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TMFBabo (100.00)

Paying Down Debt

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June 19, 2011 – Comments (32) | RELATED TICKERS: DE , BT

As I type this, I carry a mortgage at 6.25% and a student loan at 5.6%. Since late 2008, the proper capital allocation decision in my eyes has been to invest my free cash instead of paying down those debts. Thus far, it has been the right decision.

However, I feel differently now. I don't think rock bottom interest rates, high commodity prices, excess housing inventory, high unemployment, and low consumer confidence are the stuff of bull markets. I'm not calling for an outright crash, but I feel that it'd be tough for the markets to have a sustained multi-year rally from where we stand right now with the S&P 500 at 1271. 

As a result, it wouldn't surprise me for the market to go up or down 10% to 20% for the next year or two. I believe we deserve to go down more than we deserve to go up, but my belief has nothing to do with future stock market performance.

Due to this uncertainty, I am very close to sending most of my free cash towards my debts for a while. Since my 6.25% and 5.6% debts are paid with after-tax money, I view them as equal to earning 8.3% or 7.5% in the stock market (assuming 25% short-term capital gains equal to income tax). I know there are deductions for interest on mortgages and student loans, but not paying them off because I want to deduct more from my income is like spending a dollar to save 10 cents - you still lose out. It's not that simple and the deductions are beneficial to me, but I prefer not to factor it into my decisions.

Anyway, paying down my debt would earn me a guaranteed 7.5% to 8.3% return on my money. Given the uncertainty in the market, that seems like a much better deal than at other points in the past 3 years. I'm not very confident that the market will return a guaranteed 8.3% for the next few years, so it would finally seem that the debt repayment is a viable strategy for my free cash.

Here are a few things to keep in mind:

1. This is only free cash flow I'm talking about (which at the time is not much). The rest of my assets will remain in carefully selected stocks/options/ready-to-deploy-cash.

2. Paying down the mortgage is a fairly high priority in my life right now, so there is that added incentive on top of the guaranteed 8.3% pre-tax equivalent return.

3. I really, really hate debt. I carry a pretty big amount of it though, because I have favored investing over paying down extra principal for a long time. 

4. I carry some energy stocks as a hedge against inflation. These stocks shouldn't move as well as gold/silver in the face of inflation, but should still do pretty well. My debt repayment would result in negative real returns if ugly inflation reared its head, but the debt repayment would be so small compared to my investable assets that I don't think I'll be crying over it.

Just typing these thoughts out have helped me solidify my decision. Anyone employing a similar strategy? I'd love to hear your thoughts.

32 Comments – Post Your Own

#1) On June 19, 2011 at 11:35 PM, rd80 (99.12) wrote:

Why not refinance the mortgage and use the extra cash flow to tackle the student loan?

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#2) On June 19, 2011 at 11:38 PM, TMFBabo (100.00) wrote:

Ah, it doesn't make sense to carry a 6.25% loan with rates much lower - you are right. I forgot to mention I am upside down on my mortgage (hence the desire to pay it off).

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#3) On June 20, 2011 at 12:11 AM, ETFsRule (99.90) wrote:

I don't think rock bottom interest rates, high commodity prices, excess housing inventory, high unemployment, and low consumer confidence are the stuff of bull markets.

I disagree with most of this, except for excess housing inventory. I believe this is a strong bearish indicator.

However, I think the others are bullish indicators. For instance:

Bull markets usually start when unemployment is high, and they usually end when unemployment is low. Graph.

My take is that increasing employment results in increasing corporate profits, which basically defines a bull market.

I'll spend more time researching consumer sentiment and commodity prices, but I think you will probably see the same trend: you should buy stocks when these indicators look "bad", and your stocks will go up as they improve.

As for interest rates, I think low rates are sort of a weak bullish indicator. So, these rates indicate that we should buy stocks... unless you expect rates to increase in the near future.

