consciously or unconsciously know that the free road is five miles longer and will increase your fuel consumption and wear and tear on your car? Do you consider two dollars an acceptable fee for saving ten minutes? What if the toll road saved you three hours in driving time? What if the cost of the toll road was $45? By the way, I have paid $45 U.S. just to cross a bridge going from Denmark to Sweden. Then I had to pay another $45 three hours later to cross back into Denmark!
The point is this. We all analyze our options in life…and we do it pretty much every day. We make assumptions. In the above example, we assume we can save ten minutes if we take the toll road. We assume if we take the free road, we will save two dollars even though the cost of gas might decrease those savings a good deal.
Today I’m going to tell you how I expect to create $600,000 in free cash flow for my wife and me. If you don’t need $600,000 then I recommend you stop reading right now. However, if I am the only person this morning taking the time to show you how you can gain a real financial advantage then you might want to continue reading.
I will make certain assumptions. You may or may not agree with every assumption. You might get to a point where you think that I won’t create $600,000 in cash flow but a number closer to $800,000. Others are going to see the opportunity being worth only $300,000. Assumptions are just that. They are the best guess as to how the future might play out.
Like you have probably done, I’ve been making assumptions all my life. Some future predictions have worked out well and others not so much. I believe that is impossible to predict the future. However, the future doesn’t need to be predicted perfectly. It only needs to be predicted well enough to benefit the decisions about the future that you make.
Are you ready to get started? Good. I recently had a reader ask me a few questions. Lots of readers do that. In order to help this person understand how I was thinking about things, I provided this analysis about financing homes.
I know. You’ve heard me talk about interest-only mortgage loans in the past. However, I have never really provided the important COMPARISON between having an interest-only loan and having no loan at all or having a fully amortized principal and interest loan. This comparison is a lot like asking yourself, “Do I take the toll road this morning or not?”
I will make some statements that will make a few folks shutter. Remember when you first began to learn a foreign language? It was hard, wasn’t it? Learning is hard. That’s why so many people drop out of high school or college or whatever. Receiving new information that you’ve never heard before…or heaven forbid receiving new information that you don’t agree with is hard. It’s a lot easier to just drop out without understanding whatever alternative is being offered up. The following is for those people who don’t want to drop out of this discussion.
I don’t want to have ANY equity in my home. Oh my! Why would Randy say that? Haven’t you been taught since you were old enough to understand that it’s a good idea to “build up your home equity”?
Unfortunately, my banker doesn’t agree with my statement that I don’t want to have any equity in my home. They want me to have a little skin in the game. The last thing I would want to do is make a down payment any larger than I absolutely needed to when buying a home or refinancing my current mortgage.
Did you know that every dollar put into a down payment and therefore home equity is really “dead money”? Home equity earns nothing with one exception.
Warning! It will be easy to get off into the weeds with all of these numbers
Here’s a simple example. Let’s say you buy a home for $295,000 (that’s the median price for a home in the U.S. right now). You put down 20% because that’s what the bank requires. That makes your down payment $59,000.
Your new mortgage is $236,000. You should know that all of these calculations come from my asking Siri on my iPhone to make the computation. Your down payment doesn’t really “earn” anything. The value of your house in the future has NOTHING to do with your home equity when you bought the house or at any point in the future. You knew that, right?
Your home equity doesn’t “grow” because of your down payment. Your home equity grows because of the current home market in your neighborhood, the cost of construction and your home’s condition. Your home will increase in value if you remodel the kitchen but not because you made a 10% or 20% or 50% down payment.
Your home’s market value is 100% independent of how much home equity you have. Are we 100% in agreement with that fact?
I said, “Did you know that every dollar put into a down payment and therefore home equity is really ‘dead money”’? Home equity earns nothing with one exception. What is that one exception?
