Archive for the 'Real Estate' Category
Thursday, July 2nd, 2009
You may have heard the term “three-legged stool”, taken from the idea that a stool needs three legs to maintain balance. (Photographers use tripods, no duopods or quadrapods. Even a four-legged chair will likely wobble.)
Old Three-Legged Stool of Retirement
Traditionally, the components of the three-legged stool of retirement have been presented as Social Security benefits, Pensions, and Personal Savings (401k, IRA, and other assets).
This is partially supported by data from the Social Security Administration:
The Qualified Retirement Plans slice combines pensions, 401ks, and IRAs together, making it hard to see the breakdown. The Other Assets include income from other investments like capital gains or dividends from taxable accounts and real estate. We observe that a quarter of all income in retirement is still from working for a paycheck.
Shaping Your Own Retirement Legs
These are just averages, and each of us will have their own path to retirement. If you’re planning on retiring early, you won’t have Social Security yet. For people born after 1960, the full retirement age for benefits is already 67, and expect it to rise even further the younger you are. I think some form of SS will still be around when I’m 70, but who knows.
1. Flexible, reliable, part-time income
We already saw that lots of people over 65 still work. Even though I want financial independence early, I’ve also come to realize that I’ll never stop working. Ask yourself what are you really going to do in retirement? In addition, I think it would be stressful to stare at a big pile of cash and think to myself - “Crap, I hope this lasts for 30+ years!” Maintaining a part-time job and the related skills would help my cashflow, and also ensure that I could return to the workforce if disaster strikes.
I would want a part-time job that could provide some socialization and a sense of improving your community or helping others. Most of my imagined jobs involve teaching, coaching, sporadic technical consulting, or something tourism-related. It can’t be 9-5, and I’d want to be able to take months off at a time. This won’t be easy to find, so I need to start developing more “fun” skills as well as personal relationships now.
2. Personal Savings: Accumulate 30 times annual (non-housing) expenses
Without a pension or Social Security, you’ll need to live off your own savings. If you invest in a balanced portfolio of 60% stocks and 40% bonds, studies have estimated that you can have a “safe withdrawal rates” of about 4% per year. By being a bit more conservative than that, this means accumulating 30 times your annual expenses.
For example, if your annual expenses are $30,000, then you need to save $900,000. This is a very general rule of thumb. Taxes are tricky, but if your income is only $30,000 per year, you won’t be paying very much income tax. Check out the historical effective tax rate over a past 25 year timespan:
For reference in 1995, to be in the bottom 50% (safely in Q1/Q2) your adjusted gross income had to be under $31,000. And this even includes payroll taxes of about 9%, which you won’t have to pay on investment income. The result: very low taxes (possibly under 5%) if you keep your expenses down! Which brings me to…
3. A Paid Off House
I don’t think everyone needs to own a home. However, I happen to enjoy many of the intangibles of owning a home, I love my house and neighborhood, and plan on staying here a while. The cost of this leg can vary widely, from a $1,900 house in Detroit to… where I live, so choose where you want to live carefully. 
Financially, owning a home protects you from future inflation and rising rents. You are still subject to property taxes and maintenance costs.
In addition, not having to pay rent means you need less income from savings, reducing your needed nest egg in #2 above. You also pay less taxes. Withdrawing additional money from an IRA, for example, will mean subjecting them to your marginal tax rate, which could be 25% or higher. So to pay $750 in rent, you’d have to withdraw $1,000. Not very efficient.
So there, you have it, my three-legged stool. Yours may be very different - you may like renting, have a pension, own investment property, or have some other sources of income. I still worry about health insurance, but I’m still hopeful that some positive health care reform will occur that will create affordable health insurance for individuals under 65 not covered by an employer group plan.
* You can read more about the last two legs in my related post A Quick & Dirty Plan To Reach Financial Freedom.
Posted in Frugal Living, Real Estate, Retirement, Taxes | 8 Comments »
Wednesday, July 1st, 2009
I saw this LA Times article San Francisco beefs up renter protections over at SavingFreak, and it nagged at me all day as both a recent renter and possible future landlord.
Here’s the quick summary. City Supervisor Chris Daly introduced legislation to add the following additional tenant “protections”:
- Landlords cannot raise the rent above 33% of tenant’s income. An alternative amendment restrict this to situations where the tenant has a “hardship” - defined as being unemployed, having wages cut, or living on a fixed income and receiving a cost of living increase.
- Allows tenants to add roommates other than family to help pay rent, even if explicitly forbidden in the rental contract.