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#4) On June 20, 2011 at 12:31 AM, Valyooo (99.81) wrote:

I agree with ETFsRule.  If interest rates are low, then the earnings yield of a company would have to make the p/e go up a lot to match bonds....if bonds are yielding 3% then people are going to bid the hell out of stocks because the other alternative is terrible.

However, I do expect some deflation and a decent crash (15% more) before a big bull market because of the debt problems all over the world.  US won't default though.

You're the top fool...I find it hard to believe you can't find some safe high yielders to yield better than 8.3%...PHK and AGNC come to mind.  For me, 9% is the threshold

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#5) On June 20, 2011 at 12:32 AM, ikkyu2 (99.51) wrote:

What have you done with the real TMFBabo?  This makes no sense.

a)  You make an argument about opportunity cost to justify paying off your home mortgage.  You have, however, adjusted in exactly the wrong direction for tax effects.  You state that your mortgage is paid with after-tax money.  But it's not; the interest is paid with pre-tax money.  If you pay more towards principal, it reduces your principal accordingly, with the result that next month the amount of the payment paid in pretax money is smaller than it would have been.  Disregarding this because "it's a deduction" makes no sense.  Paying down the principal only makes sense if you think that's the best use for your money at this time; the real opportunity-cost return on this money is (6.25/(1+(Babo's marginal tax rate)) percent.  Probably about 4%.  You of all people could do better than that in the market.

b)  Paying your mortgage faster because the home is underwater doesn't make sense to me.  Why would you do this?  Seems like good money after bad, trying to catch a falling knife, watering the weeds, all that stuff.  You don't make that mistake in CAPS, or in your personal portfolio, I'd bet; why make it in your house?

c)  Market may go up or down, you're right.  But you of all people - you've proven you can pick stocks and do pretty well at it.  If I had whatever you're using for a brain, I'd use it to make money stock picking.  I'm surprised that you'd allocate any money elsewhere. 

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#6) On June 20, 2011 at 12:33 AM, ikkyu2 (99.51) wrote:

If you're trying to sell your house or refi your house, I guess, then paying off principal faster does make sense - you didn't mention those things.  It's very hard to sell or refi a house that's underwater.

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#7) On June 20, 2011 at 12:41 AM, HarryCarysGhost (99.77) wrote:

rd80- The banks are not as willing to refinace as advertised. I've been trying for a year now.

My mission statement at this time simply states- pay off underwater loan (my weapon of choce happens to be Mr Market). And I'm getting there slowly but shirley (and don't call me shirley)

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#8) On June 20, 2011 at 12:55 AM, HarryCarysGhost (99.77) wrote:

Kirk, would'nt it make sense to pay off a mortgage in one lump sum?

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#9) On June 20, 2011 at 1:09 AM, TMFBabo (100.00) wrote:

@ikkyu2:

If you're trying to sell your house or refi your house, I guess, then paying off principal faster does make sense - you didn't mention those things.  It's very hard to sell or refi a house that's underwater.

Bingo! I am trying to move right now. My commute is awful and I'm underwater. That said, I don't see it wise to risk money in the market I will need within a few years - it's one of the cardinal sins of investing. Of course you didn't know any of this before this comment.

On the mortgage interest, I concede my earlier point. I had this right in my head earlier and it became garbled. No, I don't believe it either. It's quite a simple concept and I don't think myself a dummy (though I'm pretty sure a lot of you are thinking it now)

I do believe I can crush the lower than 5% rate I'd earn through the mortgage given enough time, but I'm trying to move ASAP and I can't GUARANTEE myself a much higher return - it all comes with considerable downside risk in the short-term.

@ETFsRule:

You bring up good points and I now wish I'd broken out that sentence. In general, I wanted to highlight the uncertainty that's in the market right now as I view it (and yes, I'm often wrong).

Here's how I view each item:

Low interest rates: the lower the rate, the more you're encouraged to take risk. I do believe in higher rates  going forward - the 10 year treasury is at a multi-decade low and I think rates go up, not down in the medium/long term. This should lead to more attractive bonds (and less attractive stocks) in the future.

