My question is, what is an easy way to calculate my ‘profits’ from paying debt? It would be so cool to have a spreadsheet where I have my credit card payments listed and put against my outstanding balance, and then using the interest rate have a cell that contains a ‘total earned’ or ‘total saved’ category. I think part of the reason people don’t always pay off debts is because in the short term there is no reward. But this could help offset that.

What do you think?

What you are doing is 100% correct. Don’t change it.

Before you pay down a mortgage, you must look closely at the tax deductions you’re receiving. This calculation requires you to be comfortable with “tax math” and understand how federal and state income taxes work. Thus, most people don’t actually do the math.

In general, if you have a high income and high state/local taxes, you are receiving the biggest benefit from the tax deduction.

I did the calculations for my family. I found that state income taxes and property taxes pushed us over the standard deduction. Thus, all mortgage interest we pay is fully deductible. Further, we are in the 25% marginal federal bracket and the 6% marginal state bracket (and the same amount of mortgage interest is fully deductible from state taxes). So, our mortgage has a 6.375% interest rate. Our “after-tax” interest rate is 69% of that number: 4.39875%

Pre-paying a mortgage is a long-term investment. In my case, I’m in the first year of a 30-year mortgage and we have just built our dream home with no intention of ever selling it. So I don’t get the benefit of the investment in my mortgage for years. If I pre-pay and cut 10 years off my payments, then I get a return in 20 years. My return is the future payments I don’t have to make for years 20 – 29.

But those payments are worth less in 20 years due to inflation. If I have a mortgage payment of $2000 and inflation averages 3%, then that $2000 payment is worth $1088 in 20 years. In 29 years, that payment is worth $827.

This means that as you contine to pay the same fixed-rate mortgage payments, the amount you pay is worth less to you as inflation decreases the purchasing power of $1.

By the time your mortgage pre-payments result in a benefit, you will likely be paying more for property taxes than for the mortgage itself.

The only way to get a short-term return on a mortgage pre-payment (without selling) is to re-finance the mortgage. This is risky because you are betting that interest rates will be the same or lower than your current mortgage and that you will be approved for a re-finance.

Instead, consider putting the extra principal payments into a stock index mutual fund and hold it. Once that amount equals the remaining principal on your mortgage, cash in and pay it off. By long-term holding an index fund, you reduce your capital gains tax. You continue to get the full available mortgage tax deduction while growing the mortgage pay-off funds. The return is highly likely to exceed the after-tax mortgage rate (though it’s not guaranteed–that’s the risk you accept to get that return). And, that investment is liquid. If you need that money, you can get it.

Am I doing that? No. I have too many short-term goals right now that are more important than future mortgage payments.

Sorry for the length of this comment, but I just had to point out that a 30-year tax-deductible mortgage is an entirely different kettle of fish from credit card debt and car loans.

Hi, I’m Sharon.
It’s true that kind of money is rarely needed but wonderful if you have it. I didn’t have this year, but was saving because I am a teacher and I didn’t want to work this summer if I didn’t have to. So I started saving. And I kicked out my roommate mid Feb so I could move during Spring break and reduce my expenses. (roommate wasn’t paying half and wasn’t paying on time). I knew I could get a one-bedroom and be more secure about costs (not pay the heat bill) and pay about the same or less than I was paying with the roommie. Such a good plan.
Enter: THE HEALTH SCARE
Doctor found a “mass” in my belly in early March so I ended up taking all the rest of my sick days and my Spring Break doing fun things like having a colonoscopy.
Now I could afford the two bedroom apartment I was in…just that my savings rate went to almost nothing. And there were all those pesky co-pays and things like laxatives for the colonoscopy to pay for.
About the same as I found out for sure that the tumors were benign
ENTER: NON-RENEWAL OF CONTRACT
For non-stated reasons, my school decided to not renew my contract in September. If you are non-tenured they can do that.
So, I was left with no job money after June, a question of whether to have a surgery to remove the tumors in July, and whether I qualify for un-employment.
Because I had six weeks of expenses saved (at the cheap apartment rate), I chose split a plane ticket for my mother to come out to help me move and be around after my surgery (no health insurance after Aug 31…when it became a pre-existing condition) and I took about two and a half weeks before going back to an old part-timeish job..after all moving costs money as well.
I am lucky that this bad paying job doesn’t require a huge amount of labor so I can go part time for a few weeks until I am 100%. NOw that I am feeling better (I’m still not feeling great, but I am surviving.), I am increasing my hours.
So, my goal is to look for “a real job” while doing the “part-time job” for about 50 hours a week. Yes, it is crazy, but I think I can do this
It beat lying to the state during the month of July that “I was able to start work at anytime” I’ll work hard to be honest.
And that saved money gave me options to work with so that I could do everything I needed. As soon as I get “a real job” my goal will be that three months of expenses. Being able to take off the whole summer and just look for work would have been great.
You are right that this is rare, but if you add in other issues like illness, I am guessing it happens for than anyone would like to think.

“You shouldn’t pay down your mortgage or your student loans because of the tax benefits!
Yes, some debts have tax benefits and those should be looked at carefully – but not overinflated. On student loans, you can deduct the paid interest each year, but all extra payments will do is reduce the amount of interest you pay in future years, just slightly reducing your deduction there.”.

I have a student loan of 10K at interest 8.25 % in Canada. I was thinking of making large lump sum payments of 2k every 2 months( after keeping some money for emergency). Is this quote saying that it is not worth making lump sum payments as fast as I can?

