Inflation Investments

Inflation Investments

With the cost of living on the rise in 2021, many investors are asking about inflation investments. What is a good way to position your portfolio to grow and maintain its purchasing power? Where should we be positioned for 2022 if higher inflation is going to stick around?

Inflation was 5.4% for the 12 months ending in July. I share these concerns and we are going to discuss several inflation investments below. Before we do, I have to begin with a caveat. We should be cautious about placing a lot of weight in forecasts. Whether we look at predictions of stock market returns, interest rates, or inflation, these are often quite inaccurate. Market timing decisions based on these forecasts seldom add any value in hindsight.

What we do know for sure is that cash will lose its purchasing power. With interest rates near zero on most money market funds and bank accounts, it is a frustrating time to be a conservative investor. We like to consider the Real Yield – the yield minus inflation. It would be good if bonds were giving us a positive Real Yield. Today, however, the Real Yield on a 10-year Treasury bond is negative 4%. This may be the most unattractive Real Yield we have ever seen in US fixed income.

Let’s look at inflation’s impact on stocks and bonds and then discuss three alternatives: TIPs, Commodities, and Real Estate.

Inflation and Stocks

You may hear that inflation is bad for stocks. That is partially true. Rising inflation hurts companies’ profitability and consumers’ wallets. In the short-term, unexpected spikes in inflation seem correlated to below average performance in stocks.

However, when we look longer, stocks have done the better job of staying ahead of inflation than other assets. Over five or ten years, stocks have generally outpaced inflation by a wide margin. That’s true even in periods of higher inflation. There are always some down periods for stocks, but as an asset class, stocks typically have the best chance of beating inflation over a 20-30 year horizon as an investor or as a retiree.

We can’t discuss stocks and inflation without considering two important points.

First, if there is high inflation in the US, we expect that the Dollar will decline in value as a currency. If the Dollar weakens, this would be positive for foreign stocks or emerging market stocks. Because foreign stocks trade in other currencies, a falling dollar would boost their values for US investors. Our international holdings provide a hedge against a falling dollar.

Second, the Federal Reserve may act soon to slow inflation by raising interest rates. This would help slow the economy. However, if the Fed presses too hard on the brake pedal, they could crash the economy, the stock market, and send bond prices falling, too. In this scenario, cash at 0% could still outperform stocks and bonds for a year or longer! That’s why Wall Street has long said “Don’t fight the Fed.” The Fed’s mandate is to manage inflation and they are now having to figure out how to keep the economy growing. But not growing too much to cause inflation! This will prove more difficult as government spending and debt grows to walk this tightrope.

Inflation and Bonds

With Real Yields negative today, it may seem an unappealing time to own bonds, especially high quality bonds. Earning one percent while inflation is 5% is frustrating. The challenge is to maintain an appropriate risk tolerance across the whole portfolio.

If you have a 60/40 portfolio with 60% in stocks and 40% in bonds, should you sell your bonds? The stock market is at an all-time high right now and US growth stocks could be overvalued. So it is not a great buying opportunity to replace all your bonds with stocks today. Instead, consider your reason for owning bonds. We own bonds to offset the risk of stocks. This gives us an opportunity to have some stability and survive the next bear market. Bonds give us a chance to rebalance. So, I doubt that anyone who is 60/40 or 70/30 will want to go to 100% stocks in this environment today.

Still, I think we can add some value to fixed income holdings. Here are a couple of ways we have been addressing fixed income holdings for our clients:

  • Ladder 5-year Fixed Annuities. Today’s rate is 2.75%, which is below inflation, but more than double what we can find in Treasury bonds, Municipal bonds, or CDs.
  • Emerging Market Bonds. As a long-term investment, we see attractive relative yields and improving fundamentals.
  • Preferred Stocks, offering an attractive yield.

TIPS

Treasury Inflation Protected Securities are US government bonds which adjust to the CPI. These should be the perfect inflation investment. TIPS were designed to offer a return of inflation plus some small amount. In the past, these may have offered CPI plus say one percent. Then if CPI is 5.4%, you would earn 6.4% for the year.

Unfortunately, in today’s low yield environment, TIPS sell at a negative yield. For example, the yield on the Vanguard short-term TIPS ETF (VTIP) is presently negative 2.24%. That means you will earn inflation minus 2.24%. Today, TIPS are guaranteed to not keep up with inflation! I suppose if you think inflation is staying higher than 5%, TIPS could still be attractive relative to owning regular short-term Treasury Bonds. But TIPS today will not actually keep up with inflation.