My take. I think this going too far, and I am glad the mayor seems to agree and will veto it. Already 88% of rental units in San Francisco are subject to rent control, with annual rent increases being capped at an average of 2% per year. Now a landlord must charge rent based on a person’s future income? How can they control that? And then tenants can bring in whomever they want as additional roommates, also creating more wear and tear on the place?
This is different from having the government provide unemployment benefits, or even “bailouts”. This is forcing individuals to directly subsidize other individuals arbitrarily. Imagine being a cabinet maker and being forced to accept a 50% discount to any customer who lost their job recently, regardless of your own costs or financial needs. I echo the concerns of this editorial:
We all like the idea of businesspeople doing the benevolent thing when their customers are hurting, but it is not fair for a public entity to force such behavior on a private one.
Am I missing something here? Let me know in the comments.
Posted in Real Estate | 36 Comments »
Monday, June 22nd, 2009
As pointed out by reader Jason, another consideration when evaluating the cashflow potential for a rental property is whether you can deduct the mortgage interest on your taxes. To see what the rules are, I always like to start directly at the source, which meant a stroll through those fun IRS publications.
First, I started with IRS Pub. 936, Home Mortgage Interest Deduction. There is the basic definition of a “qualified” home:
For you to take a home mortgage interest deduction, your debt must be secured by a qualified home. This means your main home or your second home. A home includes a house, condominium, cooperative, mobile home, house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities.
Then there is the question of how much you live in the second home:
Second home rented out. If you have a second home and rent it out part of the year, you also must use it as a home during the year for it to be a qualified home. You must use this home more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair rental, whichever is longer. If you do not use the home long enough, it is considered rental property and not a second home. For information on residential rental property, see Publication 527.
If you live in it enough, it is treated as a “vacation” property and you can deduct the mortgage interest. In general, you are limited to the interest paid on the qualified loan limit of $1,100,000 for “home acquisition debt” combined for both first and second houses.
However, for a full-time rental, we are led to IRS Pub. 527, Residential Rental Property, which states:
Generally, the expenses of renting your property, such as maintenance, insurance, taxes, and interest, can be deducted from your rental income.
Interest expense. You can deduct mortgage interest you pay on your rental property. Chapter 4 of Publication 535 explains mortgage interest in detail.
Okay, now I’m off to IRS Pub. 535, Business Expenses, specifically the section on Interest.
You can generally deduct as a business expense all interest you pay or accrue during the tax year on debts related to your trade or business. Interest relates to your trade or business if you use the proceeds of the loan for a trade or business expense. It does not matter what type of property secures the loan. You can deduct interest on a debt only if you meet all the following requirements.
* You are legally liable for that debt.
* Both you and the lender intend that the debt be repaid.
* You and the lender have a true debtor-creditor relationship.
There are special rules for the capitalization of interest if you actually build the home yourself.
Summary
I am not a tax professional, but from reading the above publications, it appears that mortgage interest on a 100% rental home is not tax-deductible as an itemized deduction as your primary house may be.
However, chances are that it is an eligible expense that can offset your rental income and still reduce your tax burden in a similar manner. If you made $10,000 in annual rental income but paid $8,000 in mortgage interest, and ignoring other factors like depreciation, you’d only owe income taxes on the difference of $2,000. (Dealing with writing-off rental losses is for another post.) The amount paid that lowers your loan principal is not an eligible expense.
As long as you have adequate rental income, this would make the mortgage interest as an expense better than just an itemized deduction, since everyone gets the standard deduction. For 2009, the standard deduction is $5,700 for single filers, and $11,400 for married filing jointly. Only total itemized deductions above that amount would provide added savings.
Posted in Real Estate, Taxes | 13 Comments »
Thursday, June 18th, 2009
CNN Money recently listed 5 new tools for homebuyers, one of which was InvestorLoft.com. At first glance, it looks like a Zillow for investment properties.
I decided to run a quick search using their PropScout tool for an investment property in California for under $300,000. I sorted by cashflow, as I that would be a primary requirement were I ever to get into a rental property. One of the top results was a little ski chalet in South Lake Tahoe for $269,000. With a estimated positive cashflow of over $50,000 per year, I was starting to think InvestorLoft was in serious “Beta”, but decided to keep looking further. Besides, I’ve spent a good deal of time up there, so I was intrigued. Could I swing a nice little ski cabin for myself?
Cashflow Breakdown: InvestorLoft vs. My Numbers
You have to register (free) to see details, but here is the property link. Click on the “View Financials” tab to see the breakdown.