Here’s the exception. Some amount of down payment is normally required by the lender to, at a minimum, get you into the homeownership “ball game”. Just about every lender is going to ask you for a down payment. Why do they do that? They don’t want you taking the toll road out of town and leaving them with a totally destroyed $295,000 home with a $295,000 mortgage that is now worth $195,000 because you (not you but you know what I mean) destroyed it.
One should never confuse opinion with fact
I’ll stop for just a second. I believe that every general principle I mentioned to this point is a fact and not an opinion. I never want to mix or for that matter confuse facts with opinions.
Some people, especially those that I affectionately call “people of age,” prefer a principal and interest mortgage. Others don’t want to have a mortgage at all. These are the folks who learned decades ago that it was a “good idea to build up home equity”.
Some of the thinking goes like this. “If I pay down some of the principle, I will be leaving more money for my heirs”. Don’t even get me started on parents enabling kids. Have you ever done things in your life that created exactly the opposite effect of what you thought would happen? I think the strategy of “paying down principle” creates exactly the opposite effect for what it sounds like it might do. In all likelihood, NOT paying down the principle would leave more money for your heirs. Does that surprise you? Read on.
Let’s say that you have a $500,000 mortgage at an interest rate of 2.875% on a principal and interest basis. After 10 years you would have reduced your principal by about $122,000.
A payment for this loan would be about $2,074 monthly. On the other hand, if you had an interest-only loan for 10 years for $500,000 at 2.875% your monthly payment would be much lower at $1,178. By the way, you will hear me referring to “10-year” interest-only loans time and again. The longest term I have ever seen for an interest-only loan is 10 years. If I could get a 30-year interest-only loan I would do it in a heartbeat.
The difference between those two payments is $877. If on day one you invested that $877 at 8% you would have a taxable gain in ten years of $55,498. That gain would be taxable at long-term capital gains rates.
Why do I use 8% as an investment rate? It’s because in 19+ years of retirement I have actually earned more than 8% on my investments, actually 8.6%. There is no guarantee I will continue to earn 8.6% in the future. Heck, I might earn 10.6%! My 8% future investment return is an ASSUMPTION. Remember, we assumed you might save 10 minutes of driving time using the toll road? Why did we assume that? Because you normally save ten minutes using the toll road. For 19 years I “normally” earn an annual average of 8.6% on my investments. At least I have 19 years of results supporting my assumption!
Want to read more about the way I look at financial planning?
Randy’s Financial Plan of a Lifetime – Updated through 2020
Later, I will talk more about other potential outcomes (good and bad) from having an interest-only loan for ten years rather than having a 30-year fully amortized loan with principal and interest payments or no loan at all.
This is important. Don’t miss this part.
In the above example with a fully amortized $500,000 loan, you could have $122,000 more in home equity after ten years. Alternatively, with an interest-only loan, you could have $105,360 in smaller mortgage payments and another $55,498 in investment gains. You get those gains by investing the $877 you didn’t pay in principle every month. That’s a total advantage of $160,858 that comes with an interest-only loan. Having an interest-only loan gives you a more than $38,000 ($160,858-$122,000) advantage over a P&I loan in just ten years.
This is how I do it. I have a good deal of experience with interest-only loans.
I’m going to tell you about my experience with interest-only loans. It’s important to remember that you are not going to get my results. You might do better and you might not.
I’m sharing all of this for just ONE reason. Sharing my info doesn’t hurt me in the least. Sharing my info might help someone else. It’s sort of like giving blood. I’m hoping some folks can take the principles I am sharing and use them and whatever else they come up with to make a positive change in their financial lives. This is never a race against my results. It is always a race against an individual’s own results. A person doesn’t need to be a rocket scientist to benefit. But a person might have to leave their comfort zone to get the fullest benefit.
When I refinanced my loan (from one interest-only loan to another) a few months ago, I was able to increase my loan amount from $2.20 million to $2.53 million. I know those loan amounts sound high. How could I qualify for this loan? My good looks? I say that because my mother used to always ask me how I was going to get something done, “With your good looks?” Who knows why a leading bank would lend me more than two and one-half million dollars when I have not earned a thin dime from work income since I retired in 2002. I do know this. I did not get my loan based on my good looks. I have never ever personally met my loan officer and I’ve now done two loans with her!
