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Assuming you have a mortgage, haven't refi-ed beyond the $100K limit for tax deductibility, and are an experienced investor (fee/tax minimized, diversified), do you have a well thought out amount of home equity vs financial investments?

I mean, is there a reason you have a $300K mortgage and $100K in a taxable account vs the other way around?

Increasing home equity is equal to investing at your mortgage rate, after all tax effects. After tax, your mortgage is probably only worth 3-4%, versus long term stock returns of twice that. But the mortgage prepay "return" is risk free.

So I guess if you have a long time horizon, you should have a bias toward less home equity and more in stocks. Does anyone have a rule or guideline for home equity % vs age?

There are other considerations as well- I have friends whose "earthquake insurance" is having only 10% equity in their properties.

I've refied to the 100K limit, so would have to buy a new place to reset the mortgage basis.

Nick
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Nick,

I didn't understand your post, specifically, "haven't refi-ed beyond the $100K limit for tax deductibility." Are you implying that interest is deductible for tax purposes only on RE loans of $100K or less? Such a limitation would make interest on most RE loans on properties on the east and west coasts non-deductible. Of course, high property values tend to be in blue counties, so that might be a way for GWB to raise taxes without political bite.

db
Montecito, CA
A blue town with very high RE prices
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hey db,

These rules have been around since about 1987 or so. See http://taxguide.completetax.com/text/c60s10d285.asp

Sorry, but you can't blame W for this one.

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I didn't understand your post, specifically, "haven't refi-ed beyond the $100K limit for tax deductibility." Are you implying that interest is deductible for tax purposes only on RE loans of $100K or less? Such a limitation would make interest on most RE loans on properties on the east and west coasts non-deductible.

Nick was referring to home equity debt, which is indeed limited to up to $100,000 of the debt or all of the equity one currently has in one's home, whichever is less. This is a different animal from home acquisition debt, which is limited to $1,000,000 or the purchase price of the home, whichever is less.

See IRS Publication 936: Home Mortgage Interest Deduction: http://www.irs.gov/pub/irs-pdf/p936.pdf
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I obviously missed the distinction, given that he used the term "mortgage" in the original post, the post to which I was responding. I automatically think of a mortgage as the primary loan, unless it is specifically specified as a second mortgage. Home equity means to me the value of the property minus encumbrances, most likely loans. The title of the post was "rational home equity policy," which some of us might believe deals with the common issue of whether to retire a RE loan or invest the proceeds.

Still, capping interest deductiblitiy at loans of $100K or less might be a sly way to raise taxes on the great unwashed from the blue counties. Hell, a $100K in Neb might buy enough land that it can be claimed as a farm, on which you might be paid for not growing some crop.

db
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Scott Burns discusses this issue here: http://www.dallasnews.com/s/dws/bus/scottburns/columns/archives/1999/990711SU.htm

We are intending to move when we retire, so resetting the mortgage basis is not an issue with us.

There are a few things Scott did not analyze as thoroughly as I would have liked.

One is liquidity--having a lot of your assets tied up in a not-very-liquid investment is definitely a drawback. OTOH, if you have enough liquid assets to cover any conceivable emergency, a paid-up primary residence may be a very good thing.

Another is the tax situation. If your income in retirement is high enough to put you into the AMT range, transferring assets into a fully-paid house has some interesting consequences. You get the occupancy return, but since no money actually changes hands it is a completely non-taxable return. This is a nice example of a tax-free return on investment.

What you lose is the leveraged appreciation of the real estate.

I expect that it will take more than a few hours with a spreadsheet and a tax advisor to get this exactly right, but if you have the assets, you get more than one chance at it. For instance, move into a new primary residence with about a 50% down payment and a no-prepayment penalty loan. You can transfer as much money as you want into the primary residence at any time.
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...do you have a well thought out amount of home equity vs financial investments?

I mean, is there a reason you have a $300K mortgage and $100K in a taxable account vs the other way around?

Increasing home equity is equal to investing at your mortgage rate, after all tax effects. After tax, your mortgage is probably only worth 3-4%, versus long term stock returns of twice that. But the mortgage prepay "return" is risk free.

