Author Topic: My First Home w/o Wheels OR 7 years to go  (Read 6369 times)

Bakari

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My First Home w/o Wheels OR 7 years to go
« on: September 24, 2015, 09:26:02 AM »
It official!
Loan funded, we were handed the keys.


We first found the listing for a 3 (+) unit property a few miles from where I grew up, and 1 block from the local light rail system, in May.
Submitted an offer 5% below asking, they countered above their own asking price (despite having no other offers in).
That's how this started...
There was a hoarder...
The sellers are elderly, live across the country, take weeks to respond to any question or sign any document (even though they are all "signed" by computer), they picked a realtor with a 1-star yelp rating, the tenants have changed the keys, they are unwilling to negotiate on any point, they apparently have no written leases for the tenants...


and we end up using our contingencies to back out.
A month goes by, we see other places, put in another offer and get outbid by 75k...


And I drive by the first place and notice one of the key issues has been resolved: the hoarder they claimed was being evicted over a month before has finally actually left.  We found a better realtor, and submitted a second offer on the same place as the first time.
All the same issues as before (minus the hoarder), but this realtor actually gets things done - and has patience with how slow it all goes.

Inspection says we have a lot of work to do, just to make the place legal and safe, nevermind attractive.
But my spreadsheet says the numbers still work, far better than anything else we can afford in our area.

Bakari

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #1 on: September 24, 2015, 09:26:27 AM »

May to almost October.  Almost 5 months!  Holy crap.  Not 5 months looking, total, but 5 months just in inspections and negotiations and escrow on this one place. 
Which is, of course, why we got it - the numbers were good, and there is a lot of investor money in the SF Bay Area, a lot of it cash, most places get bid above asking price.  But no one wanted to deal with there people.
Now I'm a freggin land owner!
Me, whose average income over my working career (2001-today) has been $19,500 annually. 


I managed to save 80K by living on the cheap, and combined with my partner's savings and some family gifts, plus leveraging my good credit into quadrupling our cash on hand, I now own something worth nearly a half million.  This is f*ckin crazy!


Bakari

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #2 on: September 24, 2015, 09:26:41 AM »




So, anyway... we have to spend the first year's rent (above the mortgage) on repairs and upgrades, and maybe large thank you gifts to the people who helped us.
I'm hoping we can refinance to a 15-fixed with a lower rate as my fiancee's credit score gets closer to mine and we have experience as landlords.
And then I start putting 100% of rent money into the mortgage, plus we add the equivalent market rent from our own unit into the mortgage each month, and we should be able to pay it off in 7 years (thereby saving about 200k in interest payments)


I know, I know, it is more profitable to put all that money into the market at an average yield of 7% rather than paying off a 4.625% mortgage - but my goal isn't maximum profit, it's minimum time.
As soon as the mortgage is gone, the rent income (after taxes and insurance) is about $2400 a month - coincidentally just about the same as I bring in from working...
That means retirement in as little as 7 years.

It would take me at least twice that long to save enough to live off of a 4% withdrawal of stocks.
So, it looks like its all gonna happen.
It always seemed so abstract when savings just meant different digits on my computer screen. 


Now there's these actual physical buildings, and according to the law, I "own" them.

=0

waffle

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #3 on: September 24, 2015, 10:06:21 AM »
I wouldn't put 100% of rent money into the mortgage... Even if you did just do all necessary repairs during the first year you still need to put a lot of that money aside for continued maintenance and vacancies.

brooklynguy

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #4 on: September 24, 2015, 10:13:30 AM »
I know, I know, it is more profitable to put all that money into the market at an average yield of 7% rather than paying off a 4.625% mortgage - but my goal isn't maximum profit, it's minimum time.

Congratulations on your foray into landownership!

If you believe the performance of investing in the market will, in the long-run, outpace the performance of prepaying your mortgage, then how does prepaying your mortgage reduce your remaining time until retirement?  (That is, if you invest in lieu of prepaying, then in seven years you will have a lump sum of investments that can be used to service your remaining mortgage payments for you.)

(Note that I'm not trying to persuade you to invest in lieu of prepay if that's not what you are inclined to do (especially with an above-4% mortgage rate), but just want to make sure you are performing the cost/benefit analysis correctly for purposes of making that decision.)

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #5 on: September 24, 2015, 10:31:31 AM »
Bakari bought a HOUSE???  What is the world coming to??  Next thing you know, there will be little Bakaris playing in the yard!!

Fortunately, you know how to fix things and can do it on the cheap.  Keep it up, and you will be Oakland's next real estate millionaire!

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #6 on: September 24, 2015, 03:33:14 PM »
Awesome story! Can't wait for more details and stories of your land lording experience:)


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Re: My First Home w/o Wheels OR 7 years to go
« Reply #7 on: September 24, 2015, 03:45:32 PM »
woo hoo!  congratulations!

nice job on finding a deal in spite of an overheated bay area market

Bakari

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #8 on: September 24, 2015, 08:47:10 PM »
I wouldn't put 100% of rent money into the mortgage... Even if you did just do all necessary repairs during the first year you still need to put a lot of that money aside for continued maintenance and vacancies.


We still both have our regular jobs for saving up emergency funds and such.  I'm planning on keeping a reserve in the house account for house stuff.

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #9 on: September 24, 2015, 08:51:16 PM »
I know, I know, it is more profitable to put all that money into the market at an average yield of 7% rather than paying off a 4.625% mortgage - but my goal isn't maximum profit, it's minimum time.

Congratulations on your foray into landownership!