Just a quick reminder. You are not trying to replicate my situation. You are trying to create a better situation for yourself.
The increase in my loan amount during this most recent refinance was roughly $333,000. What was this $333,000 really? It was my attempt to take money out of my home because of its long-term appreciation results. I was increasing my loan so I could get my grubby little hands on some of my home equity that came from our home appreciating.
In order to make this happen my California bank has a special program. They will increase my old loan amount as described above from $2.20 million to $2.53 million. But… I can’t get the “extra” money ($333,000) for two years. So, from day one of the refinance, I will pay a monthly loan payment based upon a loan balance of $2.53 million. Then in two years, I get $333,000 back in cash. Nice!
When I get that $333,000 I could pay down my loan and then my payment would be based upon a $2.20 million balance. Of course, with my borrowing rates fixed for ten years at 2.75%, the last thing I would want to do is pay down the loan. You gotta spend money to make money!
What will I do when I get that check for $333,000? I guess I’ll use it for everyday living expenses…and/or maybe an expense or two that someone in my age range should incur just for the hell of it. Of course, I am required by law to take an RMD from my IRA retirement account each year. The extra “appreciation money” will be available to supplement my RMD if necessary.
Here’s a key point. That extra $333,000 can be invested and earn approximately 8%…about what my retirement portfolio ROI has been for nearly 19 years. If I decided to invest that $333,000 it would be worth approximately $616,360 (source: calculateme.com) in a period of eight years. It’s important to remember there are no guarantees that my projections will come true. However, my projections are what is most likely to happen based upon twenty years of real-life experience. Oh yeah, one more thing. The investment earnings I refer to throughout this message will be subject to long-term capital gains income taxes.
Net gain from investing what some might think of as HELOC funds: $280,000 ($613K-$333K)
If my loan amount of $2.53 million was a fully amortized loan for 30 years at 2.75% my monthly payment would be $10,592. That seems pretty high considering our very first apartment required a $140 monthly rent payment!
As it is, with my 10-year INTEREST-ONLY loan at 2.75%, my monthly payment is “only” $5,851. The difference between my interest-only loan monthly payment and the P&I loan monthly payment from above is $4,741. If I invested that $4,741 each month at an annual return of 8% the value of that investment after 10 years would be $873,395! Source: nerdwallet.com.
I mentioned that with my loan IF I had a P&I loan would have a monthly payment of $10,592. As it IS my interest-only loan has a monthly payment of only $5,851. I would have made $568,920 in contributions (the difference between my IO and P&I payments, $4,741×120) to an investment account rather than mindlessly pouring more money into home equity.
The investment earnings with this strategy would be $304,475. That’s $873,395, the value of my investment account, less $568,920 in contributions (see above) into the account to finish with a total of $873,395. I would earn over a ten-year time period more than $300,000 by NOT having a fully amortized loan and paying both principal and interest.
Net gain from investing what would have been the principal with a P&I loan: $304,475.
What is my total gain from this strategy?
Total gain from these two income streams: $602,475 ($298,000 & $304,475).
Let’s just stop this for one danged second. If you read and fully understand every one of these numbers then you really are “good with numbers”. Or, you are spending way too much time on your computer!
What’s the point here? For me, it’s that I’m going to generate more than $600,000 in funds over a ten-year period of time by taking my savings (in the form of a lower payment) and investing them because I have an interest-only loan and not a fully amortized principal and interest loan.
But…what about those folks who have a fully paid-for home? If their home is valued at the median price in the U.S. for a home, they have a home with a market value of $295,000. What’s the equity in their home which is fully paid for? Most folks can answer this question. $295,000.