So I guess if you have a long time horizon, you should have a bias toward less home equity and more in stocks. Does anyone have a rule or guideline for home equity % vs age?


Nick,

I think that this decision is based on so many variables which are different for each individual, that it's relatively impossible for there to be a rule/guideline that would satisfy the myriad requirements, which include:

Tax Effects - Marginal ordinary income tax rates, LTCG tax rates, and AMT exposure both before and after 'retirement'.
Mortgage rates
Home ownership vs: renting
Individual Risk Tolerance
Availability of discretionary dollars

Currently I make mortgage payments at an after-tax rate of 3.91%. I need to earn (on average) an annual return of 4.6% to offset the mortgage cost. So far I have been able to do this. I have no AMT exposure. Currently I have 90% of my mortgage balance available in taxable accounts (discretionary dollars).

As I'm in my mid-50s, I would feel more comfortable if I had 100% + of my mortgage principal available in taxable accounts. I say more than 100%, because liquidation would result in taxable gains, thus tax liabilities would also have to be covered by the taxable account. This 100% + number is based on my own individual risk tolerance--I would feel more comfortable knowing that if I had to remain where I currently live and hunker down, I could pay off the mortgage, thus decreasing my monthly outgoing expense dollars considerably. I intend to meet this 100% + goal by the end of 2005.

When I retire in 8-10 years, I intend to move and will therefore sell my current property. Whether I buy/rent/mortgage a new property will depend on the tax laws at the time, my individual tax rates, risk tolerance, etc. IOW, the decision will have to be revisited again.

One financial advisor that I know always recommends that one goes into retirement with NO mortgage debt. For myself, I tend to agree, as I would like to have the option open of a reverse mortgage if dire circumstances make it necessary. OTOH, here's an article from AARP that indicates more seniors are taking on more home equity debt than ever before in history:

http://www.aarp.org/bulletin/yourmoney/Articles/a2004-09-13-house_party.html

Although they don't necessarily recommend that route:

Experts say that before you borrow or refinance—especially if you're ready to retire and will have less income—have a hard look at your financial situation and be sure you can pay off the debt. It may be easy these days to get large loans, but just because you can get more money, Zhu says, doesn't mean you should. "You better think twice before you jump."

Here's another one, not as recent, that goes into more detail on senior debt:

http://www.aarp.org/bulletin/yourmoney/Articles/a2003-06-25-olderamericans.html

"Today's 50- to 70-year-olds are leveraged to the max," says Leonard Raymond, executive director of Homeowner Options for Massachusetts (HOME), which offers older people life planning services. "They are involved with credit cards and refinancing. They have a different perspective on debt."...

A growing percentage of mortgage debt, however, consists of home equity loans or lines of credit, often spent on cars, vacations and home improvements.

"Real estate is not as liquid as some people think," says Cohen of CFD in New Jersey. "If you run into trouble, things can go downhill fast."


I also found it interesting that ~98% of the AARP articles containing the word 'mortgage' are articles about reverse mortgages.

2old


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OldOne wrote:

Scott Burns discusses this issue here:

Thanks for the link and thoughts. Scott's article provides a good starting point for this analysis, though I thought his bit about a 12% return from home equity is misleading. You get that 12% whether you have 1% home equity or 100%. The return from paying down the mortgage is mortgage rate, no more and no less. His table at the bottom also assumes an artificially hight 7.5% mortgage rate.

He makes a couple of good points though:

The only way to get the higher return is to commit to producing enough income to make the mortgage payments, a commitment most people want to avoid as they approach retirement

Right, I think we all agree you want your mortgage paid off by the time you retire, when much of your investments will be in low returning fixed income assets anyway.

Now imagine that you have choices most people don't have: You have a stock portfolio equal to the purchase price of a house

That's true, most people have constraints that make my question a non-issue: They can't increase home equity b/c they don't have taxable investments. Or they can't decrease it since their payments would be too high to qualify for the loan.

But let's say you're young and you do have the taxable wealth. You're 30, a good investor, you have $100K in a taxable account, $100K in home equity, and a $100K 5% mortgage. Should you pull out the home equity and invest it? Historical returns say you should. I guess it's a matter of personal taste.