Expenses
InvestorLoft’s default mortgage numbers have you putting 20% down, and financing the remaining 80% with an interest-only loan. I’d probably go with a 30-year fixed fully-amortized loan, and these days investment property have much higher interest rates. At 20% down and 7% interest, I got $1,400 for an estimated mortgage payment.
This chalet is really a townhouse, so it comes with HOA fees. Property management costs look to be estimated at 10% of gross rent, although as you’ll see below I don’t agree. No maintenance costs were estimated, but as a vacation rental with high turnover, I put in $200 per month. Here are the final numbers side-by-side:
Income
Here’s where that crazy cashflow number comes from: The expected monthly rent was $6,700 a month. (This is also why the property management cost above was $670 a month.) “Rental estimates based on 26 comparable rental listings with matching number of bedrooms and size in a 1.5 mile radius. ” Hmmm. First of all, there’s no way a month-to-month tenant would pay $6,700 a month for this wood shack. It has to be a vacation rental, and I can only guess that they are assuming 100% occupancy.
For some comparisons, I looked up similar properties at VRBO.com - Vacation Rentals by Owner. This chalet does not have the nicest interior, but the location is above average and is near the main highway.
Roughly, it would seem like I could charge $100 a night (taxes not included) for this chalet during May-November, along with a $75 cleaning fee per stay. It could go up to $150 a night during peak ski season (December-April). Occupancy rates would have to be a conservative 50% during the offseason and 75% during peak season. If I assume that I break even on the cleaning fees, that would work out to an average monthly rental income of $2280.
(I wasn’t quite sure how much a property manager would charge for managing a vacation property with people coming and going, especially if bookings were made online, so I estimated it around 20% of gross rent.)
Results
Too bad, it looks like I’m not going to get rich by buying this chalet. The InvestorLoft estimated monthly cashflow was a positive $4,094 a month, while my own rough numbers have me about $200 a month in the hole. I know I am being conservative in some areas, but I think that’s how you have to do it, especially for something optional like a vacation rental. The numbers actually aren’t horrible, though, it might warrant some more investigation…
InvestorLoft looks to be another one of those internet tools that you’re happy exists because you’ll play with it, but you can’t rely on them as there is still plenty of room for improvement.
Posted in Investing, Real Estate | 19 Comments »
Wednesday, June 10th, 2009
One of the things I like to read when I get the itch for some stock market opinion (which isn’t very often) is John Hussman’s weekly market commentary. Not that he’s always right, and I don’t own any of his mutual funds, but I like to hear his reasoning. In this week’s 6/8 post, he references a chart that shows us in a temporary lull of mortgage resets. The infamous subprime “wave” is past, but there is another big wave of option ARM and Alt-A resets ahead:
As I’ve noted before, recent months have represented a lull in the reset schedule, which was accompanied until recently by a moratorium on new foreclosures. Those foreclosures are now ramping up quickly, and a fresh surge in resets will add to the difficulties beginning later this year.
The chart originates from an IMF report entitled Assessing Risks to Global Financial Stability.
These upcoming resets may not be as bad as they are supposedly borrowers with slightly better credit profiles, assuming that enough people can refinance their mortgages to something they can afford. But it’s kind of hard to refinance when you’re upside on your house. Even I’m basically upside-down on my mortgage, and I had a 20% downpayment. Thank goodness I have a 30-year fixed, a steady job, and no desire to move!
I’m not changing my asset allocation by selling stocks or anything right now, but I’m also not getting too attached to these recent market gains. Plenty of uncertainty ahead!
Posted in Investing, Real Estate | 18 Comments »
Wednesday, June 3rd, 2009
Credit Card Debt
In the past, I have taken money from credit cards at 0% APR and placed it into online savings accounts or similar safe investments that earn 4-5% interest or more, and keeping the difference as profit. I even put together a series of step-by-step posts on how to make money off of credit cards in this way. However, given the current lack of great no fee 0% APR balance transfer offers, I am have not been as active in this “game” recently. My credit score remains high enough that I haven’t seen any negative actions.
Retirement and Brokerage accounts
Markets went up, although as usual I don’t know why. I’ve been swearing off CNBC so I’m especially detached from all the buzz. Most of our retirement accounts rose about 10% the last month, which was over a $10,000 gain. I actually wish it stayed down so I could start investing some of my new cashflow at lower prices. However, waiting for it to drop again is not logical behavior, or so I keep reminding myself…
Cash Savings and Emergency Funds
We did still save a good deal of cash from our income this month, but I shifted about $10,000 of it into my brokerage account so that I can start investing in taxable accounts, which skewed the values above a bit. We still have a year’s worth of expenses in our emergency fund, which always gives me the warm fuzzies.