Instead of TIPS, individual investors should look at I-Bonds. I-Bonds are a cousin of the old-school EE US Savings Bonds. The I-series savings bonds, however, are inflation linked. I-bonds bought today will pay CPI plus 0%. Then your investment is guaranteed to keep up with inflation, unlike TIPS. A couple of things to know about I-bonds:

  • You can only buy I-bonds directly from the US Treasury. We cannot hold I-Bonds in a brokerage account. There is no secondary market for I-bonds, you can only redeem at a bank or electronically.
  • I-Bond purchases are limited to a maximum of $10,000 a year in electronic form and $5,000 a year as paper bonds, per person. You can buy I-bonds as a gift for minors, and the annual limits are based on the recipient, not the purchaser.
  • I-bonds pay interest for 30 years. You can redeem an I-bond after 12 months. If you sell between 1 and 5 years, you lose the last three months of interest.

Commodities

Because inflation means that the cost of materials is rising, owning commodities as part of a portfolio may offer a hedge on inflation. Long-term, commodities have not performed as well as stocks, but they do have periods when they do well. While bonds are relatively stable and consistent, commodities can have a lot of volatility and risk. So, I don’t like commodities as a permanent holding in a portfolio.

The Bloomberg Commodities Index was up 22% this year through August 31. Having already had a strong performance, I don’t think that anyone buying commodities today is early to the party. That is a risk – even if we are correct about above average inflation, that does not mean we are guaranteed success by buying commodities.

Consider Gold. Gold is often thought of as a great inflation hedge and a store of value. Unfortunately, Gold has not performed well in 2021. Gold is down 4.7% year to date, even as inflation has spiked. It has underperformed broad commodities by 27%! It’s difficult to try to pick individual commodities with consistent accuracy. They are highly speculative. That’s why if you are going to invest in commodities, I would suggest a broad index fund rather than betting on a single commodity.

Real Estate

With home prices up 20% in many markets, Real Estate is certainly a popular inflation investment. And with mortgage rates at all-time lows, borrowers tend to do well when inflation ticks up. Home values grow and could even outstrip the interest rate on your mortgage, potentially. I’ve written at length about real estate and want to share a couple of my best pieces:

While I like real estate as an inflation hedge, I’d like to remind investors that the home price changes reported by the Case-Schiller Home Price Index do not reflect the return to investors. Read: Inflation and Real Estate.

Thinking about buying a rental property? Read: Should You Invest In Real Estate?

With cash at zero percent, should you pay off your mortgage? Read: Your Home Is Like A Bond

Looking at commercial Real Estate Investment Trusts, US REITs have had a strong year. The iShares US REIT ETF (IYR) is up 27% year to date, beating even the S&P 500 Index. I am concerned about the present valuations and low yields in the space. Additionally, retail, office, apartments, and senior living all face extreme challenges from the Pandemic. Many are seeing vacancies, bankrupt tenants, and people relocating away from urban development. Many businesses are rethinking their office needs as work-from-home seems here to stay. Even if we do see higher inflation moving forward, I’m not sure I want to chase REITs at these elevated levels.

Inflation Portfolio

Even with the possibility of higher inflation, I would caution investors against making radical changes to their portfolio. Stocks will continue to be the inflation investment that should offer the best chance at crushing inflation over the long-term. Include foreign stocks to add a hedge because US inflation suggests the Dollar will fall over time. Bonds are primarily to offset the risk of stocks and provide portfolio defense. We will make a few tweaks to try to reduce the impact of inflation on fixed income, but I would remind investors to avoid chasing high yield.

As satellite positions to core stock and bond holdings, we’ve looked at TIPS, Commodities, and Real Estate. Each has Pros and Cons as inflation investments. At this point, the simple fear of inflation has caused some of these investments to already have significant moves. We will continue to evaluate the inflation situation and analyze how we position our investment holdings. Our focus remains fixed on helping clients achieve their goals through prudent investment strategies and smart financial planning.

