Cash Is King - Debt

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