Home Equity
Using four different internet valuation tools - Zillow, Cyberhomes, Coldwell Banker, and Bank of America (old version) - I took the average and took off 5% to be conservative and 6% for real estate agent commissions. These sites are really wonky. Last month I was actually up, but this month my home’s estimated value dropped over $32,000 in a month. Shrug. I’m lucky that our work situation is doing well and we have no plans on moving.
According to my quick and dirty plan for financial freedom I should start paying extra towards my mortgage, but I’m having a hard time pulling the trigger on this one as well. I feel inflation coming. Should I just invest in stocks, and keep my 5% mortgage as long as possible?
Posted in Goals, Investing, Real Estate, Retirement | 28 Comments »
Tuesday, May 12th, 2009
Another one of my new joys of home ownership is having to worry about termites eating my house from the inside out. Munch munch munch! The previous owners were signed up for something called the Terminix Inspection and Protection Plan, and the bill for next year came in recently so I’m trying to decide whether to renew. According to the Terminix website, it includes
- Certified annual inspection of your home and property
- No termite control fees if activity is found
- Free repairs of new termite damage upon discovery of live activity
The price is supposed to vary by area but for me it costs about $300 per year. This fee does not include any sort of preventative treatment.
So basically, I pay a regular annual fee which will cover all of my future termite control costs. Sort of a termite insurance plan. Well, almost all because the fine print excludes drywood termites, which are different from the more common ground or subterranean termite. According to Orkin, subterranean termites cause 95% of all termite damage in North America. However, they also thrive primarily in warmer coastal areas like where I live. So… I don’t know if this is a big deal or not.
Annual Inspection - Visual Only
I’ve already experienced an annual inspection earlier in the year, and I wasn’t really impressed. Basically a guy shows up with a stick and walks around the inside and outside of your house looking for evidence of termite activity. He looked under the sinks, inside cabinets, and pokes a few spots here and there. He did not inspect the attic, which would seem to be an easier place to spot termite damage. It took less than 20 minutes.
I pointed out a beam in the garage that had a hole in it and that released what looked like termite droppings (little brown salt-sized bits) when poked. He confirmed that it was termite droppings, but concluded they were old and there was no live termites. The house had been treated for termites when we bought it, so he might be right. But how can he tell that they haven’t returned? He didn’t take any samples for testing, take pictures, or anything like that.
No More Termite Bait Traps
Since our house has a bunch of those little green termite bait traps all around the outside, I thought he’d be checking those as well. Nope, it turns out that they stopped using that system (at least in my area). That struck me as lazy and/or cheap. I’d much rather be able to lift up a cylinder and see if there are termites lurking around, rather than only rely on seeing termite poop or actual visual damage to my house. I mean, look at this little factoid taken from their own site:
Costs vs. Alternatives
In the end, I’m not all that excited to pay $300 for someone to visit my home once a year, especially when they have an incentive to not find anything wrong. I don’t even get any preventative treatments, say once every 3 years or something. I haven’t gotten a quote back from Orkin yet, but according to their website they still do the bait and monitoring system.
According this CostHelper page, chemical treatment would cost around $1,350-$2,500 and a tent fumigation would cost $1,200-$2,500 for a 1,250 square foot house. Extreme damage would involve wall removal and replacement, which Terminix supposedly covers but sometimes only with a fight (see below).
Consumer Complaint Websites
I read through this RipOffReport page as well as this Terminix Consumer Alert page.
What do you think? Anyone have any experience with Terminix, especially their “Inspection and Protection Plan”?
Posted in Home Improvement, Real Estate | 39 Comments »
Monday, May 4th, 2009
Credit Card Debt
In the past, I have taken money from credit cards at 0% APR and placed it into high-yield savings accounts or similar safe investments that earn 4-5% interest or more, and keeping the difference as profit. I even put together a series of step-by-step posts on how to make money off of credit cards in this way. However, given the current lack of great no fee 0% APR balance transfer offers, I am have not been as active in this “game” recently. My credit score remains high enough that I haven’t seen any negative actions.
Retirement and Brokerage accounts
The market rally was sustained during April, so our predominantly passive investment portfolio increased a bit. We contributed another $2,312 in 401(k) salary deferrals this month including company match. See my investment portfolio page for more details.
I get attracted to various different ideas as time passes, but I really haven’t changed my investment portfolio in about two years now. I always need to remind myself to stick to the basics.
Cash Savings and Emergency Funds
Our cash savings rose again, and although I want to keep one year of expenses for our emergency cash reserves, I need to start putting more money to work in the stock market and other investments. It’s just hard to let go of the security of cash right now. We are contemplating whether we want to save up for a rental property.