Inflation and Real Estate

Inflation and Real Estate

In recent weeks, people have become more concerned about the possibility of inflation and its impact on Real Estate. This is a complex subject, but certainly important for your financial security. With interest rates near historic lows, now is a great time to get a 15 or 30 year mortgage. And with the possibility of inflation increasing, buying a home now could lock in both today’s real estate prices and interest rates.

Globally, governments are spending at an unprecedented rate, taking on vast amounts of debt. According to the US Debt Clock, we presently owe over $224,000 per US taxpayer. Will we ever repay this debt? There’s no appetite for austerity – reducing spending – or raising taxes to payoff the debt. No, we will need to inflate our way out of debt. With 3% inflation, $1,000 in debt will “feel like” only $912 in three years. Ask someone who borrowed $250,000 twenty years ago for a house. It probably felt like a huge amount at the time, but became easier to pay over the years.

For people who don’t have a house, there is a real fear of missing out. Many are concerned that if they don’t buy right now, real estate prices may soon rise to the point where they can no longer afford a house. In densely populated parts of the country, many people are already priced out of the market. People from California, New York, Seattle, etc. are moving to Dallas, Austin, Nashville, or other places in search of better real estate prices and lower taxes.

I bought a house in January and moved to Little Rock, which is even more affordable than Dallas. We are really enjoying our new neighborhood and city. When you work from home, it’s important to have a place you love. So, I understand the feelings people are having about inflation and real estate today. Here’s my advice to first time homebuyers and to people consider their house as an investment.

Buy Versus Rent

I do think now is a great time to buy a house – at least in theory! Owning can make financial sense versus renting, but primarily with two considerations:

  1. The longer you stay in the house, the better. It takes a long time to really benefit from the impact of inflation on real estate. If you stay in the house less than five years, you may only break even, after you pay realtor fees and closing costs.
  2. Your house is still an expense. There are taxes, insurance, mortgage interest, maintenance, furnishings, etc. When I see people stretch for the most expensive house they can afford, it often means they are unable to save as much in their other accounts. Twenty years later, they have only a small 401(k). Meanwhile, their colleagues who maxed out their 401(k)s could have a million dollar nest egg.

So, if you are ready to put down roots, yes, buy a house now. However, I have a feeling that we may see these low interest rates for a while longer. If the time isn’t right for you personally, then wait. If your career may take you to another location, then wait. Growing family? Get a house you can keep and not out grow. I do think you will have plenty of chances to get in real estate in the future. Renting is not only fine, it may even allow you to grow your net worth when you invest your savings versus owning. Renting provides flexibility and fixed costs, versus the surprise expenses that come with having a home. If anything, we need to remove the stigma from renting that it is somehow a barrier to financial success.

Your House is Not an Investment

If Real Estate is such a good inflation hedge, then it would make sense for everyone to buy a million dollar mansion and get rich off their home, right? Should you buy the most expensive house you can afford? Let’s consider this carefully.

Increasing house prices is not the same as an investment return. To measure inflation of real estate, many people refer to the Case-Shiller Home Price Index. It is great data, but flawed if you are trying to use it for an investment rationale. It simply measures the selling price of a house compared to that house’s previous sale. That’s what your return would be as a homeowner, right? No, the homeowner makes much, much less.

While the Index shows what it costs to buy a house, it does not reflect the return to owners. The index does not include: transaction costs (6% realtor commissions are egregious today, really), ongoing expenses (property taxes, insurance, etc.), or improvements. Taxes and Insurance can run 2.5% to 3% a year. Someone who puts in $100,000 in renovations to a house and adds two rooms? Case-Shiller doesn’t consider any of these costs that may occur between sales of a house.

As of 12/31/2020, the Case-Shiller 20-City Composite shows a 10-year price increase of 5.39%. That’s impressive, but that’s not the net return to home owners. So, let’s not think this data is saying that a house is the same as a mutual fund that returned 5.39% over the past 10 years. (By the way, over that same 10 year period, an investment in the Vanguard 500 ETF (VOO) had a return of 13.84%.) Past performance is no guarantee of future results, but I just want people to understand that comparing the Case-Shiller index to an investment return is flawed and not the purpose of that data.

Remodels and Affordability

Planning to remodel? That’s fine to enjoy your home, improve its usability, and to save you from having to move. However, is it a good investment? According to Remodeling Magazine’s 2020 National Data, no type of remodeling recouped 100% of its cost. The top 10 types of remodels recouped 66.8% to 95.6% as a National Average. It’s fine to improve and update your home, but let’s not try to rationalize that decision by thinking that we are making a great investment. The data suggests this is unlikely.