However, that's not the intent there. I was saying that I'm not so sure stocks can beat the 8.3% hurdle (yes, I'm aware it's actually a much lower hurdle and yes, I'm still not sure it can beat the lower hurdle).

High unemployment: you have a great point. When this reverses, great things will happen in the economy. I should add that I don't feel the reversal happens soon. Maybe I rely on the Duke CFO survey too much, but the consensus among those running many companies' budgets seems to be renewed capital spending but little hiring going forward.

Housing: we agree, so nothing to say there.

Commodity prices: I think these have to come down for companies to have stable margins or margin expansion going forward. I do believe inflation is headed our way (whether it's a small or large amount) going forward, so I don't see improving profit margins going forward. 

Consumer confidence: I agree it's hard to evaluate this one, but we need this for spending (and growth) to occur.

@everyone:

By now, you're starting to see a clearer picture of what I intended through my comments. I made a true blunder with the mortgage rates.

I guess the true lesson is to not post "quick" blogs here on CAPS with tons of mistakes in them. 

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#10) On June 20, 2011 at 1:22 AM, TMFBabo (100.00) wrote:

Another important point: I'm not bullish. I am roughly 80% long and 20% cash in real life, but I am not bullish - I just see few alternatives out there with most asset classes sucking. I'm definitely long-biased in CAPS, but much less than you'd think due to bearish green thumb bets via dividend payers.

I see too much uncertainty to risk money I'll need within a year or two. If I were bullish, I'd probably consider doing so. 

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#11) On June 20, 2011 at 4:03 AM, ikkyu2 (99.51) wrote:

Now it all makes sense.  Best of luck to you - Zillow says I'm underwater too!  Luckily I like my house.

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#12) On June 20, 2011 at 4:51 AM, portefeuille (99.78) wrote:

(6.25/(1+(Babo's marginal tax rate))

(6.25*(1-(Babo's marginal tax rate))

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#13) On June 20, 2011 at 7:58 AM, TMFBabo (100.00) wrote:

Interestingly enough, Zillow suggests I'm not upside down, but recent sales suggest otherwise. I bought at 100x monthly rent -- a reasonable price -- but one of the most recent sales sold for far below that.

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#14) On June 20, 2011 at 10:51 AM, Teacherman1 (48.58) wrote:

I am at "break even" on my house right now, but this has worked out well for me. This has lowered my RE taxes, both to the county, and to the School District ( which in my area is much higher than county taxes).

I don't mind this though, since I am not planning to sell, and my house payment is well below what I can afford to pay, and I am not looking to move for some time, if at all.

Additionally, since school taxes become "fixed" at a certain age ( which I am ), when the values go back up, ( as they are, slowly but surely in my area ), I will have the advantage ( unless I move ), of paying school taxes at a much lower amount than my house would suggest. They can not be raised above what they were when they were capped at the bottom of the market.

I understand your reasoning, part of which is not really based on economics, but on the desire to be able to sell and move.

You know values and trends for your area much better than any of us making comments here.

I say go for it, but keep an eye on it. It's not like you are doing anything that you can't change.

Good luck.

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#15) On June 20, 2011 at 11:18 AM, portefeuille (99.78) wrote:

(6.25*(1-(Babo's marginal tax rate))

(6.25*(1-(Babo's marginal tax rate)))

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#16) On June 20, 2011 at 11:52 AM, 4wheelfool (71.72) wrote:

TMFBabo wrote:

Bingo! I am trying to move right now. My commute is awful and I'm underwater. That said, I don't see it wise to risk money in the market I will need within a few years - it's one of the cardinal sins of investing. Of course you didn't know any of this before this comment.

If you need this money in a few years, I wouldn't risk it paying down your mortgage either. That is a good choice for someone who would blow saved money on something else. But if you can manage money, I say keep it.  Once it is paid to the bank you will not be in control of the money. You may want to use it in a situation where you do not sell or refinance your home. You may want to rent your current home and buy another. You may decide to stay in your home.  If you can make the 4% or so investing on your own, you will maintain flexibility by doing this yourself.  You lose all other options when you pay it to the mortgage.