If you believe the performance of investing in the market will, in the long-run, outpace the performance of prepaying your mortgage, then how does prepaying your mortgage reduce your remaining time until retirement?  (That is, if you invest in lieu of prepaying, then in seven years you will have a lump sum of investments that can be used to service your remaining mortgage payments for you.)

(Note that I'm not trying to persuade you to invest in lieu of prepay if that's not what you are inclined to do (especially with an above-4% mortgage rate), but just want to make sure you are performing the cost/benefit analysis correctly for purposes of making that decision.)


I can't tell you the exact mathematical formula, I suppose it has something to do with leveraging additional cash or the fact that we have tenants paying us, but from running the calculations on paying the minimum and investing the rest, versus paying it down, after 30 years I come out ahead by investing, but in 7 years I make enough to stop working by paying the mortgage (and not by investing).


I think because I need 25 times my annual income for the 4% safe withdrawal rate, but I only need 20 times my annual income in rental property.  Or something.  Maybe someone with more math skills than me can explain it better.

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #10 on: September 24, 2015, 09:14:14 PM »
Congrats on your entry into landlording.

- Start building those cash reserves as soon as you can.  Upgrades can wait.  There is a lot that can go wrong on a $500k property and your cash reserves should be significant.

- (Mortgage+Tax+Insur) - (Gross Rent) = Does not equal profit.  You have maintenance/repairs, long term capital expenses (roof, furnace, etc), vacancy, etc.


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Re: My First Home w/o Wheels OR 7 years to go
« Reply #11 on: September 24, 2015, 11:05:15 PM »
Congrats on your entry into landlording.

- Start building those cash reserves as soon as you can.  Upgrades can wait.  There is a lot that can go wrong on a $500k property and your cash reserves should be significant.

- (Mortgage+Tax+Insur) - (Gross Rent) = Does not equal profit.  You have maintenance/repairs, long term capital expenses (roof, furnace, etc), vacancy, etc.


Agreed.  When I say "upgrades" I mean basic safety stuff, like bringing electric up to code and replacing rotted deck wood.


None of them have fancy stuff like central air, so the furnace I have to replace will be under $1000.  But I get what you're saying.
I should probably do more precise estimates of long term numbers, but for now I'm just being conservative in income estimates and estimating high on costs, and kind of assuming that will more or less cover periodic expenses.  I do the majority of my own repairs (worked as a general handyman for the past nine years) which keeps the biggest part of those costs down.

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #12 on: September 24, 2015, 11:09:08 PM »
I know, I know, it is more profitable to put all that money into the market at an average yield of 7% rather than paying off a 4.625% mortgage - but my goal isn't maximum profit, it's minimum time.

Congratulations on your foray into landownership!

If you believe the performance of investing in the market will, in the long-run, outpace the performance of prepaying your mortgage, then how does prepaying your mortgage reduce your remaining time until retirement?  (That is, if you invest in lieu of prepaying, then in seven years you will have a lump sum of investments that can be used to service your remaining mortgage payments for you.)

(Note that I'm not trying to persuade you to invest in lieu of prepay if that's not what you are inclined to do (especially with an above-4% mortgage rate), but just want to make sure you are performing the cost/benefit analysis correctly for purposes of making that decision.)


I can't tell you the exact mathematical formula, I suppose it has something to do with leveraging additional cash or the fact that we have tenants paying us, but from running the calculations on paying the minimum and investing the rest, versus paying it down, after 30 years I come out ahead by investing, but in 7 years I make enough to stop working by paying the mortgage (and not by investing).


I think because I need 25 times my annual income for the 4% safe withdrawal rate, but I only need 20 times my annual income in rental property.  Or something.  Maybe someone with more math skills than me can explain it better.


Wait, I know (or at least part of it). Because, aside from the mortgage, what I expect to get from rent Is about 7% of the purchase price.  But that's a fixed amount, not a long term average.  And it's all in the equivalent of dividends, and is all "safely withdrawn" (well, aside from reserves for big repairs and vacancies). 

sammybiker

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #13 on: September 25, 2015, 01:00:38 AM »
Sounds good!  And yeah, that handyman background is a huge value...

Best of luck!

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #14 on: September 25, 2015, 07:07:20 AM »
Congratulations Bakari, you're inspirational!

brooklynguy

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #15 on: September 25, 2015, 07:40:08 AM »
Wait, I know (or at least part of it). Because, aside from the mortgage, what I expect to get from rent Is about 7% of the purchase price.  But that's a fixed amount, not a long term average.  And it's all in the equivalent of dividends, and is all "safely withdrawn" (well, aside from reserves for big repairs and vacancies).

The rent you collect will not change depending on whether or not you have a mortgage.

Once you assume that stock market returns will outperform your mortgage rate (which is the assumption that led you to conclude that you will come out ahead after 30 years), then investing in lieu of prepaying will not have the effect of delaying your attainment of financial independence (unless your investment return assumptions include market-timing predictions about the stock market's precise sequence of returns).  It sounds like you've fallen into the common trap of thinking that a 4%-Rule-based retirement plan would require you to accumulate an amount equal to 25x your aggregate annual mortgage payments, which is not true (because mortgage payments, unlike most other living expenses, (i) have a known, finite lifespan terminating on the mortgage's final maturity date and (ii) do not adjust with inflation).

