Financial Limitations Corollary
March 25, 2008, 9:00 am
Filed under: Uncategorized | Tags: ,

Yesterday, I discussed my aghast reaction to an acquaintance choosing to purchase a house with no money down, and interest only for the first 10 years. My argument was that this was wasteful, because look at the long term cost of the loan.

However, I discussed this with my father. Generally speaking, my German family is very cheap and very financially savvy.  Perhaps I am young and naive, but I may have found a time when I disagree with him.

He defended the acquaintance, saying that depending on your tax bracket, having a long, big mortgage is beneficial. For instance, if you are in a mid-level tax bracket, but you work a lot of overtime (cops, social workers, blue collar workers, etc), that overtime (according to my father) is taxed not at the tax bracket your base salary is in, but at the highest possible tax bracket. By having deductions, such as children, mortgages and things like that, you can off-set those taxes. I disagree with this. The difference between the large, long mortgage and my preferred mortgage was about $70,000. I cannot believe that that mortgage will save you more than that in terms of taxes. Again, perhaps I am young and naive. Before I buy a house myself, I will have a discussion with a tax specialist to see what his opinion would be. Chances are, it won’t save me any money because neither Bear nor I will be working in jobs that involve a substantial amount of overtime, if any at all.

Therefore, if you’re just trying to lower your yearly taxes, but the cost of the loan per year is more than what you’ll be saving in tax deductions, won’t you be coming out behind in terms of total money?  I know that both I and my father are opposed to giving money to the gov’t. But if giving more to the gov’t and less to the bank means I have more in my pocket, THAT IS WHY I AM GOING TO DO.

There is also the opportunity cost. Whenever you buy anything, be it a latte or a house, you have lost the opportunity to spend that money on something else. If you buy a latte, now you’re 5 dollars poorer than you were before. If you only had $10 in the first place, now you have lost the opportunity to buy anything that is more than $5. So, if you have $20,000 sitting around, and you spend that on a down payment on a house, you have lost the opportunity to spend that money on something else. Like a new kitchen for your new house. Or a new car. Or something else fun like that. So, many people look at that opportunity cost and say that the down payment just isn’t worth it.

However, there is a hidden opportunity cost. This is an idea I have learned from Trent at http://www.thesimpledollar.com, and he was introduced to it by the book “Your Money or Your Life”. Every time you spend money, you lose the opportunity to use that money for something else. I just repeated myself, right? It goes further than that. You lose the opportunity to spend the money on YOUR LIFE. Something you truly want to do with yourself, not that temporary sugar and caffeine high from your latte. You lose the opportunity in another 20 years to retire early, and start a new career in something you truly love. Or, the opportunity to buy that dream vacation home in the Bahamas. Or, the opportunity to spend your retirement watching your grandbabies. Whatever it is that you truly wish you could do in your life, by spending your money unwisely today, you are paying the opportunity cost of those lost dreams.

I would argue that by not putting down that $20,000 on your mortgage and instead using it for a kitchen, you are paying the opportunity cost of reaching your genuine dreams. That cost comes in the form of the extra money you pay on your mortgage. Yes, you pay the opportunity cost initially by choosing down payment over kitchen. But, the secret opportunity cost is what you pay 30 years later when you don’t have that extra $70,000 in the bank, earning interest over those years, to fund your new business venture or space flight. It all comes down to the choices you make: what is it you want in life? The $20,000 kitchen, or the space flight? If the $20,000 kitchen is more important, then you ought to make that choice. But in the grand scheme of things, I would prefer the opportunity later in life to have an extra $70,000 to do with as I please, rather than paying a max amount of interest.

Another point my parents brought up was another possible choice. The acquaintance has a child, and is planning for more relatively soon. In fact, that is why they bought the new house: the old one could not possibly fit another baby. By paying 10 years of interest only, the acquaintance’s wife could stop working, or cut down to part time, in order to have more babies and get all of the children into grade school. If they didn’t do that, they might not be able to afford the loss of her salary. Since they need to have the babies now (biologically speaking) and not wait 30 years, it would make sense to do that.