4wheel

 

 

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#17) On June 20, 2011 at 12:59 PM, dwot (99.49) wrote:

I always favoured paying down debt.  

The markets and investment strategy have not made sense for a long time, and I think payback for the foolish decades of manipulation will soon be upon us.  And actually, I think the whole being upside down on your mortgage is part of the payback, but the payback will get worse.

Once we are through the payback, investment strategy will make sense again and paying back debt first will usually come out a winner in decision making. 

Steven Keen has a couple very good videos in this link, http://www.debtdeflation.com/blogs/2011/06/10/two-more-youtube-videos/ .

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#18) On June 20, 2011 at 3:13 PM, swank9 (< 20) wrote:

why can't you just rent the house out and move?

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#19) On June 20, 2011 at 4:26 PM, JakilaTheHun (99.93) wrote:

I'm like you; I've opted to invest my money rather than pay down debt over the past few years.  Since the beginning of this year, however, I have started paying down a little extra debt, but my allocation is still heavily skewed towards cash and liquid investments.

My preference right now is to invest in mortgage REITs that pay hefty dividends.  Hatteras (HTS) and Dynex (DX) are two that should actually benefit from lower rates. So while I've paid a little bit of debt off, I've prefered to park money into these mortgage REITs and collect the dividends.  It's certainly not a fool-proof strategy, but I'm wagering I'll earn more than 7% on them.  Even if I don't, it's not necessarily a disaster.

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#20) On June 20, 2011 at 4:37 PM, rfaramir (30.46) wrote:

valyooo: "US won't default though." By 'paying' our debts by printing more money, we are already defaulting.

Babo: Since you have pretty low AND fixed interest rates (that's not an ARM, is it?), you'd probably be better off investing than paying them off. If the rates could rise (credit cards or ARMs) or were already high, then I'd pay them off ASAP.

Can't fault you for your desire for stability. That's your choice. You're exactly right that there is no guarantee in the market. But remember, that with higher inflation coming, the real cost of these debts could go negative. If the US doesn't raise the debt cap (unlikely) and instead of cutting spending decides to default (also unlikely), then interest rates on 'safe' bond investments could easily be higher than your current debt rates. Of course, the rates would be high because they would NOT be safe in real terms.

Part of your dilemma is low interest rates in an uncertain world. If interest rates were truly set by the market, they'd be a lot higher. Your choices would be more rational. The Federal Reserve is forcing/tempting you to invest in riskier things by driving safe investments to record low returns, some negative in real terms. What's worse is it is doing this by devaluing our currency.

With your current stock mix, I'd seriously consider precious metals at this time.

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#21) On June 20, 2011 at 5:14 PM, Gonzhouse (69.33) wrote:

I'm in something of a similar situation:  I hate debt and I can pay off my fixed rate 5.0% mortgage in 2.5 yrs with additional principal payments but I know I can do better than 5.0% in the market.  The issue was solved by an offer to re-financing at 3.875%;  no more additional principal payments.

I agree with  rfaramir;  look up TMFSinchiruna's blog and TMF stories.  He has more interesting precious metal investment ideas than I have money so it's always a battle for me to select one to go with.  Even if you aren't sold on the market in general, it's tough to argue that precious metals will drop, given the ocean of liquidity we are in and emerging market demand.

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#22) On June 20, 2011 at 5:26 PM, TSIF (99.96) wrote:

With the additional info you've appended then the decision does become much more difficult.