Think about it this way:  assume you can get investment returns at some fixed constant rate that is higher than your mortgage rate.  For the next seven years, you deposit all the excess dollars that you would have otherwise deployed towards prepaying your mortgage into a dedicated investment account which you have labeled "Bakari's Mortgage Payment Fund."  At the seven year mark, that account will contain enough money to repay your mortgage in full, with more than enough left over to compensate for all the mortgage interest you had been paying over those seven years.  So you can pay off your mortgage at that time and retire in accordance with the plan you've outlined above.  Alternatively, you can retain your mortgage, and use that account as a sinking fund to service your remaining mortgage payments (i.e., every month for the next 23 years, you would withdraw an amount from that account to be used to make your mortgage payment).  This will have zero effect on your non-mortgage expenses -- you can use your rental income (or whatever other sources you had otherwise planned to use) to cover the balance of your expenses, just as if you did not have a mortgage.  But, at the end of those 23 years, Bakari's Mortgage Payment Fund will have a positive balance.

The above analysis ignores tax consequences (which, generally speaking, tend to weigh even more in favor of investing in lieu of prepaying) and impacts on eligibility for any applicable means-tested financial assistance programs, so, to properly perform the cost-benefit analysis, these considerations should be taken into account as they apply to your personal situation.

Again, I'm not trying to convince you to engage in leveraged-investing-via-mortgage.  It's a totally reasonable decision for someone to decide to prepay their mortgage because it helps them sleep at night, or because they don't want to incur the risk of the stock market (or other alternative investment alternatives) underperforming their mortgage prepayments from a CAGR perspective.  But the rationale you are using (i.e., that prepaying your mortgage will speed up your attainment of financial independence even though it will underperform the stock market) appears to be based on flawed reasoning.

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #16 on: September 25, 2015, 09:43:55 AM »
Ah, thank you - that was quite helpful. 
Although, it actually helped me confirm my reasoning is valid.

Think about it this way:  assume you can get investment returns at some fixed constant rate that is higher than your mortgage rate.  For the next seven years, you deposit all the excess dollars that you would have otherwise deployed towards prepaying your mortgage into a dedicated investment account which you have labeled "Bakari's Mortgage Payment Fund."  At the seven year mark, that account will contain enough money to repay your mortgage in full, with more than enough left over to compensate for all the mortgage interest you had been paying over those seven years.  So you can pay off your mortgage at that time and retire in accordance with the plan you've outlined above. 
More or less.  According to this here internet based amortization calculator, the loan would be at 266k, and after 6 years of interest at 7%, I'd have 259k in the account (I don't expect to have any surplus the first year, as there are many repairs to do and etc).  Still, close enough that I get the point, and after 8 years the investment account is higher than the mortgage total.

Quote
Alternatively, you can retain your mortgage, and use that account as a sinking fund to service your remaining mortgage payments (i.e., every month for the next 23 years, you would withdraw an amount from that account to be used to make your mortgage payment).  This will have zero effect on your non-mortgage expenses -- you can use your rental income (or whatever other sources you had otherwise planned to use) to cover the balance of your expenses, just as if you did not have a mortgage.  But, at the end of those 23 years, Bakari's Mortgage Payment Fund will have a positive balance.
True again - but if I pay it off in 7, and then start putting the amount of the old mortgage into the market, at the end of 23 years I have a positive balance too. Even if I only put the amount of the difference between rent and the old mortgage into investments, and spend everything else, I'd end up with even more after those 23 years - both hypothetical accounts are making 7%, but one of them is also losing 4% at the same time.

So it seems its kind of like accelerating to maximize MPG from a full stop.
Your instant mpg is lower if you accelerate slowly, but your long-term average is better if you accelerate fast and get into a higher gear as soon as possible.

Or, in other words: the rental income is about 7% of the purchase price. 
So if I had paid in cash, the investment would match the stock market long-term average.

Since I paid with a mortgage, there's an additional debt involved, so the question is just, is it better to pay that off quickly or slowly.
Its true that if I pay it slowly, and put all excess money in stocks, after 30 years I have 3.25 mil

But the trade off is in that scenario, after 7 years I only have 260k, which, if I tried to stop then, would only provide 866mo (@4%), plus the 889 rent above mortgage = 1755 mo cash flow, compared to about $2500mo if the mortgage is at zero (but I have no investments).
I might still come out ahead after 30 years - I didn't run the numbers, cause I'm more interested in time than in money.

Quote
The above analysis ignores tax consequences (which, generally speaking, tend to weigh even more in favor of investing in lieu of prepaying) and impacts on eligibility for any applicable means-tested financial assistance programs, so, to properly perform the cost-benefit analysis, these considerations should be taken into account as they apply to your personal situation.
Good point.  Esp. considering there is a student loan forgiveness program involved here also.  We need to look into the details of that.

Quote
Again, I'm not trying to convince you to engage in leveraged-investing-via-mortgage.  It's a totally reasonable decision for someone to decide to prepay their mortgage because it helps them sleep at night, or because they don't want to incur the risk of the stock market (or other alternative investment alternatives) underperforming their mortgage prepayments from a CAGR perspective.  But the rationale you are using (i.e., that prepaying your mortgage will speed up your attainment of financial independence even though it will underperform the stock market) appears to be based on flawed reasoning.
Yeah, 7% is a bit of an assumption, and avoiding risk and variability definitely has real value.

But after running specific numbers, using your scenarios, I still think the time is faster with prepaying - the curves cross at some point later than 7 years.  The house returns are at 100% from day one (but stay fixed), while the market investments grow exponentially.  Before the curves cross, the house does better.  After, the market does better.  After 30 years the market does WAY better, but I don't want to wait that long.