As seemingly unrelated aside, I have a story. Last month, Bear and I  went to his home town for the weekend. His sister has identical twin boys, who are about 15 months old. They are adorable, but they are also rambunctious. We took them to the mall so that Bear could get his hair cut. His parents didn’t have the stroller with them that weekend, so we had to carry and/or attempt to restrain the boys so they wouldn’t run off. 15 month old little boys are resistant to holding hands, too. Independence and such. So, we had leashes for them. They were cute leashes: they look like a monkey is strapped to their banks, and then you use the tail to hold onto them. However, the tail is so low that if you pull too hard, you pull their feet out from under them. That’s mean, so we turned them upside down and had the tail on top, head on the bottom, so it looked like the monkey was sniffing their little butts. Awww. Generally speaking, the idea of putting children on leashes is a little disconcerting to me. They’re children, not dogs. However. When you are in a public place with two rambunctious toddlers who don’t respond well to verbal commands yet, and you want to avoid losing them, you have to put them on leashes. It’s one thing when you have one toddler, or when you have multiple children of various ages. But with twins? Good lord, the insanity! When we were putting them back in the monkey leashes after eating some lunch, I overheard a woman nearby say, “Oh, I hate when people put little kids in leashes. It’s just wrong.” VALUES JUDGMENT. Her values are such that putting a kid in a leash is wrong. Ok, fine. But I see you have two girls, about 5 years apart. It was probably fairly easy for you to wrangle the first one when she was this age. By the time the 2nd one was this age, the older one was around 7, and the younger one probably adored her, making it easy to have the older one help wrangle. Right? Not so with twins. Don’t judge, and keep your mouth shut. Plenty of people, Bear included, were put in leashes as children and they turned out fine. You know why? Because they didn’t get lost in a mall, abducted by a stranger, and then raped and murdered. You don’t know what it’s like with twin boys. I was a little pissed about that. I decided to try to avoid making values judgments about other people, especially out loud.

So, long story short, my parents reminded me without saying it that I don’t know the exact financial, tax and family situation in which these people are at the moment. Without being privy to their values and priorities, I don’t have any place in making judgments. Since I try to avoid values-based judgments (see above), I ought not judge them for choosing to spend more money in the long run on their mortgage. It is their money, they are free to do with it as they please. Knowing them, I am sure that they are not wasting it on booze and hookers, as my father so eloquently put it, nor are they racking up ridiculous credit card debt. Therefore, they are still making wise financial decisions, even if they are decisions I would not make.

But, I still hate interest, and I am going to sacrifice for 15 years in order to make sure that I can have my mortgage and student loans paid of ASAP. That’s important to me. I am willing to pay the opportunity cost of the nicer vacations, the bigger house and the luxury cars.



Financial Limitations
March 24, 2008, 1:41 pm
Filed under: daily | Tags: ,

I am German. That could mean a number of things to you:

1. That I must be a Nazi. HA! Funny story! My Grandma’s family came from the part of Germany that Hitler was from (Bavaria). Not only that, but they were from the next little village over from his. So, because of that, Grandma regularly tells me that we’re related to Hitler*, because “you know, all those people inter-bred and everything. But shh! Don’t tell anyone! They might be disturbed by it.” She usually tells me this in a public place. With other people around. Loudly enough for them to hear. “Hokay, Grandma! Won’t tell anyone!” Of course, if you use that logic, then everyone in Europe is related to Hitler. Going further back, we’re ALL related to Hitler, because we’re all humans! Whoa! No, we are NOT related to Hitler. Or the pope.

2. That my family collects large quantities of clock and beersteins. No, Emily, that’s just what YOUR Germans do.

3. That my family is painfully cheap, to a fault. Ding ding ding! We have a winner! My grandfather was convinced that he could get a better deal on furniture if he didn’t buy anything that matched. Brown and orange sofa with a red plaid chair? They MUST give you a deal because you have such terrible taste! We never followed that logic. Nor did he ever get a good deal on it. THAT’S HOW STINGY WE ARE. Anything to save a buck.

With that in mind, spending money gives me a stomachache. Spending large quantities of money makes me ill. Debt makes me pass out. I hate the idea of buying money. That’s what debt is. Somebody gives you money, and you pay for it. You don’t just pay them back, you give them EXTRA money for giving you the money in the first place. So, if you’re buying money you don’t need (for instance, going into large amounts of credit card debt to support your latte habit), you’re being exceptionally wasteful.

Now, I do believe that certain amount of debt is good. Student loans, for instance. It’s financing your future. Low rates, blah blah. Without that money, you can’t go to college (or whatever higher ed you want), and without that degree, you have an extremely limited earning potential. Student loans are an investment in your future. Totally worth it.

