Of
all the people I talk about, Frank E. South (my grandfather, to whom this guide
is dedicated) perhaps had the greatest impact on me. He understood financial
reversal from experience and passed his knowledge on to anyone willing to
listen.
When
the Great Depression struck, his family owned a very nice home and a string of
businesses, some of which he sat on the boards of, at what seemed to me to be a
young age. They had cars at a time it wasn’t common. They had horses and
tutors. All mortgaged to the hilt. As the crisis from the crash continued year after
year, his father ended up selling off those assets one by one.
With
little more than his education, my grandfather rebuilt a comfortable life for
himself and his family. Even after a health crisis involving my grandmother at
the end of her life ate up much of what he’d saved, he still left my mother and
aunt a small but tidy inheritance. Not enough to set either up for retirement,
but enough for him to feel that he’d done his job in looking after them.
One of the first financial stories he related to me was
about buying his first house. The Great Depression was still on. He’d recently
gotten married. He and my grandmother wanted to start a family. They needed a
home. He looked around and found something modest he could afford. He had an
engineer’s salary which, just like today, is firmly middle class. The house he
chose cost around $6000, which was a fair piece of money at the time.
Now when he said “could afford”, he meant something a
little different than you and I. He intended to pay cash for the bulk of it. In
fact, he and his father got into a debate over just that point. His father,
ever the leveraged businessman, insisted he would be better off buying a larger,
more expensive house and financing it all. In ten years he would never miss the
money.
My grandfather insisted he didn’t want to pay “on time”
which is what having a mortgage or buying on credit was called at the time.
Because he was younger, I think, he saw the Great Depression differently than
his father. Where his father saw a deep yet transitory situation, my
grandfather saw an existential change in circumstance he didn’t wish to go
through again. He had learned his family’s lesson where perhaps my
great-grandfather had not. Or perhaps they just had different perspectives,
neither wrong.
My grandfather bought that house with cash he’d saved and
a small mortgage which he paid off after four or five years. He and my
grandmother lived there until he retired. The proceeds from the sale of that
house became his primary nest egg and emergency fund to supplement his pension
and social security.
His basic philosophy was, contrary to most of what
business schools teach, don’t use other people’s money unless you absolutely have
to. You are paying someone for the privilege, sometimes quite a lot. If
circumstances change and you miss a couple payments, the bank will reclaim its
collateral. Default or bankruptcy is a last resort for extreme situations.
Situations he hoped to avoid if at all possible.
Now most of us, including me, are not in a position to buy
our first house without a mortgage, or even a small one. How long would Karen
and I have had to save up to buy our first (and only) house with cash? About
seven to ten years. Perhaps five if we’d really applied ourselves and maybe
purchased something smaller.
Now anyone who has ever bought a home knows there’s a
little piece of paper in the mountains of other documents that you sign at
closing that fulfills the Truth in Lending Act. This is a federal law enacted
in 1968 that basically says the bank or other lender has to discloses all the
terms and costs of the loan, including the calculation of total interest. This
little document is the one that gives most homeowners the biggest reality
check. It’s the one that say exactly how much interest they will pay over the
life of the loan.
I vividly remember this document. When I looked at the
final number, I saw it that was roughly three times the list price of the house.
I liked the house, and on most days I still do, but no way in west hell was it
worth three times what it was listed for. I swore to myself I would never pay
that much.
And I didn’t.
But my word is my bond, which is exactly what I had given
when I signed the note. So how did I do it?
Well, I had a little experience in this arena already. As
I mentioned in an earlier essay, I came out of school with debt. On top of
student loans, I had to borrow a modest amount from my father just after I got
my first job for a few things I needed, mostly professional clothing and a down
payment on a car. As well, I owed Karen some money from moving expenses while I
was unemployed.
I didn’t quite have the mechanism as refined as I did by
the time I started paying off the house.
Now I would do it slightly differently. What I did then was pay Karen
first (very kindly, she didn’t charge me interest). That got me floating about
even, finally. I took some of the difference in my budget and began paying down
my father. At the time, I was paying him about $100 a month. I still remember
how amazed he was when I paid him off early. Next, I let that extra $100 build
up and then paid off the smaller of my student loans.
An important note here. Most, but not all loans, do not
have an early payment penalty. I have no idea where I ran across that piece of
information but I knew it at the time. I checked both my student loans and
indeed they did not. But paying them off early did not avoid the total money
owed as I remember. Still, I took the money those missing payments from the
smaller student loan freed up, along with the extra from my dad’s loan and let
it build until I could pay off the larger student loan. That, too, quickly
disappeared.
Now I was mostly starting with a clean slate. Almost but
not quite. I still had a car payment, as did Karen. By then, I’d found a new
job in Florida that paid more with a lower cost of living.
But because I was living below my means, I was saving
money fairly steadily even with giving myself a pretty generous allowance
(which was more than it is today). But I knew I needed a down payment on a
house, so I left the car loan alone for the moment.
That loan repayment scheme set up probably the best
financial decision of my life.