I appreciate you taking the time to suggest these alternatives, its been very helpful.  If you notice any mistakes in my new explanations, I'd love to read them too
« Last Edit: September 25, 2015, 09:45:51 AM by Bakari »

brooklynguy

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #17 on: September 25, 2015, 10:17:59 AM »
More or less.  According to this here internet based amortization calculator, the loan would be at 266k, and after 6 years of interest at 7%, I'd have 259k in the account (I don't expect to have any surplus the first year, as there are many repairs to do and etc).  Still, close enough that I get the point, and after 8 years the investment account is higher than the mortgage total.

Something somewhere must be off in your number-running.  As an unwavering fact of math, if you have two otherwise equal pots of money, over an equal period of time, the one with a higher CAGR will be bigger.

Maybe lay out the results of the calculations you ran (or, if you don't want to share your exact numbers, equivalent calculations using hypothetical figures)?

Quote
But after running specific numbers, using your scenarios, I still think the time is faster with prepaying - the curves cross at some point later than 7 years.

Let's figure out the explanation for the discrepancy above, because I think the conclusion you are still reaching (that remaining time to FI gets accelerated even assuming a constant, fixed rate of investment return that is higher than the mortgage interest rate) rests on that faulty premise.

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #18 on: September 25, 2015, 02:42:34 PM »
Something somewhere must be off in your number-running.  As an unwavering fact of math, if you have two otherwise equal pots of money, over an equal period of time, the one with a higher CAGR will be bigger.

Maybe lay out the results of the calculations you ran


Be happy to!


Ok.
Starting with today: 0 investments, -307500 loan.  -1580 min payment (plus 529 tax/insur = 2109). +3000 in rent.  891 surplus each month.


If I put 2891 a month to loan starting in year 2 (all rent, plus some 2000 out of pocket) extra, loan is paid to zero in a little over 7 years.  At that point rent above ongoing expenses is 2471.


I make minimum payments for 7 years, loan drops to -267779,
and put that 2891 into investments starting year 2, that's 6 years of compound interest, total of +259,268
slightly less than the total to pay off remaining mortgage.


brooklynguy

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #19 on: September 25, 2015, 03:32:15 PM »
Ok.
Starting with today: 0 investments, -307500 loan.  -1580 min payment (plus 529 tax/insur = 2109). +3000 in rent.  891 surplus each month.


If I put 2891 a month to loan starting in year 2 (all rent, plus some 2000 out of pocket) extra, loan is paid to zero in a little over 7 years.  At that point rent above ongoing expenses is 2471.


I make minimum payments for 7 years, loan drops to -267779,
and put that 2891 into investments starting year 2, that's 6 years of compound interest, total of +259,268
slightly less than the total to pay off remaining mortgage.

Ok, I think the error is that you are comparing the two scenarios at different points in time (at precisely the seven year mark (84 months into the loan), in the "invest" scenario, and at the seven year and seven month mark (91 months into the loan), in the "prepay" scenario).

In the prepay scenario, the loan would be fully paid off in the 91st month.

In the invest scenario, at the 91st month, the remaining loan balance would be $262,303, and your investment account balance (still assuming fixed 7% returns) would be $288,539 (enough to pay off the loan in full at exactly the same point in time as in the first scenario, with an extra $26k leftover).

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #20 on: September 27, 2015, 02:59:24 PM »
Ok.
Starting with today: 0 investments, -307500 loan.  -1580 min payment (plus 529 tax/insur = 2109). +3000 in rent.  891 surplus each month.


If I put 2891 a month to loan starting in year 2 (all rent, plus some 2000 out of pocket) extra, loan is paid to zero in a little over 7 years.  At that point rent above ongoing expenses is 2471.


I make minimum payments for 7 years, loan drops to -267779,
and put that 2891 into investments starting year 2, that's 6 years of compound interest, total of +259,268
slightly less than the total to pay off remaining mortgage.

Ok, I think the error is that you are comparing the two scenarios at different points in time (at precisely the seven year mark (84 months into the loan), in the "invest" scenario, and at the seven year and seven month mark (91 months into the loan), in the "prepay" scenario).

In the prepay scenario, the loan would be fully paid off in the 91st month.

In the invest scenario, at the 91st month, the remaining loan balance would be $262,303, and your investment account balance (still assuming fixed 7% returns) would be $288,539 (enough to pay off the loan in full at exactly the same point in time as in the first scenario, with an extra $26k leftover).


Possibly... but what I'm really comparing is doing either of those 7 year scenarios vs paying the minimum for 30 years.  If I start living on the rent after 7 years I wouldn't be able to aggressively save, my total life time 'stach is limited, but I am FI sooner.

I'll double check my numbers down to the month, but I think the guaranteed nature of the prepay option may be worth a few thousand...

brooklynguy

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #21 on: September 27, 2015, 04:09:49 PM »
Possibly... but what I'm really comparing is doing either of those 7 year scenarios vs paying the minimum for 30 years.  If I start living on the rent after 7 years I wouldn't be able to aggressively save, my total life time 'stach is limited, but I am FI sooner.

No, you wouldn't be FI sooner -- that's the point I've been trying to emphasize.  If investment returns outpace your mortgage rate, you would be FI later by prepaying.

I think this will become clear when you re-run the numbers for the alternative scenarios, but it should make intuitive sense if you think about it.  Pretend you just received a windfall in an amount equal to your current outstanding mortgage balance.  You could use it pay off your mortgage in full, erasing that liability from your balance sheet.  But if you have an investment option available to you that earns a fixed rate that is higher than your mortgage rate, then paying off the mortgage instead of keeping it and investing the windfall would be equivalent to turning down a free supplemental income stream (the earnings accruing on the investment, minus the (lower) interest payable on the mortgage).  As long as the investment is liquid (so that you can use it to satisfy your monthly mortgage payments over the 30 year life of the loan), how can having an extra income stream possibly have the effect of delaying your attainment of financial independence?