In many cases if you are "borderline" on a mortgage it is  possible to refinance if you use local banks and do your homework.  (I agree it's not easy).  I purchased a bank foreclosure four years ago, stretched to renovate it, and am a little surprised that I have no equity even though I bought so low and put a great deal into it. The problem is that banks and appaisers are skittish and they start with the last "selling" price and then try to comp it with area sales that just don't exist in enough variety. (They exlude other foreclosures and non-market sales).  I  managed to refinance down last year, using using a local bank with more flexibility and obtained a 4.625 mortgage for a decent savings...but it was not easy and there was no option to add an equity loan on for more flexibility.  In a few years as I clear up a few other one time life issues I hope to refinance into a 15 or 20 biweekly and time it to be paid off before retirement.  I believe I can refinance with the same bank with minimal if any refinance costs.

Since you're underwater,  (might be worth actually checking rather than using rental rates and getting some working numbers), then I would agree with other posters it doesn't make much sense to pay extra to the bank.  If something were to occur down the line with your employment or health then that is money you could not get back.  Still there is a great deal to be said for paying extra on principle and compounding overtime. 

I agree that I see little promise in the markets the next year or two, but there are pockets of promise and if you are a trader there might be opportunity.  I'm confident you can find opportuntity to turn trader, and less investor, but it's a hard trait to change.

One of my ways to look at a problem that seems to big is the "How do you eat an elephant?"    One bite at a time. 

 The house situation seems to be rung of the ladder that's in the way. If you could lump togther enough funds to refinance in the 4's AND clear your underwater condition that would appear to make the most sense.  You'd then have flexibility to sell if opportunity presented itself.  The nice thing about selling and moving since you're not "attached" to your house is that opportunity, as a buyer,  is rampant for someone who does their homework.  Patience and homework could net a new home that suits your present situation and that costs you less, leaving you more to invest.

Until you clear the house issue, the student loans seem minor, but again there is something to be said for compounding.  I always try to pay a little extra when I can on loans.   Overtime it just might generate that key moment where the end of the tunnel suddenly dances out into bright sunlight.

My suggestion would be to figure what you need to have clearance on your house and to work toward that goal first.  Don't pay extra to the bank, but pay it to another "Babo" fund that you build as quickly and safely as you are able.  Put what you don't need into the fund, treat it prudently, add to it, massage it, water it.  Track what you need based on your underwater house and set a goal.

Get the Babo Better Living Home Fund to the point where you can refinance the current home at a level that leaves you flexible.   Then start saving for the Babo Time to Move fund and try to work a buy and sell.  All in all a 2 to 4 year project if things go well depending on how much water you have.  Depending on the timing, it may not pay to refinance, you may skip right into selling and covering the difference in price. Overall, the guidelines not to refinance if you plan on moving in X years is highly overrated.   A 1.5% delta on your mortgage interst can cover refinance charges in under a year if you avoid points.

By breaking the mortgage/underwater problem into a separate fund and identifying what you need I think you would have some clearer goals/targers.  Good luck with that elephant!

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#23) On June 20, 2011 at 5:33 PM, JaysRage (93.75) wrote:

If you're trying to move, then it's a moot point.   You have a double-reason to dump money into your debt.    Otherwise, I would have suggested pulling investment cash to subside a refi and then taking the increased cash flow and using it to replace investment cash.    That said, it doesn't really matter.   This isn't an investment question, it's a life choice situation.   You want to move.   You've got to pay down your debt to make it possible, so you make the choice.   Refi when you're going to move is dumb, so paying down the debt makes sense.    It's a different question than you were originally posing, however. 

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#24) On June 20, 2011 at 5:47 PM, amassafortune (29.98) wrote:

I favor paying off debt at this point in history. At the macro level in the U.S., we are spending (or commiting to spend) at least $1.5 trillion more per year than federal tax revenue supports.

With the finreg bill now in place for nearly a year, the regulation of derivatives has changed from 0% in 2008 to exactly 0% in 2011. That market is estimated at about $100 trillion, but there is no accounting that tells the U.S. citizenry how much of that market is backed by taxpayers future expected receipts.

As a result, investors can't be sure if printing (digital money creation these days) will lead to inflation, or if the unprecedented debt will lead to deflation as was experienced in the 1930s.