As I said in an earlier essay, when Karen and I bought the
house, we weren’t married. We were each responsible for our half of the
mortgage, though we owned the house as joint tenants with rights of
survivorship (a legal arrangement that basically guaranteed both our rights to
the property in case something happened to either one of us). That meant that
if I wanted to put extra toward the principal each month, I had to convince
Karen to do the same. So I showed her the numbers.
Being an engineer, I found the formula on how loans get
repaid based on the interest rate charged. Then I designed a program to
calculate how much we would save and when we would pay off the mortgage based
on adding extra payments.
Many people don’t understand that even though you have a
thirty-year mortgage, the interest of that loan is recalculated each year based
on the outstanding principal and the agreed to interest or annual percentage
rate (APR). Basically, the first year you pay a mortgage, you are pretty much
paying interest because only a tiny fraction of your payment actually pays off the
principal. Over time, you build up equity, meaning you owe less on the note and
more of your fixed payment goes toward the principal. Until by the last five
years, you are mostly paying down principal. The whole payment schedule is just
a formula that allows you to have equal payments for the duration of the loan,
a convenience really. It doesn’t cost you anything unless interest rates go
down, though it saves you if interest rates go up. Like insurance, it’s a hedge
against uncertainty, at least with fixed interest rate loans.
Which means paying principal early becomes a big deal
going forward.
How big?
Well if I remember my calculations right, by Karen and I
each contributing an extra $50 a month ($100 total), we would pay off the
30-year mortgage in 20 years. With an extra $100 a month ($200 total), that
went down to 15 years. That alone would save over the list price of the house
in interest over the life of the loan. So we’d only be paying double the list
price instead of triple.
That big.
Now keep in mind that at the time interest rates were
running high. And I mean what today we would consider usuriously so (at least
until you look at the APR on your credit card). We had a 9% rate which at the
time was considered good (and we paid for the privilege to secure the loan). We
have been spoiled by a decade of amazingly low interest rates.
Remember way back in the first essay when I talked about
average S&P returns? Our APR was almost that. Investing that little bit
extra a month would pay just 1% less than what investing that same money in an
S&P index would pay on average, only guaranteed. No good years, no bad
years, just steady returns.
Once I explained all this to Karen and showed her the
calculations, she was onboard. But since we were in fairly different financial
circumstances (there were points before this she was working a second job to
pay down her debt and keep afloat), she could only afford the extra $50. Soon,
as her situation stabilized and she grew more comfortable, she could afford the
extra $100.
The one caveat was we had to write a separate check for
the additional payment and note that it was paying principal, not interest
(some banks will pay off interest for the year first with additional payment
unless you make it clear).
The next phase in the plan involved another piece of
mortgage arcana I’d run across. Every mortgage I’ve ever seen has a line item in
the payment schedule for mortgage insurance. Mortgage insurance protects the
bank in case you default but conveniently, you pay for it. But you don’t have
to. Once you have 20% equity (own 20% of the value of the house through a
combination of your down payment and paying off principal), you can cancel the
mortgage insurance. After that, the bank figures they will break even by
seizing the property if you default.
Can is the operative word. It doesn’t happen
automatically. The bank would have been quite happy to let us pay it for the
life of the loan.
I want to say ours was roughly 5-10% of our loan payment
(not including homeowners insurance and property taxes) but I forget. Either
way, it was money I could put to better use. So the moment we had our 20%
equity, we went to the bank and cancelled the mortgage insurance. We then
rolled that additional money directly into paying the mortgage principal, too.
Then we got married and I kicked my evil plan into
overdrive. At the time we bought the house, we both had car payments. By the
time we’d gotten engaged, I’d paid the Jeep off early (while contributing extra
to the mortgage). Karen paid her car off with some money she’d inherited. After
we were married, I took most of the money we would have been paying toward
those two cars and dumped it into the mortgage principal, too.
All of which meant we paid down the note in just over five
years. So instead of paying three times what the house was listed for, we paid
1.5 times, including all the fees and commissions we’d paid to buy it (which weren’t
included in that Truth in Lending Statement).
I remember telling my grandfather what we’d done and why.
He gave me a look of pride I rarely see in my family. He finally knew I’d
listened and understood. I’d benefited from his experience.
Of course, if I were to do it again, I would observe a different
hierarchy. I would start by paying off the loan with the highest interest rate.
When that loan was paid off, I would roll that payment directly into the next
highest, and on down the line until I came to the lowest. In general, that lays
out credit cards first (I’ve never carried a balance, but as I said Karen has
briefly), then auto loans, student loans and mortgage.
I call that leverage, though it’s not the kind most
investors mean when they use the term. But “give me a big enough lever and I will
move the world.”
Interestingly, our financial advisor at the time told us
we were nuts for paying off the mortgage early. As did Karen’s father. Both
thought we could make more in the market which was in the midst of the dotcom
boom. Yeah, that would have positioned us to experience the brunt of the bust,
though we couldn’t have known that in advance.
But they did have a point worth considering.