Home Equity
I used the same internet valuation tools as before - Zillow, Cyberhomes, Coldwell Banker, and Bank of America (old version).
I have zero personal input here, I just average out what the sites say. They say up. The number shown is after an additional 11% reduction to be more conservative. Not that it really matters, as I am primarily focused on paying off the mortgage, as outlined in my quick and dirty plan for financial freedom!
Posted in Goals, Real Estate, Retirement | 14 Comments »
Friday, April 24th, 2009
Yesterday in Part 1, we talked about the basics of amortization and mortgage prepayment. In this post, I just wanted to share some other interesting results I got when tinkering around with the amortization schedule.
Are you always paying the same amount of interest?
As I noted before, amortization is a way to make equal payments but still preserve the right ratio of principal paydown and interest. You can check this using the same schedule of payments as before, except now I’m just looking at it broken down by 12 years instead of 360 months. ($200k mortgage, 30-year fixed at 5%).
If you have a loan of $200k at 5% interest, simple arithmetic will lead you to guess you’ll pay around $10,000 of interest the first year. As you see above, during the first year you actually pay $9,933 towards interest, as your loan balance went from $200,000 down to $197,049 over time. If you simply divide the $9,933 by the average of $200,000 and $197,049, again you’ll get 5%.
This just provides a rough estimate, but you can see that you’re always paying 5%, even as the principal shrinks. Only at the very end does it vary slightly, not sure why exactly, but I’m guessing due to smaller numbers. The lender isn’t ripping you off by having you pay a ton of interest in the first year. You just have a lot of interest to pay! Kind of neat, actually.
Is your investment return from paying extra towards principal really the mortgage’s interest rate?
When you pay down your mortgage at 5% interest, it is often assumed that this is the same as investing that cash elsewhere and earning 5% per year. (Ignoring tax issues.) But is it?
Again, a quick check on the spreadsheet confirms this. Let’s say I am just starting Year 2. If I prepay the entire equity portion of $3,102, this will advance me to Year 3 of the schedule, and I will be shaving off one year from my mortgage. In other words, my $3,102 will be worth an entire year’s worth of payments, or $12,884, in 29 years. This works out to be the same as a 5.03% annualized return. Close enough for me. Again, if you prepay near the very end of the term, the percentage starts to drop off a bit. But remember, if you’re prepaying, you’ll probably be finished with your mortgage well before reaching that point.
I’ve plotted both the effective interest rate paid and the paydown investment return (gain) below:
You can play with the spreadsheet yourself at Google Docs or in Microsoft Excel format.
Posted in Investing, Real Estate | 8 Comments »
Thursday, April 23rd, 2009
I’ve been tinkering around with my mortgage. Have you ever wondered how the monthly payment was determined? It’s called amortization. An amortization schedule is a way to make equal payments over a period of time, but have the payments split between principal and interest so that the interest paid over time decreases over time along with the loan amount remaining. It is a balancing act to be fair to both borrower and lender, and you can find a mathematical derivation here.
The most direct way to see where you are on your amortization schedule is to ask your lender to send you a copy. Alternatively, you can generate one yourself by using a mortgage calculator with this feature. Here is the amortization schedule for a $200,000 loan with a fixed interest rate of 5% over 30 years.
(May not be visible in RSS format. Here is the direct link.)
As you can see, in the beginning most of your payment goes towards interest, and only a little reduces your principal, or outstanding loan amount. As time goes on, your payment stays the same, but the chunk going towards interest decreases as the principal shrinks.
Mortgage Principal Prepayment
If you want to pay off the loan in less than 30 years, you’ll have to pay more than required. This is known as principal pre-payment. The effect of making such additional payments can be visualized by imagining that it moves you “ahead” in the amortizaton schedule.
Here’s an example using the schedule shown above. Let’s say you’re just getting ready to make your first payment of $1,074. At this rate, you still have 359 out of 360 monthly payments left to go! How much money would it take to shave off one extra payment off the end? To find that, you just have to look at the principal portion of Month #2, which I highlighted orange: $241.
If you pay $241 additional with your first payment now, you’ll won’t have to pay the $1,074 due on Month #360. Why is this? Working backwards, you can confirm that this is pretty much a 5% compounded return on $241 for 30 years, as expected. In addition, you’ll be shifted forward to Month #3 on the schedule. So next month your (still required) payment of $1,074 will have a bit more applied towards principal, and a bit less towards interest.