I am erring on the side of deflation and have no credit card, auto, or home debt. Yes, my house is losing value at the rate of $50 - $100 per week, but I know that for just the cost of real estate taxes, repairs, and homeowner's insurance my family has shelter. That is worth $50-$100/wk in my view.

If I am wrong and we have a decent recovery with inflation, the house will appreciate and I won't be sharing that inflation with a lein holder. If wages increase during an inflationary period, my standard of living improvement will exceed the average due to my mostly fixed housing costs. 

We don't know the status of the Fed's true balance sheet, the Fed's or Treasury's off-balance sheet, or the value of what resides in Fort Knox. Just today Z/H reports that 41% of Belgium's gold has been lent or offered as collateral.  

In an age when the U.S. Federal Reserve has given itself permission to cover or co-sign for the debts of foreign entities in an effort to stabilize private banks that recklessly used excessive leverage, the average citizen needs to consider owning outright all assets they need to preserve to care for their friends and family.

 

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#25) On June 20, 2011 at 7:31 PM, ETFsRule (99.90) wrote:

I just want to mention, if you have an FHA mortgage you can refinance very easily - even if you're underwater. It's called the "streamline" refi program.

Even if it's not an FHA loan you might be able to do the same thing (and get 10% of the principal taken off the loan). But this could hurt your credit score.

http://www.fha.com/fha_article.cfm?id=176

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#26) On June 20, 2011 at 7:54 PM, awallejr (80.08) wrote:

It is difficult to advise since there are too many unknowns.  You mention you want to move, but would you be looking to buy or rent?  How soon? How many years are you into your mortgage.  I asume it is a 30 year.

The early years are mostly interest, which gives you a declining tax deduction as the years pass.  Additionally when you make pre-payments that gets applied at the back end, meaning it basically cuts off the years it would take to pay off the debt, it doesn't reduce you monthly payment, something readers may not have been aware of.

Because you mentioned a desire to move and your house is underwater, it would make more sense to basically bank it despite low interest rates since you will need that cash on the "buy" end (downpayment, closing costs, moving costs). 

On the "sale" end while paying down the mortgage will also lower the amount you owe and hence hopefully putting you above water, you still are subject to market conditions, namely your house could still be declining.  And if, perchance, things do turn around, market conditions might move it above water.

My advice would be bank the cash instead to create that "moving" warchest.  Now if you are talking many years from now, then invest that into income generating stocks.

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#27) On June 22, 2011 at 1:12 PM, TMFBabo (100.00) wrote:

Thanks for all the responses. I agree that I didn't share all the information beforehand and that I have multiple incentives to pay down the mortgage instead of investing the money (it's short-term in nature, I want to move really badly, I'm not overly bullish right now, etc).

Another idea I'm considering is to keep extra cash in a brokerage account and pounce if and only if I get an extremely, extremely fat pitch. Otherwise, maybe it doesn't get "risked."

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#28) On June 24, 2011 at 7:39 PM, ikkyu2 (99.51) wrote:

I have the opposite Zillow situation from yours: Zillow's Zestimate shows me underwater by a small amount, but the comps don't bear that out. 

Zillow's weird.  Sometimes I wonder if they aren't just an infinite number of monkeys. 

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#29) On June 25, 2011 at 4:15 PM, HarryCarysGhost (99.77) wrote:

If I may play Devils Advocate-

Strategic default - Wikipedia, the free encyclopedia

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#30) On June 29, 2011 at 2:08 AM, valuemoney (99.99) wrote:

Can you short-sell the home?

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#31) On June 29, 2011 at 2:17 AM, valuemoney (99.99) wrote:

Talk to your lender. You might have already done this. It was not stated but that would be the best move (short-sell) if at all possible.

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#32) On July 05, 2012 at 7:45 PM, StarWitchDoctor (98.60) wrote:

I am not underwater, i bought in cash.

Just out a truckload of cash.

SWD.

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