Nick

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But let's say you're young and you do have the taxable wealth. You're 30, a good investor, you have $100K in a taxable account, $100K in home equity, and a $100K 5% mortgage. Should you pull out the home equity and invest it? Historical returns say you should.

One thing to be very careful about is the difference between the average returns and their variability. If you plan to pay the mortgage with cash flow from the investment then you are taking a risk. The so-called safe withdrawal rate is 4% (see the Retire Early Home Page discussion board here at the Fool and http://www.retireearlyhomepage.com/ for details).

This means that if you need to pay your mortgage from your investment, and take out more than 4%, then you have some chance of depleting the investment before you have paid off the loan. Even so, on average, you will end up coming out ahead. So if you have alternative sources of cash to pay the loan, and are willing to take on some risk, then it may make sense.

http://www.retireearlyhomepage.com/ has links to some nice calculators that let you figure out what the risk is based on historical returns. It is geared towards making your retirement nest egg last, but it is a similar question to the mortgage one.
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I created a spreadsheet some time ago to answer the question of whether paying off a mortgage was a good idea or not. I used monthly S&P prices back to 1871 to compare the returns of paying off a mortgage. I looked at two cases:

a) Invest an amount (X) in an S&P index fund for the term of the mortgage (15 or 30 years).

b) Apply an extra amount (X) to the mortgage. When the mortgage is paid off, invest the mortgage payment plus X in an S&P index.

I compared total values for every 15 & 30 year period from 1871 to present for both cases. Taxes were not considered since the amounts in case a) could easily be invested through a tax advantaged account and taxes would be owed on gains in both cases if invested in taxable accounts.

In my case ($200k loan, 4.875%, 15 year, $200 extra payment) investing yielded more in 81% of the periods. If you consider deducting interest payments, investing was better 97% of the time.

30 year loans at current interest rates show investing is better more than 95% of the time.

With that in mind, why didn't I max out my loan amount when I refinanced a couple years ago? When asked that question on another board, it occurred to me, I'm always more than willing to delay payment if I can do so at a low or no interest rate. I minimize my withholding and pay tax in April, I use my credit card for nearly all potential purchases, etc. But, I won't take on added debt and responsibility for the sake of making a few points of return. Things can happen such as losing a job, disability, etc. It's simply not worth the risk.

OTOH, the S&P is up 19% since my last refi.

-murray
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One thing to be very careful about is the difference between the average returns and their variability. If you plan to pay the mortgage with cash flow from the investment then you are taking a risk. The so-called safe withdrawal rate is 4% (see the Retire Early Home Page discussion board here at the Fool and http://www.retireearlyhomepage.com/ for details).

Actually, that link is NOT to a fool board. You shouldn't say it is when it isn't!

JLP
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OOPS! My fault. I guess I should have read more clearly before I posted! Sorry!

JLP
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Murray,

I did the same thing with the spreadsheet. We must think alike!

I think the "big picture" is about building wealth, not necessarily being out of debt. I laugh to myself when I see the Dave Ramseys and other "experts" talking about how much interest you save by paying down a mortgage quickly. They don't ever address the opportunity cost of doing so.

JLP

http://AllThingsFinancial.blogspot.com
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I wrote a piece about the mortgage thing a couple of months ago. I would post it here but it won't format right. So, for those interested, you can read it here:

http://allthingsfinancial.blogspot.com/2004/10/which-is-better-15-year-or-30-year.html

JLP
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see the Retire Early Home Page discussion board here at the Fool and http://www.retireearlyhomepage.com/ for details.

Actually, that link is NOT to a fool board. You shouldn't say it is when it isn't!

Sorry for the confusion. The word and was meant to indicate I was talking about two separate websites.
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Yeah, I'm sorry about that. I should have read it more clearly first. If I could delete my post, I would!

JLP
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I think the "big picture" is about building wealth, not necessarily being out of debt. I laugh to myself when I see the Dave Ramseys and other "experts" talking about how much interest you save by paying down a mortgage quickly. They don't ever address the opportunity cost of doing so.