Quote
but I think the guaranteed nature of the prepay option may be worth a few thousand...

Yes, the prepay option provides a guarantee while the investment option involves uncertainty.  As I mentioned initially, given that the stock market might underperform mortgage prepayments, the desire to avoid uncertainty would be a legitimate reason to stick with the prepay option.  But that's a different rationale than the one you've been describing.

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #22 on: September 28, 2015, 10:48:06 AM »
  Pretend you just received a windfall in an amount equal to your current outstanding mortgage balance.  You could use it pay off your mortgage in full, erasing that liability from your balance sheet.  But if you have an investment option available to you that earns a fixed rate that is higher than your mortgage rate, then paying off the mortgage instead of keeping it and investing the windfall would be equivalent to turning down a free supplemental income stream (the earnings accruing on the investment, minus the (lower) interest payable on the mortgage).  As long as the investment is liquid (so that you can use it to satisfy your monthly mortgage payments over the 30 year life of the loan), how can having an extra income stream possibly have the effect of delaying your attainment of financial independence?

If that was 410k, at a 4% swr, I get 1366 a month.
If I pay it off in full, I get 1580 a month (because eliminating a payment is mathematically equivalent to additional income)
It wouldn't matter if the mortagage was 0%, if I had the full amount, I would make more next month by paying in full today versus investing.



But see, I didn't just receive a windfall in the total amount of the mortgage.
The investment only makes its 7% return on the amount that is currently in the account.


The current amount is zero.  So it is producing zero.
After 7 years the investment account is only making 864 a month (@ 4% swr).
It would take ~9.5 years to save the 474,000 it would take to make 1580 from investing.
It doesn't matter if the mortgage is at 0% or 5% or 10%, the moment it is paid off, I have an additional 1580.  If that takes 1 year or 30 years, the amount is the same.  It just so happens that the fastest I could do that is about 7 years - which is sooner than I could make the same amount by putting the same excess cash into an investment account.

brooklynguy

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #23 on: September 28, 2015, 11:40:41 AM »
If that was 410k, at a 4% swr, I get 1366 a month.
If I pay it off in full, I get 1580 a month (because eliminating a payment is mathematically equivalent to additional income)
It wouldn't matter if the mortagage was 0%, if I had the full amount, I would make more next month by paying in full today versus investing.

You've fallen back into the trap of thinking that 4%-rule-based retirement planning requires you to assume that only 4% per year of Bakari's Mortgage Payment Fund would be available for use towards your mortgage payments, but that's not true -- you can tap deeper into the principal of that account.  Run the numbers properly and you will see that as long as you assume an investment return in excess of your mortgage rate, you will always achieve FI faster by investing in lieu of prepaying (subject to the disclaimer I made initially re: tax and means-tested benefit consequences).

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After 7 years the investment account is only making 864 a month (@ 4% swr).
It would take ~9.5 years to save the 474,000 it would take to make 1580 from investing.
It doesn't matter if the mortgage is at 0% or 5% or 10%, the moment it is paid off, I have an additional 1580.  If that takes 1 year or 30 years, the amount is the same.  It just so happens that the fastest I could do that is about 7 years - which is sooner than I could make the same amount by putting the same excess cash into an investment account.

I've already shown you that you can save up enough to fully pay off your mortgage in less than the 7.6 years it would take you by prepaying, if the investments earn a rate of return higher than your mortgage rate.  In that case, you could pay off your mortgage in less than 7 years.

But, in addition, what you're still missing is that you could also choose to keep your mortgage, and still be financially independent at that point.  You would keep the mortgage, and keep Bakari's Mortgage Payment Fund, and use that account that pay your mortgage according to its original amortization schedule.  Set up autopayments to your mortgage lender from that account, and pretend that neither your mortgage nor that account continues to exist.  For all intents and purposes, they would both cease to exist--you would use whatever other sources of funds you have to finance whatever other expenses you have--except, at the end of the life of the loan, you can stop pretending, because at that point your mortgage will actually no longer exist, and Bakari's Mortgage Payment will magically have a positive balance of extra funds that you can use for whatever you wish.  Do you see how this plan has zero impact on your other sources and uses?  You have the same "additional 1580" to use to cover your living expenses whether you pay off your mortgage or not.

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #24 on: September 28, 2015, 08:58:21 PM »
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You've fallen back into the trap of thinking that 4%-rule-based retirement planning requires you to assume that only 4% per year of Bakari's Mortgage Payment Fund would be available for use towards your mortgage payments, but that's not true -- you can tap deeper into the principal of that account. 

Are you suggesting withdrawing as much as the account returns (supposedly an average of 7%), or more?  If the principal is getting lower, how am I coming out ahead?

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Run the numbers properly and you will see that as long as you assume an investment return in excess of your mortgage rate, you will always achieve FI faster by investing in lieu of prepaying
Perhaps you would like to show me actual numbers?
I mean, I certainly don't mind if you don't feel like it, but as long as you are taking the time to keep responding, you may as well use actual numbers.
Loan is 307500
I expect to pay only the minimum (and to have nothing left over for investing or prepaying) for the first year.
After that I expect to have about 2890 above the minimum mortgage payment.

But, in addition, what you're still missing is that you could also choose to keep your mortgage, and still be financially independent at that point.  You would keep the mortgage, and keep Bakari's Mortgage Payment Fund, and use that account that pay your mortgage according to its original amortization schedule. ...  Do you see how this plan has zero impact on your other sources and uses?  You have the same "additional 1580" to use to cover your living expenses whether you pay off your mortgage or not.