Making a 30-year Mortgage into a 15-year Mortgage
This actually creates an interesting way to shorten your mortgage. What if you kept paying the next month’s principal payment on top of your required $1,074 each month. You’d add on $241, then $243, then $245, and so on. Every month you’d shave off one month off the end, leaving you with a 15-year mortgage! You can also imagine this as skipping every other payment by just paying the principal and saving the interest.
This can work out nicely because the extra required will start out reasonably low at $241, and increase gradually with time along with your income and/or cashflow.
An alternative is to add $510 to every payment each month to shorten the term to 15 years. Although if you’re sure you want to do that, you might want to just get a 15-year fixed mortgage at a lower interest rate.
Read on in Part 2: Return on Investment Verification.
Posted in Investing, Real Estate | 34 Comments »
Monday, April 13th, 2009
Despite the current financial funk, I still desire financial freedom. The general idea is simple; I need to generate enough income from my assets to pay for my expenses. Here is how I’ve been framing the problem in my mind recently. I’m 30 now, let’s say I want to be “retired” by age 50.
Part 1: Accumulate 30 times annual (non-housing) expenses
There are numerous studies about the “safe withdrawal rate” from a portfolio, and they usually end up at around 3% to 4%. This usually means that with $1,000,000 dollars, you have a high (say 99%) chance of being able to produce $30,000 to $40,000 of income each year plus inflation adjustments for a long period of time (30+ years).
This is the same as saying you need to save 25 to 33 times your annual expenses.. If you’re conservative (or young), I’d go with a higher number, so I picked 30. Multiply your annual expenses by 30. You need that much money to retire. All of these are based on historical numbers, so this is only an estimate.
Right now I’d estimate our annual non-housing expenses at about $24,000 per year ($2,000 per month). Previously I’ve found that we spend about $18,000 per year, but that neglects a few things like health insurance and car deprecation. (Again, health insurance for those that retirement very early and are not healthy might be a bogey.)
$24,000 x 30 = $720,000.
At about $200,000 in non-housing assets right now, that leave me $520k left. Divided by 20 years and assuming no investment return, that would require $25k per year (not inflation-adjusted). At a 3% annual real return, I’d still need to save nearly $20k per year.
Remarks
With this part, you can see the power of frugal living, or the damage done by lifestyle inflation. $500 a month is $6k per year. $6k x 30 = $180,000.
So if I could cut $500 a month in my expenses, I’d need to save $180,000 less. On the other hand, if I grow some bad habits and start spending $500 more a month, I’d need to save $180,000 more. Either way, that’s a big number! This is why I still need to complete my line-by-line examination of expenses.
Part 2: Own my house / Pay off mortgage
I currently have 29 years left on a 30-year fixed mortgage. For us, that would mean another ~$470,000 in mortgage principal, but more when you count in all that interest.
According to this mortgage calculator, if we make one extra monthly payment per year (simulating a bi-weekly acceleration plan), that’d give us about 24 years before we’re done. If I made two extra monthly payments per year, it’d be shaved down to 20 years, which has the house paid off at age 50. Lots of other considerations, but I’m strongly leaning towards it.
Remarks
I know that you could easily roll up “housing” costs into Part 1 above, but I didn’t for a few reasons. For one, housing is one of the few expense areas where you can essentially “buy” all future costs. For example, you can’t pay a lump sum in exchange for all the electricity you’ll consume in your lifetime. Same thing for your grocery bill, or even a car since you’ll have to replace it. But if you own your house, you’ve basically cut out rent forever (just left with maintenance and property taxes). It also reduces the danger of inflation eating up your spending power.
The second reason is lower taxes. Owning your own house not only saves you from have to pay a housing payment, but also keeps you from having to earn the gross income needed to generate that after-tax amount. Ignoring house, I saw above that I only need to generate $24,000 of income per year total. The income taxes on that amount is very, very small. Using current numbers it might be less than 5% overall, with my marginal tax bracket at a mere 10% after taking out the personal exemptions and standard deductions.
But if I need to generate another $24,000 of income to cover housing ($2k per month in rent), then that additional $24k would be taxed at much higher rate of 15%. With state tax, the difference might be another 5%.
Try out this method with your own numbers, and see what happens. When I run the numbers like this, I know that I could retire much earlier if I moved to a cheaper place upon retirement. But is it worth it? It’s all about priorities…
Posted in Real Estate, Retirement, Taxes | 39 Comments »
Thursday, April 9th, 2009
Since I mentioned it during my recent net worth update, I’ve been thinking more about whether I should commit some additional funds to pay down the principal on my mortgage and reduce my interest paid.
There is already a good deal of discussion on this topic in my posts Why Paying Down Your Mortgage Early Can Be A Smart Investment and 10 Reasons You Should Never Pay Off Your Mortgage, but I’ve tried to summarize all the pertinent points into something more coherent below.