Mortgages are the same thing. As long as you don’t get caught up in the tail end of a bubble (and bubbles ALWAYS burst), your property will increase in value over the long haul. Financing that with a mortgage, and you will have a nice amount of change AND a roof over your head AND a warm place to pee. An investment in your future. Totally worth it.

However, that doesn’t mean you should pay more for it than you need to. I had a conversation with someone over the weekend who recently bought a house. A lovely house. Beautiful house. Great place to have a family. Et cetera. However, he told me in no uncertain terms that he does not believe in putting any money down for anything that he finances. That it is a waste of money, because you throw away your money and then never see it again. I was aghast. Uh. Gassed. I had to bite my tongue to keep my jaw from hitting the floor, because that is the exact opposite of good finances. He has the money to put down a down payment. But instead of doing that, he’s spending it to BUY the x amount of money to pay for the house.

Aghast!

Let’s do some math! Say you want to buy a house. The asking price is $100,000. You get a 30 year, fixed rate (5%) mortgage on the house. That means that the bank gives you $100,000 for the house. You are now $100,000 in the hole. The cost of that money comes in the form of interest, which is 5%. The monthly payment is found by this formula, as given to me by wikipedia.org

c = (r / (1 − (1 + r) N))P

c stands for monthly payment. r is the monthly interest rate, as expressed by percentage/100/12 months (5/100/12= 0.24). N is the period of time in months (360). P is the amount borrowed (100,000).

So, your monthly payment would be (0.24/(1- (1+ 0.24)^-360)) x 100,000, which equals, as calculated by Coldwell Banker’s mortgage calculator, $536.

Now, if you multiply that by 360 (the number of times you will write out that check over 30 years), you get: $192,960. What is that number? That is the total cost of the loan. You are borrowing $100,000, and they charged you $92,960 for it. Just think about that for a little. You spent $92,960 to buy $100,000. You nearly doubled the price of the house. Nauseating, isn’t it?

However, if you pay a down payment, your cost will go down. What is a down payment? Essentially, you are paying for a portion of the cost of the house, and taking a loan out for the remainder. A recommended percentage is 20% of the price. So, if you want to buy a $100,000 house, you ought to put down $20,000. That’s a lot of money, no? Of course it is! However, look at what it saves you. Instead of buying $100,000, you are only buying $80,000. Plug in those numbers, and you’ll be paying $429 a month. That’s only a savings of $107/month. That doesn’t seem worth it, does it? Doling out $20,000 bucks in order to save $100? True. I will grant that there is sticker shock there.

However, multiply that times 360. You get $154,440. That is the total cost of the loan. You are still paying a lot of extra money, still. However, by spending that $20,000, you just saved yourself $38,520 between the two loans. Overall, the difference in cost is $18,520. The more money you put down initially, the more you save.

You can also save money by decreasing the length of the loan. By speeding up the rate you pay, you obviously increase your monthly payments. However, since the interest is charged per month of the loan, the shorter the period is, the less interest is charged, making the loan cheaper.

The same loan ($100,000) over 15 years rather than 30 costs $729 a month. That is almost a $200 difference per month, which might seem hard to swallow. However, over the course of 180 months, you will pay $131,220. And that’s without a down payment. With a 20% down payment, your monthly payments would be $632. The cost of the loan will be $113,760.

Now. Look at those numbers. The first number, $192,960 is with the acquaintance’s theory (no down payment because you never see the money again, long loan period). The last number with my theory (at least 20% down payment, short loan period) is $113,760. That is a huge difference. Essentially, if you choose to have $20,000 in your pocket at the beginning of the loan, and a few hundred dollars extra a month, you are paying for that luxury with $79,200.

So tell me how a down payment is money that is taken from you, never to be seen again? Maybe it’s just my German stinginess coming out, but I think that that’s actually the definition of INTEREST.

*Funny enough, the new pope, Benedict, was also from that general vicinity. People made the same conclusions about him. He’s from Bavaria! He must be related to Hitler! Pope Hitler! However, when I pointed out that Benedict was from there, and there was a good chance that he was related to us (my dad maintains that he’s the spitting image of HIS grandfather), she said, “Oh, Katie. Don’t be silly. We’re not related to the POPE!”