I'm not so much missing it as ignoring it.
By the reasoning there, everyone should logically roll over their mortgages indefinitely, take out home equity loans and put all the money into the stock market, as well as low interest credit cards and put living expenses on them so you could put all your cash into the market, etc.  The 7% is a long term average.  Is bad years, it means I potentially have to work again, to make sure I make those payments, which don't get any lower just because the market crashed.  My goal isn't to maximize returns, so I have no interest in continuing to gamble once the possibility of FI exists.
« Last Edit: September 28, 2015, 09:00:04 PM by Bakari »

brooklynguy

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #25 on: September 29, 2015, 08:42:25 AM »
but as long as you are taking the time to keep responding

The "to prepay or not to prepay" debate is one of my favorite recurring topics in the forum and I always enjoy participating in discussions about it.  Hopefully you still find this discussion useful, but if not, just say the word and I will stop prolonging it.  I didn't intend to hijack your thread :)

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Are you suggesting withdrawing as much as the account returns (supposedly an average of 7%), or more?

I'm suggesting withdrawing as much as necessary to fund your regularly scheduled monthly mortgage payments.

In your case (using the numbers from post # 19 above), at the moment your investment account grows to be equal to your then-outstanding mortgage principal balance, the initial withdrawal rate would be roughly 7.3% ($18,960 annual mortgage payments / ~$260k investment portfolio).

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If the principal is getting lower, how am I coming out ahead?

Because the investment principal is growing at a faster rate than the loan principal is accruing interest.

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Perhaps you would like to show me actual numbers?

I thought that's what I did in post # 19.

As you had calculated, if you make extra monthly principal payments of $2890 starting in month 13, you will pay off your mortgage in full in the 91st month of the loan (7 years and 7 months from now).

If, instead, you make the minimum mortgage payments and make monthly investments of $2890 per month starting in month 13 (and the investments earn a constant fixed rate of return of 7%), you will be able to pay off your mortgage in full in the 87th month of the loan (four months earlier than above) (in 87 months, your investments will have grown to just over $270k, while your outstanding loan balance will have decreased to just under $267k).

So, if you're using "mortgage-free status" as your retirement trigger, this approach enables you to retire four months earlier.  But, again, as long as your investments will in fact outperform your mortgage rate, there's no reason to use "mortgage-free status" as your retirement trigger -- instead, you can keep both the investments and the mortgage, and be "even more" financially independent than if you pay off the mortgage.

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By the reasoning there, everyone should logically roll over their mortgages indefinitely, take out home equity loans and put all the money into the stock market, as well as low interest credit cards and put living expenses on them so you could put all your cash into the market, etc.

Yes, as long as the debt is both sufficiently cheap and sufficiently long-term, the optimal approach (from both a return-maximization perspective and a financial-independence-acceleration perspective) is to borrow as much as possible and invest as much as possible.  But most non-mortgage debt tends to lack at least one of these qualities, and mortgage debt could too -- in 30 years, prevailing mortgage rates may not be as low as they are today (which would defeat the purpose of the "indefinite roll over" plan).

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The 7% is a long term average.  Is bad years, it means I potentially have to work again, to make sure I make those payments, which don't get any lower just because the market crashed.  My goal isn't to maximize returns, so I have no interest in continuing to gamble once the possibility of FI exists.

Yes, now you're inching back towards the "avoidance of uncertainty" rationale, which, as I said from the get-go, is a perfectly valid reason to prepay a mortgage.  The stock market may not outperform mortgage prepayments, while the prepayment approach locks in a rate of return equal to the mortgage rate and avoids the gamble you take by relying on variable-performance investments to power you to FI.  But, again, that's not the rationale you have been defending (instead, you've been arguing that even if you could be certain that your investments will outperform your mortgage rate, you would achieve FI sooner by prepaying, which is just not true).

Moreover, the 7% fixed return example we've been using is just for ease of illustrating how investment outperformance speeds up FI.  The same is true of any investment plan with a higher CAGR than your mortgage prepayment plan, even if the investments (like the stock market) do not have a fixed, steady straight-line return.  If you're investing in the stock market in lieu of prepaying your mortgage, it's okay to dip into the investments during the down years to keep servicing your fixed-amount mortgage payments and still come out ahead, in the same way that it's okay for a retiree using a 4%-rule-based retirement plan to dip into her portfolio during down years to keep paying her living expenses and still not result in portfolio failure -- the 4% rule already accounts for market swings, and most historical success cases had at least some periods where the portfolio value fell below the initial amount.

My mortgage rate is 3.875% (with 28 years remaining until final maturity), and I'm making the minimum payments and plowing all excess dollars into the stock market.  Your mortgage rate is quite a bit higher, at 4.625%.  If I were in your shoes, perhaps I would decide to prepay my mortgage too.  You need to make that decision for yourself, but you should do so using sound reasoning.  If you decide to prepay your mortgage because you want to avoid the risk of bad stock market performance delaying your attainment of financial independence, that would make sense.  If you decide to prepay your mortgage because you believe that approach will accelerate your attainment of financial independence even if it has a lower CAGR than the leveraged-investing approach, that makes no sense, because it is mathematically impossible.

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #26 on: September 29, 2015, 09:36:51 AM »
Yes, now you're inching back towards the "avoidance of uncertainty" rationale, which, as I said from the get-go, is a perfectly valid reason to prepay a mortgage.  The stock market may not outperform mortgage prepayments, while the prepayment approach locks in a rate of return equal to the mortgage rate and avoids the gamble you take by relying on variable-performance investments to power you to FI...