Other Higher Priorities?
If you have no emergency fund, high-interest credit card debt, or don’t have your IRAs/401ks maxed out, then you probably should focus on those things before worry about paying extra towards your mortgage.
What is your tax situation?
Next is the topic of tax-deductibility of mortgage interest. Everyone already gets the standard deduction, which in 2009 is $5,700 for singles, and $11,400 for married folks. Only the amount that your itemized deductions exceed this amount actually saves you money. If you have a $150,000 mortgage at 5%, your interest is only $7,500 per year (and decreasing in the future). If that’s your only deduction, you’re not getting any real tax benefit at all.
However, some people have a big cushion of deductions, like high property taxes, state income taxes, charitable contributions, etc. Some don’t. Some people are in high marginal tax brackets, where saving 35% (and soon maybe 40%) sounds really nice. Some are in the 15% or lower tax brackets. As for us, we are in a high marginal tax brackets, and pay a good deal of state income tax, so the deductibility is definitely in effect.
Comparing with other investment options
One major argument against paying extra towards a mortgage is that you can earn a better return elsewhere. Who cares about saving 6% interest annually when your money could be earning 10% somewhere else? As we’ve seen recently, stock market returns are not guaranteed, and also not without lots of heartburn. If anything, you should compare your mortgage interest with a high-quality bond or bank account interest. If you could have your cash earning 6%+ safely, then there’s a solid alternative.
Liquidity
Another argument against paying extra is that it is hard to access the equity in your house. You may not get a home equity line of credit, or it may be frozen later. However, if your alternative investments are in IRAs or 401k’s, then those aren’t exactly liquid either. Also, if you have an adequate cash cushion (as we do) and proper insurance, then liquidity will become a lesser concern.
Inflation hedge
A nice thing about mortgage payments is that if you have a fixed mortgage, the payment stays the same each month. Meanwhile, rents will increase with inflation. If inflation starts to rise significantly, you’ll be very happy to have a loan at 5-6%. A previous landlord told me his mortgage payment was $300 per month, while our rent was $1,100!
A possible strategy?
After all that, my idea is to simply look at the current yield of a comparable U.S. Treasury bond and compare it to my mortgage interest rate. If my mortgage interest rate is a lot higher than the bond rate, then I should pay extra towards the mortgage. Otherwise, if the Treasury rate is higher, then I should invest in bonds or bank accounts directly instead. If it’s close, stick with liquidity.
For example, say my mortgage rate is now 5.125% fixed, with 29 years left. The 30-year Treasury rate is currently about 3.7%. In 1990 or in other times of high inflation, a bond with the same maturity remaining would have been yielding more than 8%.
This way, I pay down the mortgage in times of low interest rates, and keep my inflation hedge during high interest rates. That means right now, for my situation, I should pay extra towards the mortgage. Am I missing anything? (Most likely! But please tell me what.)
Posted in Real Estate | 53 Comments »
Tuesday, April 7th, 2009
Finally a bit of green!
Credit Card Debt
For newer readers, don’t worry. In the past, I have been taking money from credit cards at 0% APR and immediately placing it into high-yield savings accounts or similar safe investments that earn 5% interest or more, and keeping the difference as profit. I even put together a series of step-by-step posts on how to make money off of credit cards this way. However, given the current lack of good no fee 0% APR balance transfer offers, I am just waiting to pay off my existing balances.
Retirement and Brokerage accounts
March was a rebound month for the stock market, and our balances went up accordingly. We contributed $10,000 into IRAs, and $12,969 in 401(k) salary deferral and company match. A chunk of that was a true-up contribution from 2008. Score! See my 2009 Q1 portfolio update for more details.
Cash Savings and Emergency Funds
Our cash savings did drop due to the IRA contributions, but we still have over a years worth of expenses set aside. I want to keep one year of expenses for our emergency fund, and start looking for places to invest the rest.
Home Equity
I used the same internet valuation tools as before - Zillow, Cyberhomes, Coldwell Banker, and Bank of America (old version). The magical elves have decided that my home is worth a tiny bit more this month. The number shown is after another 11% reduction to be more conservative.
It’s been about a year that I’ve had this mortgage, and I am wondering if I should commit some cash towards paying down the mortgage principal too. If I make an extra mortgage payment each year, I replicate a biweekly accelerated payment plan, and can shave around 5 years off my 30-year mortgage.