Home affordability: House prices are based on supply and demand. Demand depends on affordability. With years of slow home building, the supply of houses is tight – at least in states with population growth. In areas of population decline, there may be an oversupply. When there are more buyers than sellers, prices rise. In the long run, however, house prices reflect what people can afford.

We’ve had thirty years of falling interest rates. I think my parents’ first mortgage was at 16%. Today, that would be under 3%. That’s one reason why home prices have grown so much. Affordability isn’t based on the home selling price, it’s based on the monthly payment. And since mortgage eligibility is based on your debt to income ratio, home prices cannot increase faster than income in the long run, without falling interest rates. So, I don’t think we are going to see house prices going up by 10% every year if wages only increase by 2%. Who will be the buyers?

Taxes and Investing

It used to be that home ownership came with a nice tax break. That’s no longer the case. I know it seems unfair, but economists finally got through to Washington that the tax benefits were disproportionally helping the ultra wealthy and not the average home owner. For 2021, the standard deduction for a married couple is $25,100. Very few people will itemize. Your itemized deductions include mortgage interest, state and local taxes (with a cap of $10,000), and charitable donations. You probably will not have more than $25,100 in these deductions. That means that you are getting zero tax benefit for your home’s taxes and interest, compared to being a renter. In 2017, I wrote about this change: Home Tax Deductions: Overrated and Getting Worse.

Don’t think of your home as an investment, but as a cost. It’s probably your largest cost. Treat it as a expense to be managed. Your ability to save in a 401(k), IRA, HSA, 529 Plan, Brokerage Account, etc., depends on your preserving the cash flow to fund those accounts. Buy the most expensive house you can and you will be house rich and cash poor. I don’t think that there will be enough inflation in real estate to make that a winning bet.

Your home equity is part of your net worth, but at best consider it like a bond. In spite of today’s inflation concerns and fear of missing out, your home is not likely to make you rich. I remain a fan of the 15-year mortgage and find that my wealthiest clients usually want to be debt-free rather than use leverage to get the biggest house possible. Read: The 15-Year Mortgage, Myth and Reality. Even as home prices increase, please recognize that inflation in real estate is higher than your return on investment once you include all the costs of ownership.

Thinking Long Term

If you are ready to buy a home, now may be a good time. Low interest rates and rising home prices are going to help you. Buying can build your net worth versus renting, if you are ready to stay in one place. Think of your house as an expense and not an investment, and you will enjoy it more and have realistic expectations. Real estate and inflation are linked, but hopefully you now realize that home prices do not equate to return on investment. Build your wealth elsewhere – through investing, creating a business, and growing your career and earnings.

Don’t be afraid of missing out, supply will catch up to demand eventually. And the rise of remote working in the past year means that more people can work from anywhere. People can move to the location they want and can afford. This will help equalize prices nationally, as more workers move from high-cost areas to places with better value.

Low interest rates should cause inflation to pick up. This is government planned financial repression, and it will penalize savers, like grandparents who want to just park their money in CDs. Those will be Certificates of Depreciation – guaranteed to not maintain their purchasing power and keep up with inflation. Low interest rates will benefit debtors, especially when that debt is used to buy appreciating assets and not depreciating things, like cars. Use leverage wisely and it can help grow your net worth. Financial planning is more than just investments, and my goal is to help you succeed in defining and creating your own version of The Good Life.

Your Home Is Like A Bond

You’re doing well. You’ve got your emergency fund, you’re maxing out your 401(k), and you don’t have any credit card debt. At this point, a common question is: Should I send extra payments to my mortgage? And with markets near their highs, maybe you’re even wondering, Should I pay off my mortgage?

There are a lot of emotional reasons to pay off your mortgage. You could own your house free and clear and never have to worry about a mortgage again. You could reduce your bills in retirement. Investments carry uncertainty, whereas paying down a debt is a sure thing. Those are typical thoughts, but that’s not necessarily a rational answer.

Maximize Your Net Worth

In financial planning, our goal is to determine the solution which maximizes utility. Will I have a higher net worth if I pay off my mortgage or invest the money?