Ok, as I said the average return on the S&P 500 is
roughly 10% (really 9.8%). We were paying 9% interest so that seems like a
no-brainer for only saving 1% with the money at risk, right? Well, we were only
paying 9% interest on paper. In reality, the Federal government was giving us a
subsidy on that interest. At the time, we could claim the interest paid as an
itemized deduction on our taxes. Which meant the government was giving us back
whatever our tax bracket was at the time (28%) in the form of lower taxes. So
suddenly, that 9% interest rate was actually 6.5%, leaving almost 3.5% in
growth by investing in an S&P 500 index in an average year. That’s just over
the average annual rate of inflation, so worth claiming, right?
Not so fast. We really weren’t getting a 28% subsidy on
our interest rate. We didn’t have any other itemized deductions like healthcare
payments (already pre-tax for us at the time) or education costs. This was well
before we could claim state sales tax. Which meant we would only be earning a
28% subsidy on any interest we paid over the standard deduction in a given year.
A quick, back of the napkin calculation told me that in the best year, we were
only paying a couple grand more in interest than the standard deduction at the
time. Which meant our subsidy would only have been about 5.6% (20% of 28%,
which was the excess of interest paid over the standard deduction) on that 9%
interest rate bringing it down to roughly 8.5% instead. A 1.5% theoretical
return doesn’t look like quite so appetizing as a reward for the risk.
And that was only in the first year. In later years, our
tax benefit would have declined even faster because there was less interest
being paid. Eventually, it would not have overcome the standard deduction.
The quality of the silence was priceless when I patiently
explained that math.
Not that the math swayed me very much. My plan from the
beginning was simple. Once we paid off the house, that freed up a significant
amount of money each year for other things. Which was the first mother-may-I
step toward our financial independence. With the mortgage gone, we always had a
place to live as long as we could pay the property taxes. Plus we could always
tap the equity in an emergency. That, for me, was a huge piece of financial
security, one I’d never trade.
Debt is a lot like dieting. The real trick is staying out
of it just like keeping off the weight once you’ve lost it. Both almost always
requires a lifestyle change. Binging as a reward almost always sets you back at
least as far as where you started, maybe farther.
Since we paid off the house, we’ve only taken out one loan,
the one for Karen’s current car. That was done with the intent of paying it off
after a few months, which we did. We could have paid cash but thought at the
time it was prudent to keep our (mainly my) credit score up. I’m not sure I
would do it again but at the time it was more of a concern.
At the same time, we haven’t bought a new car since then.
Karen’s car is seventeen years old. Mine is almost thirty. Both of them run
fine and are generally reliable. Neither of them requires repairs that approach
a year’s worth of car payments, partly because we invest in routine maintenance
so things don’t get out of hand. While each of us occasionally gets the urge
for something new (me more than her), it generally passes quickly. In fact,
last year she decided to get her car partially repainted because she still
liked it well enough to want to drive it for a bunch more years.
Some of that comes down to luck in that both cars have
held up. In the case of mine, it doesn’t get much mileage in a given year, and
hasn’t for almost twenty. Some of it came from picking a quality car that will
last. Karen’s Toyota has the reputation for running a very long time. And some
of it comes from just plain hating what’s involved in buying a new one. That’s
time we don’t get back. But some, too, refers back to the essay on priorities.
We don’t Need new cars, though sometimes we Want them. The midnight black Mercedes
I’ve always dreamt of but never bought would be a Nice-to-Have.
The same applies to the house. One of our wish list criteria
when we bought this house was that it back up to a park. We got lucky to find
one that did. We also wanted a quiet, closed neighborhood at least a half mile
away from any major road. We got that, too. Finally, it had to be big enough to
grow in if we wanted to. Turns out even if we’d had one or two kids, it would
have still suited our needs, though it might have been a little tight.
As well, we set our budget with the real estate agent so
that we could pay the mortgage on one salary if necessary. As a defense
contractor and a government employee, we were keenly aware of the potential
volatility of our careers. Unfortunately, it had to be the largest salary (mine
at the time) because we couldn’t make the smallest work and get what we wanted.
As it turned out, that decision paid off in being able to lose one salary
entirely.
Planning, patience, discipline and simplicity.
So where did all this get us?
Let’s run some theoretical numbers. Let’s say our mortgage
was $1000 a month. Let’s say as well our car payments totaled $500 a month.
What we would have freed up by paying them off was $18k a year, take home.
Which translates to roughly $29k less in salary we could
live on ($18k/0.62 which accounts for taxes at a 28% rate, 6.2% Social Security
and 3.8% Medicare). Alternatively, it was $18k or more that we could invest and
grow for retirement (with luck at 10% a year). Or $18k we could spend on things
that inspired more joy in us than paying other people interest (that’s a lot of
wargames and yarn). Or some combination of the three.
As you can see, this first step toward financial
independence opened up a number of interesting possibilities, including the
path we took.
But where exactly did that extra money come from? In
short, from living below our means. I touched on that in the last essay and
will delve a little deeper into over the next two. Then we’ll see if I can get
these seemingly disparate voices to harmonize in a third.
© 2019 Edward P. Morgan III