Posted in Goals, Investing, Real Estate, Retirement | 33 Comments »
Monday, March 30th, 2009
Speaking of internal frugality, I’d say one of the most basic ways to save on rent or mortgage payments is to… live in a smaller place. No, wait, really. Let’s think about it.
Even though it’s easy to make fun of 10,000 square feet McMansions, they are only a side effect of an overall trend towards larger houses. According to this 2006 NPR article, the size of new houses has more than doubled since the 1950s. The average new home sold in 2007 was a whopping 2,629 square feet.
Maybe as a whole we’re getting fatter and need a bit more space to move around, but not by that much! In fact, the average family size has actually been decreasing over time. Here are some stats I pulled from the U.S. Census:
Source: U.S. Census BureauFrom 1970 to 2004, the average household shrunk by 27%, but the average square footage grew by 66%. Using median numbers gave similar results.
There are several theories as to why this is happening. For starters, we may simply want a higher standard of living. (Sharing bathrooms? That’s for people in 3rd-world countries!) Perhaps it’s from us continually one-upping our neighbors. Maybe builders are pushing bigger homes through marketing. Or it may be a result of the breaking up of the American family, and how we don’t like spending time together anymore.
Most importantly, we don’t need the extra space. If a family of four could live well in 1,500 square feet back in 1950, there is no real reason they can’t do so today. It’s just a choice like any other, and we have to examine whether it is really worth the price.
Finally, it doesn’t stop with the bigger sticker price. There’s the higher property taxes and insurance rates. A bigger home costs more to heat, cool, maintain, and repair. More rooms means more furniture, more wall decorations, more room for clothes, and just more stuff in general. More appliances mean more electricity used. The list goes on and on.
In my opinion, many people don’t even notice that they are stretching to buy homes that just keep getting bigger and bigger. They just follow the crowd. This unconscious choice may partially explain why many of us feel so much more stressed financially than our parents.
Posted in Frugal Living, Real Estate | 46 Comments »
Wednesday, March 25th, 2009
As you may know, I own a house in an expensive area of the country. I love my house, and I love where I live, but I also admit that I occasionally daydream about moving somewhere with a lower cost of living.
In my experience, many people don’t like the idea of moving elsewhere because it involves something unknown and unfamiliar. However, if you ask people to think back to the places they have been, they’ll speak fondly of those places. Specifically, I think about moving back to a place that I spent several childhood years in - Austin, Texas.
Now, there are many things to consider before moving besides costs. These may include:
- Can you find a job there? If so, how will the pay change? Will it offset the change in cost of living?
- Do you enjoy the local culture? Can you easily participate in your hobbies and interests?
- Love, family, weather, traffic, nightlife, cultural diversity, etc.
I think a lot of people who haven’t lived in Texas (and most other areas) may have a misconception or stereotype of what it’s like to live there, and that is especially true of Austin. What I like about the area includes the relatively temperature weather, a large university center, a strong tech industry, and of course a low cost of living and tax burden. As for the financial details, I grabbed some graphs from the Austin Chamber of Commerce website, which were based on independent data.
Cost of Living Index, 4 Quarters Ending Q2 2007
The index takes into account the combined costs of housing, utilities, transportation, healthcare, and other factors. According to this CNN calculator based on the same index, if you are earning $100,000.00 after tax in San Jose (CA), the comparable after-tax income in Austin is 61,217.
Average Home Price, Middle Management Housing, 2007
(For the chart, a “middle management house” is a single-family dwelling model with approximately 2,200 sq.ft., 4 bedrooms, 2 1/2 baths, family room, and 2-car garage.)
These might have changed a lot since 2007, but the median home price in Austin is still a shade under $200,000. If a house in California costs $600,000 that only costs $200,000 in Austin - how many more years of work would it take to pay for an extra $400,000 plus mortgage interest? Would you move to Texas if it meant you could retire an entire decade earlier? Hmmm…
Tax Burden: State & Local Taxes Per Capita, 2005
So not only do things cost less, but I can also earn a lower salary and still get the same after-tax results. In general, Texas ranks 45th out of the 50 states in terms of total taxes per $1,000 of income. With no personal income tax, the primary taxes in Taxes are property and sales tax. In Austin, property taxes are about 2.2% of appraised value per year.
Quick Summary
Going by the numbers, moving somewhere else can certainly seem attractive. For me, not only do things cost less as a whole, but my income would take much less of a tax haircut as well. Now, I don’t think everyone should move, and I have no plans currently to do so myself. But if you are re-examining your financial situation, it can be worthwhile to keep an open mind and consider the possibilities. Everything is a trade-off, and what you gain may be worth more than what you lose.
Posted in Frugal Living, Real Estate | 50 Comments »