Moreover, the 7% fixed return example we've been using is just for ease of illustrating how investment outperformance speeds up FI.  The same is true of any investment plan with a higher CAGR than your mortgage prepayment plan, even if the investments (like the stock market) do not have a fixed, steady straight-line return.  If you're investing in the stock market in lieu of prepaying your mortgage, it's okay to dip into the investments during the down years to keep servicing your fixed-amount mortgage payments and still come out ahead, in the same way that it's okay for a retiree using a 4%-rule-based retirement plan to dip into her portfolio during down years to keep paying her living expenses and still not result in portfolio failure -- the 4% rule already accounts for market swings, and most historical success cases had at least some periods where the portfolio value fell below the initial amount.

OK. 
Now that we're talking about 4 months, I can see the math working as long as these numbers are dependant on a fixed 7%.
I'm not sure how the portfolio could safely fall below the initial amount when the initial amount is zero though.
You suggest it is essentially immaterial that it isn't really fixed, so long as it averages out to be higher, but suppose its the first several years that are "bear" years and only return, say, 4% (or even negative)?   There's no principal to dip into yet.

Moreover, I've been assuming only withdrawing dividends, since it can get more complicated with transaction fees and short-term trading penalties and capital gains taxes when adding and withdrawing from principal every month.

Its not so much just that I personally value minimizing risk - it is basically guaranteed that the market won't return a fixed 7% for the next 30 years.  It isn't even reliable to assume it will average 7% over any given 7 year period.  So I think the formula has to account for that variability - which, as you pointed out, is why the standard "safe withdrawal rate" is 4% even though long-term returns average 7%.  Its taking that variability into account.  If we could safely assume 7% fixed (or 7% average over small time frames), then the swr would in fact be 7%. 

It's not just personal risk aversion, I think mathematically you have to account for known risk. So, that's why I was using that standard 4% as well, to account for the fact that there is no reason to believe that the market will really return 7% consistently for the next 7 years. 

If the market underperforms by just a single percentage point, then over those 74 months of investment (month 87-month 13), I'm only at $259,300 (with the loan balance at 267).

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The "to prepay or not to prepay" debate is one of my favorite recurring topics in the forum and I always enjoy participating in discussions about it.  Hopefully you still find this discussion useful, but if not, just say the word and I will stop prolonging it.  I didn't intend to hijack your thread :)

No worries, I appreciate it.

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #27 on: September 29, 2015, 10:17:10 AM »
Bakari, you are correct that, assuming you are liquidating investments to make mortgage loan payments, it's not strictly true that a higher long-term compound annual growth rate ("CAGR") of the alternative investment is a sufficient condition for the alternative investment to be superior to mortgage loan prepayment. The sequence of returns also matters, but you may be overestimating the risk involved there. For starters, prior to your retirement, you aren't actually going to be tapping into your investments at all (you'll be making your mortgage loan payments with your employment income or business income or however you derive income in your non-retired life), so your statement that "the initial amount is zero though" is not accurate. The "initial amount" is the value of the account when you retire. It's also not necessary for the initial amount to exceed the balance of your mortgage at the time you retire; that's just an added level of conservatism. The initial amount being below the mortgage balance at the time you plan to retirement does not mean that investments have worked out worse than prepayment (they might, but they also might not; you don't know yet).

If you run some simulations, I think you will find that, given that the CAGR of the investments exceeds the interest rate of the mortgage, the sequence of returns would have to be spectacularly unfavourable for prepayment to be the better strategy. An ordinary bad year is not going to be fatal because you only need to take distributions equal to your mortgage payments; you don't need to liquidate the entire account. I don't know if such an unfavourable sequence of returns (where the CAGR exceeded the loan interest rate over some long period during which you liquidate investments to make minimum mortgage payments but prepayment was still optimal) has ever occurred historically; perhaps brooklynguy can answer that question.


So, that's why I was using that standard 4% as well, to account for the fact that there is no reason to believe that the market will really return 7% consistently for the next 7 years.

Among other things, the 4% rule takes into account inflation, but fixed-rate mortgage loan expenses do not inflate, so 4% is probably unduly conservative for this kind of debt. That's one of the reasons that US mortgage loans are wealth-building tools.
« Last Edit: September 29, 2015, 10:33:09 AM by Cathy »

brooklynguy

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #28 on: September 29, 2015, 11:51:25 AM »
OK. 
Now that we're talking about 4 months, I can see the math working as long as these numbers are dependant on a fixed 7%.
I'm not sure how the portfolio could safely fall below the initial amount when the initial amount is zero though.
You suggest it is essentially immaterial that it isn't really fixed, so long as it averages out to be higher, but suppose its the first several years that are "bear" years and only return, say, 4% (or even negative)?   There's no principal to dip into yet.

It is immaterial that the investment returns are not fixed, as long as the overall performance of the investment plan exceeds the overall performance of the mortgage prepayment plan over the period during which you choose to invest in lieu of prepay.  The investment balance is zero today, but it will grow as you make investments in lieu of prepaying.

(Note that in reality there's no need to establish a separate investment account earmarked for servicing your mortgage (what I've been calling Bakari's Mortage Payment Fund).  That's also just for ease of illustration.  In reality, you can intermingle your "regular" portfolio and your "leveraged-investing-via-mortgage" portfolio, and just use mental accounting to think about it as being composed of two separate portfolios, which is what I do.)

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Moreover, I've been assuming only withdrawing dividends, since it can get more complicated with transaction fees and short-term trading penalties and capital gains taxes when adding and withdrawing from principal every month.