Appreciate any advice.

RA

For emergency purposes, which is better –

(1) to have $2,000 in a savings account earning 2% interest and a $2,000 balance on a credit card charging 8%, OR,

(2) to have a credit card with a zero balance but $2,000 available credit and zero money in the savings account?

For use in an emergency, you have $2,000 available either way. But you’ll pay a $120 premium in interest under option 1, plus the risk of an occasional late fee of $25 or more if you forget to pay it on time.

Besides those costs, having high credit availability (unused credit line) versus credit debt will increase your credit score, whereas savings in the bank won’t. Higher credit scores can lower your car and other insurance rates significantly (my car insurance company gives 10% to 30% discounts for higher credit scores, which can save $100s of dollars a year), as well as lowering the cost of future borrowing.

I would stock my pantry and keep a month’s worth of cash (for food, gas, etc., in case of major disruptions) on hand (not in the bank) and then focus on paying down the debt, before I would build a six month emergency fund. Think of the growing credit line available as the emergency fund – at least until all high interest debt is paid off. THEN I would work on my six-month fund of money in savings.

Likewise, building retirement before paying down debt only makes sense in some situations. Someone whose company 401(k) plan will match her own contributions and who is in a high tax bracket should certainly do that rather than pay off student loans or credit cards, but someone with no matching program and a zero marginal tax bracket would be better off paying down debt. I think you simply need to do the math.

Spencer makes an excellent point about diversification of investments. It isn’t only an issue of having too much of your net worth in one asset (home equity), it is also being over-concentrated in one geographic region, especially if your job is at all dependent on the local economy or your employer is a major employer in the area, and even more so if your retirement account is over-invested in your employer’s company or you have a defined benefit pension. A regional economic slow-down or bad year for your employer then carries a triple whammy: Possible job loss, home value deterioration, company stock/retirement account deterioration.

If you have a loan in the amount of X and you pay the minimum + Y toward principle every month as you progress Y is going to ultimately be worth less and less. So you pay Y down on principle in month 1 and that saves you Z in interest throughout the life of the loan. In month 2 you pay Y down on principle which would be worth Z minus something?!

So, depending on the interest rates, how long until your loan is paid off, how much you put on principle or into an investment vehicle, you may be better off putting Y into an investment even if the interest rate is lower depending upon the time horizon of the investment and the life of the loan.

Does this concern make any sense to anyone else? Does anyone know how you would calculate for this?

Diversification is the only free lunch available in investing (that why we like index funds so much). Someone who is risk averse (and therefore interested in the risk-free return available in paying down a mortgage) may actually increase their risk by becoming concentrated in home equity. The value of your home is tied to one property in a very local market, it has no geographic or other diversity.

Of course this concentration makes it even riskier to by highly leveraged in your home (not enough equity), so you do have to be conscious of building a reasonable amount of equity. But after you are down to a reasonable loan to value (20% down payment or equity gets you there), your focus should be on diversifying into other investments.

After you have built up a good diversity of investments, then home equity can be increased further, without becoming an overwhelming % of total assets. The goal is to avoid being “House Rich; Cash Poor.”

This is the framework I am following. I recently got to 20% Equity in my home, and now I am focusing on building other assets, to drive my allocation to my home down to 15% or less of my total assets.

Maybe a complex way to look at things, but if you want to view debt as an investment, then might as well go all the way.

I know this post is about debt, but in your conclusion, you mentioned building an emergency fund. I take a little different approach than the standard 3-6 months of cash reserves philosophy. Maybe I’m just using my lack of that much reserve as an excuse for my logic but I’m curious what you think of the approach I’ve adopted.

I have no debt other than the my home mortgage. No car payments, no credit card debt, no nothing. I save ~ 35% of my income per year which is split between maxing two Roths, funding two 529’s, contributing heftily to my TSP (govt 401K) and funding some cash savings in an Money Market.

I don’t really think of the cash savings as an Emergency Fund. Its more like my “ah shucks” fund. Like “ah shucks” I spent too much this month, move some money over to cover us. “Ah shucks” the car broke down. While those might be emergencies to some, I just consider them the price of doing business. Sometimes the unexpected happens.

Why do we need 3-6 months of cash expenses sitting around? I suppose if you were really worried about losing all income sources (i.e. your job) that might be a nice cushion until you can get back on your feet. But how often (I’m asking, I really don’t know) does that kind of Armageddon emergency happen? I don’t know anyone who has had a catastrophic job loss like that.

In general my cash reserves are targeted for a specific purpose. E.g. a down payment on an investment property, a vacation, a new car, etc.

I have an excellent credit history and currently have a couple credit cards that give me an available credit of close to $50K should Armageddon occur.

My solution: A leveraged emergency fund should it be needed, a smaller “ah shucks” fund for those unexpected atypical needs, and the ability to attain other goals rather than tie up $35K-$50K just in case the worst happens.

I like to think I’m managing my risk appropriately, but you and your readers may see it differently. I’d be interested to hear your opinions.

Thanks
-Jeff
I’m Minding My Own Business, are you minding yours?

Bryan Ellis
http://www.FreeRealEstateTraining.com

I appreciate your insight and your ability to make financial affairs understandable. Your main premise, “Spend less than you earn…and master it” is the best piece of advice on all the personal finance sites. You provide a great resource for us.

Cade

Mike