What is the value of a $295,000 loan that appreciates at 3% a year in 10 years? It’s $396,455, source: dollartimes.com. Would this home be worth $396,455 at an appreciation rate of 3% over 10 years if the owner had a fully paid-for home or a mortgage of any amount? Yes, it would. The future value of a home is in no way affected by the amount of the mortgage on that home.
There are several potential benefits/options that could occur during the ten-year term of my interest-only loan. Each of these options has a certain probability of happening. I’m going to say that the probability of one or more of the first five options occurring totals more than 50% of the total probability.
This simply means that it is more likely than not that one of the first five options listed below would happen. You might be able to guess which of those five options I would prefer NOT to happen. However, option #6 could occur as well!
- I might refinance my current loan in the future at even lower rates. Of course, at 2.75% I have an excellent rate now. However, each time I have refinanced in the past I had an excellent rate that I didn’t think I would ever be able to beat. Each time I refinanced a loan at a lower rate I was reminded how difficult it is to predict the future! I have refinanced every 2-3 years over the past decade. With talk of negative interest rates how low is really low?
- Rather than putting money from my mortgage payment into home equity with a P&I loan, I have access to those funds that aren’t moving into home equity at a fixed rate of 2.75%. One never knows when having cash will be a good idea. Yes, a home equity loan that sits behind a P&I loan would provide a similar experience but if rates rise that could be expensive. The $333,000 I get from the bank in two years is FIXED at 2.75% for eight years. In addition to all of the above, I can also get a home equity loan behind my interest-only loan.
- Who knows I might die during the next 10 years! No, this is not the preferred option!
- If my wife and I did die our heirs would probably appreciate inheriting an investment account with a large balance rather than having to sell our home to get the money that had moved from investments into home equity via a P&I loan.
- We might move and/or decide we didn’t want to live in our current home any longer during the loan term.
- If rates are higher in ten years and we are still living in our home we could choose to roll over our current loan amount into a fully amortized P&I loan for $2.53 million at prevailing rates. That option is part of our interest-only loan program. We could also take our investment account of nearly $600,000 and pay down the loan or add additional funds and pay off the loan…if making the payment on a higher interest rate loan wasn’t a good idea for us.
This is the KEY point.
I hope you can see that keeping money OUT of home equity is really the very best financial idea.
It almost, but not quite, goes without saying that if you have a home and you have no equity in the home then you have a mortgage. If you have a mortgage, you will have a payment. At all points in life, you need to be able to make the payment. Did I really need to point that out?
Of course, I certainly think the ideas that I have put forward are the best choices for me…and actually many people of retirement age. I definitely don’t agree with the person who says, “Each person is different. What works for one person doesn’t work for the next person”. That quote is not as complete as I think it should be. I might express the thought differently by saying “there are some things that are good for just about everybody”.
By the way, some might be asking, “What does your wife say about this?” Pretty much her only comment is, “Where do I send the check?” In our house, I am responsible for a few things and she is responsible for a lot of things. I manage the stuff mentioned in this note. She don’t ask questions. She trusts me and her strategy has worked well for more than 49 years.
Some other people might say, “Can people in our age range really benefit by having more money? In most cases, yes.
Do very many people come out and say they would have a better lifestyle if they had more discretionary funds? No, they don’t. Most people will tell you, “We’re doing O.K.” When I hear those comments, in my mind the words translate to, “We’re comfortable. We’re not much for change. We’ll miss an opportunity here or there so that we don’t have to deal with change, thank you.”
It’s kind of like the person who wins $100 million in the lottery and the next day says that money isn’t going to change their life. They’ll be at work on Monday morning. It’s my guess those people are NOT at work a month after winning the lottery!
In closing, I will make these comments? Do I really need another $600,000? I don’t NEED it but I wouldn’t mind HAVING it. As I get it my plan is to spend it. I won’t live forever so having all of that money in home equity is a real waste. Remember home equity is “dead money”. I want to spend my money before I’m dead.
Randy Lewis
San Clemente, California
P.S. Gotta go pick up the grandkids from school. Didn’t have time to proof this anymore.