Yes, any transaction costs, tax consequences, and impacts on means-tested benefit programs need to be accounted for in the cost-benefit analysis (and some of these factors could weigh in on the side of investing in lieu of prepaying -- for example, if retaining the mortgage would allow you to take a deduction for the mortgage interest).  So far we've been ignoring these considerations, just to make it easier to arrive at the first-order understanding of how leveraged-investing-via-mortgage can accelerate FI (even in light of investment volatility).

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Its not so much just that I personally value minimizing risk - it is basically guaranteed that the market won't return a fixed 7% for the next 30 years.  It isn't even reliable to assume it will average 7% over any given 7 year period.  So I think the formula has to account for that variability - which, as you pointed out, is why the standard "safe withdrawal rate" is 4% even though long-term returns average 7%.  Its taking that variability into account.  If we could safely assume 7% fixed (or 7% average over small time frames), then the swr would in fact be 7%. 

It's not just personal risk aversion, I think mathematically you have to account for known risk. So, that's why I was using that standard 4% as well, to account for the fact that there is no reason to believe that the market will really return 7% consistently for the next 7 years. 

If the market underperforms by just a single percentage point, then over those 74 months of investment (month 87-month 13), I'm only at $259,300 (with the loan balance at 267).

4% has been a historically safe withdrawal rate for an all stock portfolio, but that's after accounting for inflation adjustments to the withdrawals.  Mortgage payments do not adjust with inflation, which explains why a higher withdrawal rate can be used without resulting in portfolio failure.  (But, again, to reinforce the underlying principle behind the leveraged-investing-via-mortgage strategy, note that there there's no upper bound on how high the withdrawal rate can go without resulting in failure, as long as the investment outperforms mortgage prepayments -- if your mortgage interest rate is 20%, but you can earn 21% on your investments, you will be better off investing in lieu of prepaying (ignoring tax consequences, etc.), even though your initial WR would be over 20%).

The investment horizon for your investments in the invest in lieu of prepay scenario is not the 7.6 years it would take you to pay off your loan in full under the prepay scenario; it's the weighted average life to maturity of your loan over the full 30 years it would remain outstanding.  A bad sequence of returns could definitely render the invest scenario the worse alternative, but underperformance during the first 7.6 years would not necessarily render it the worse alternative (because it still has 23 remaining years to make up the difference).  It's no different than when you look at a cFIREsim output graph for portfolio success.  Using cFIREsim's default settings (which shows a standard 4% WR-based retirement), over 95% of the squiggly lines resulted in success, even though, among those success cases, there are lots of them where the trajectory headed downwards for a while in the beginning but ultimately resulted in success.

You can use cFIREsim to determine the historical success rate of a leveraged-investing-via-mortgage plan.  You should be able to use it to model your precise plan, but it doesn't seem to be working properly with multiple spending and savings plan inputs.  Instead, I just ran a simulation testing the historical odds of coming out ahead if you had a lump sum equal to your mortgage balance today.  I set the portfolio value at $307,500 and the yearly spending at $18,960 (not inflation adjusted), and the success rate is 91.3%.  So that tells you that historical odds of coming out ahead by investing a lump sump equal to your mortgage balance instead of using it to pay off your mortgage in full (but this success rate actually understates the true historical success rate because cFIREsim's withdrawal assumptions don't align with a mortgage's amortization schedule, as I described in this post).  On the other hand (and as discussed at length in that linked thread), there are reasons to believe that current market conditions leave the market poised to deliver below average returns, so it is entirely possible that we could be in a situation like one of the ~10% failure cases (or worse).  Again, that's why it could make sense to prepay, and why I'm not trying to make that case that you should invest (but just trying to help you utilize the correct reasoning in performing the cost-benefit analysis).

it's not strictly true that a higher long-term compound annual growth rate ("CAGR") of the alternative investment is a sufficient condition for the alternative investment to be superior to mortgage loan prepayment.

As usual, you are correct; I've been trying to loosely (and technically incorrectly) use the term CAGR to compare on an apples-to-apples basis a leveraged-investment-via-mortgage plan to a mortgage-prepayment plan (and that's what I was trying to convey with my initial comment that, once you assume the stock market will outperform the mortgage rate, it will not have the effect of delaying FI "unless your investment return assumptions include market-timing predictions about the stock market's precise sequence of returns").

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Re: My First Home w/o Wheels OR 7 years to go
« Reply #29 on: September 29, 2015, 07:28:21 PM »
Alright.  With all those caveats, I'm convinced.

Of the accuracy, that is... not to actually change my plan! :P
The inflation factor in particular is one I hadn't considered, and makes the case for not prepaying stronger.
The invest instead of prepay scenario would statistically most likely come out ahead with enough certainty that it is probably the most logical course.


But the time difference and/or dollar difference over the first 7-8 years is small enough that I don't feel it justifies any risk when the alternative is basically guaranteed.
Its not like I don't believe in the market - all of (my portion of) the down payment money came from liquidating stocks.  And once this is paid off, that's where I'll put future savings.


But I'd prefer not to borrow money to gamble with, even if the deck is stacked heavily in my favor. 
I'd prefer not to gamble with any amount I can't afford to simply lose permanently.






Anyway - first full day of work on the new place.  Haven't even started on any major projects (I need to add and ground outlets, put in a new doorway and door, replace all the floors, replace most of the outdoor stairs and decking...) just little things, and it took all day and I put a fairly small dent in the list.
I'm going to have to convince my partner it's worth getting a bed and some food over there and staying the night on days we can work there consecutively...

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