We all use different measuring sticks and different criteria for our lives. In my case, I don't happen to think that opportunity cost is everything, nor do I agree that the big picture is about building wealth. That may be true for you, but there are probably more than a few like me that measure other things in the big picture like having my health, being able to put my children through the college of their choice, and being able to retire early, all of which are my goals. To do that, though, it doesn't mean that I have to funnel every extra dollar into investments to simply make more money.

There is that sleep-at-night factor where I want to know that I will simply always have a place to sleep and the wherewithal to be able keep it. It doesn't mean that I have to maximize every investment dollar particularly if I am already meeting the goals which I have set for me.

Having a larger pile at the end is not my goal. I want a sufficient pile with a little breathing space, that allows me to buy some toys along the way, pay down the mortgage so that it will be paid by the time the kids are out of college, be financially independent, and generally do a few other things besides work and save. I am on that path, so there is no need to try to accelerate it or add any risk with which I may not be comfortable.

That is not to say that the way you view things is wrong. It is just different than the way I view things. But different is fine as long as that is adequate for each of us.
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Yes, there are different strokes for different folks. You have to do what you feel is best for you.

But, keep in mind that that "larger pile" you are talking about can allow you to provide for your grandkids' education.

JLP

http://AllThingsFinancial.blogspot.com
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But, keep in mind that that "larger pile" you are talking about can allow you to provide for your grandkids' education.


Except that's not my intention. In fact, I will most likely not leave much, if anything, to my children and they know it. I will provide them with an education which is something that will always be theirs and cannot be taken away. But I do not intend to leave them with much other than that. My preference, and they know it, is to leave whatever is left to establish some sort of scholarship for learning disabled children so that they can go to college, similar to the opportunity that I am giving to my children, one of whom does have a signficant learning disability. And even with that, my intent is not to be able to have enough money to support him and/or his children for the rest of his life. At some point, he's got to be able to stand on his own two feet, and I intend to provide him with the best tools for that.

So even though you can think of things that you may want to do with that larger pile, once again, we simply have different goals, because if I have a larger pile, I would either prefer to spend it on me or to leave it for a scholarship.

As I have always believed and told my children, an inheritance is not a right, and I do not want them to live their lives thinking that it is, and wasting any opportunities that come their way to live full and happy lives. I've seen too many families broken apart by money and inheritances, and I would prefer not to do that to my own family.
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There is that sleep-at-night factor where I want to know that I will simply always have a place to sleep and the wherewithal to be able keep it.

I agree, but I think we need facts to make decisions. The FACT that 95+% of the time through history I would have been better off NOT paying down my mortgage helps me sleep quite well at night.

-murray
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The FACT that 95+% of the time through history I would have been better off NOT paying down my mortgage helps me sleep quite well at night.

Then you must not have lived here in MA during the 1990's when the market tanked, people were being laid off left and right and couldn't find new jobs, and real estate prices dropped like a stone. My next door neighbors both got laid off from two different companies in the same week. They had plenty of investments, but those tanked as well, and they had to sell lots of stuff at a loss to pay the mortgage. That only lasted so long til the husband finally had to take a job, any job, and it turned out to be in CA. The wife stayed here with the kids to sell the house, which they finally did at a $100k+ loss, and they just barely squeaked by not having to declare bankruptcy. Here we are 13 years later, and I think they have finally purchased another house out in CA where they still are.

This was not an isolated incident. There were many more folks like this, some of whom I knew personally.

So although your data may be a fact for 95% of instances, I don't happen to be willing to take that 5% risk. What's a 5% risk, you say, since the chances of it happening are so very small? Well, I'll tell you. I happen to have a 13-year-old son who only had a 10% chance of surviving infancy. Someone had to make up that 10%, and I am eternally thankfull he fell into that side of the statistic. Similarly, someone makes up that 5% statistic, and I would prefer it not be me.

Again, I do not need to have a huge pile. I need a sufficient pile with some safety factor. I have that.

You may prefer a much larger pile, and may find that 5% risk to be well within your risk profile. For me, however, that is simply too much chance for me to take with the roof over my head, particularly when I don't need to do it and will not suffer any adverse consequences for it.
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Then you must not have lived here in MA during the 1990's when the market tanked, people were being laid off left and right and couldn't find new jobs, and real estate prices dropped like a stone. My next door neighbors both got laid off from two different companies in the same week. They had plenty of investments, but those tanked as well, and they had to sell lots of stuff at a loss to pay the mortgage. That only lasted so long til the husband finally had to take a job, any job, and it turned out to be in CA. The wife stayed here with the kids to sell the house, which they finally did at a $100k+ loss, and they just barely squeaked by not having to declare bankruptcy. Here we are 13 years later, and I think they have finally purchased another house out in CA where they still are.

You are correct. If you owe on your house and the economy turns on you, you could lose it. However, even if you own the house and times get tough, you won't have access to the equity in your house unless you sell it. No banker will give you a home equity loan if you have lost your job. And, if the housing market has tumbled, you might have to sell your house for much less than it is worth.

JLP

http://AllThingsFinancial.blogspot.com
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But, keep in mind that that "larger pile" you are talking about can allow you to provide for your grandkids' education.

More isn't always better. Enough is where I'm good to go.

rad
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I think that this decision is based on so many variables which are different for each individual...which include:

Tax Effects - Marginal ordinary income tax rates, LTCG tax rates, and AMT exposure both before and after 'retirement'.
Mortgage rates
Home ownership vs: renting
Individual Risk Tolerance
Availability of discretionary dollars


2old,

Great post, I think you've got it all figured out. And interesting question to ask people who have a mortgage and a taxable account is: Why not buy stocks on margin? After all, you can deduct the margin interest, so your cost of capital is only 3-4%. Of course margin interest is variable, but otherwise investing and having a mortgage is no different than buying on margin (something most sensible investors don't do).

Nick
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Why not buy stocks on margin? After all, you can deduct the margin interest, so your cost of capital is only 3-4%. Of course margin interest is variable, but otherwise investing and having a mortgage is no different than buying on margin (something most sensible investors don't do). <P>

There is an enormous difference between a mortgage and buying stocks on margin.

If the house value declines the bank can not call the mortgage. If the stock value declines you get a margin call & either have to sell out at a ruinous loss, or come up with more money on a day's notice.
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Why not buy stocks on margin?

I answered that question here: http://boards.fool.com/Message.asp?mid=21975247

To recap-

With that in mind, why didn't I max out my loan amount when I refinanced a couple years ago? When asked that question on another board, it occurred to me, I'm always more than willing to delay payment if I can do so at a low or no interest rate. I minimize my withholding and pay tax in April, I use my credit card for nearly all potential purchases, etc. But, I won't take on added debt and responsibility for the sake of making a few points of return. Things can happen such as losing a job, disability, etc. It's simply not worth the risk.

-murray
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2gifts:

As I have always believed and told my children, an inheritance is not a right, and I do not want them to live their lives thinking that it is, and wasting any opportunities that come their way to live full and happy lives. I've seen too many families broken apart by money and inheritances, and I would prefer not to do that to my own family.

Here, here, 2gifts.

I used to work with a guy who said he believed that it was every generation's responsibility to add to the family wealth and leave a bigger and bigger pot to the next generation until at some point there would come a time that one would not need to work. He and his wife lived very frugally so he could sock away as much $$ as possible, but not with the intent that this was for them or their retirement.

I questioned him about this and pointed out that it was very possible that a future generational member would simply squaunder the money and wouldn't it be a good idea if he and his wife used a little of the money for themselves to make their lives "happier" and "more fulfilling"?

He said, he intended to "educate" his children about the "plan" and fully believed that they would do the same with their offspring. In a worsecase scenario as I outlined above, that would be sad, but didn't change the fact that the plan should be.

I asked if his parents left him a large inheritance and he said they had not. But, their irresponsibility would not deter him.

Frankly, I was amazed.

3MM
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I used to work with a guy who said he believed that it was every generation's responsibility to add to the family wealth and leave a bigger and bigger pot to the next generation until at some point there would come a time that one would not need to work.

The Rockefellers and Kennedys and other have done well using this idea. At one time, I wanted to leave a legacy, too. But, I'll never have the kind of money it takes to make something like that a perpetual thing. I think it's the right thing to do, but most of us just won't be able to. I guess when you're thinking about the Rockefellers and Kennedys, you also need to think about the Hiltons. :o)

Hedge
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