The answer, then, is it depends. It depends on the rate of return on your investments compared to the rate you are paying on your mortgage. If your mortgage is 3% but your cash is earning 0.5%, you would be better off paying down the mortgage. (Assuming you still kept sufficient liquidity for emergencies). On the other hand, what if your mortgage is 3% and you could be making 7%? Then, you would maximize your net worth by staying invested and not pre-paying your mortgage.

Most people would prefer to be debt free. However, if you can invest at a higher return than you borrow, you will grow your net worth faster. I don’t think of a home as being a great investment. Houses generally keep up with inflation, but have returns similar to bonds, or slightly less.

Home Versus Bonds

Looking at the Case-Shiller 20 City Home Price Index (which includes Dallas), the overall rate of return since 2000 was 4.02%. Let’s look at an actual bond fund, not just hypothetical indexes. An investor could have earned 5.15% a year in the Vanguard Intermediate Term Bond Index fund, since fund inception in 2001. 

The money you put into your house, will likely behave like a bond, although possibly with more volatility. Over a long period, it should keep up with inflation, or if you’re lucky, a little better than inflation. (See below for my concerns about home prices, or thinking of a home as an investment.)

I do believe it is realistic, based both on historical returns and projected returns, to anticipate a return of 5-8% from a diversified portfolio containing 60% or more in stocks. That’s not guaranteed, but if your time horizon is twenty or thirty years (i.e. same as a mortgage), it’s a reasonable assumption. And the longer the time period we consider, the greater likelihood of a positive outcome from stocks.

While it is important to consider the overall levels of risk and return of your portfolio, a portfolio is made up of specific segments. Today, the yields on high quality bonds are very low. With the 10-year treasury yielding only 1.25%, there’s not much return to be had in bonds.

Using Cash or Bonds to Pay Down Mortgage

Let’s consider an example, using round numbers for simplicity. Let’s say you have a $1 million portfolio in a 60/40 portfolio: $600,000 in stocks and $400,000 in bonds. You also have a $200,000 mortgage at 3.5%. The expected returns (hypothetical) for stocks is 7% and for bonds 2.5% today. That would give the overall portfolio an expected return of 5.2%, which is higher than your mortgage rate.

On the bonds, though, the expected return of 2.5% is less than your mortgage cost of 3.5%. If you believe that today’s low yield environment is likely to persist for a long time, it might make sense to take $200,000 from your bonds to pay off the mortgage. That would leave you with a portfolio containing $600,000 of equities and $200,000 in bonds, a 75/25 portfolio. 

The new portfolio would be more volatile than the original 60/40 portfolio, but the dollar value of your stock holdings would remain the same. And your net worth will grow faster, since we paid off debt at 3.5% with bonds that would have yielded only 2.5%.

Provided you are comfortable with having a more volatile portfolio, you might maximize your net worth by withdrawing from bonds but not from your equities. This means increasing your equity percentage allocation. However, I wouldn’t sell stocks to pay down a long dated mortgage. Consider the math on that decision carefully.

Additional Considerations

There’s a lot to evaluate here, so it is important we discuss your individual situation and not try to simplify this to some type of universal advice or rule of thumb.

  1. If your choices are to send in extra mortgage payments or do nothing, then yes, send in extra payments. That’s better than spending it!
  2. Are you choosing between extra payments versus another investment? Then, consider the long-term expected rate of return of the investment versus the interest rate of the mortgage.
  3. While bond yields are low today, it is possible they could rise in the future. If you have short-term bonds you might gradually reset your yields to higher levels. A fixed mortgage, however, will stay at the same rate for the full term of 15 to 30 years. Now is a great time to borrow very cheaply. If we have higher inflation in the future, it will benefit borrowers and penalize savers.
  4. You can invest outside of a retirement account. In fact, if your goal is to retire early, become a millionaire, or create a family trust, you need to do more than just a 401(k). Some people stop after funding a 401(k) and think they don’t need to make any additional investments. Paying down a mortgage is not your only option; consider a taxable account.
  5. A mortgage is a form of forced savings. If you have a monthly mortgage of $1,500, maybe $500 of that is interest and the remaining $1,000 is building equity in your home. If you pay off your mortgage from investments, you will save $1,500 a month. You will feel wealthier because you improved your cash flow. But if you don’t invest that $1,500 a month going forward, you will likely just increase your discretionary spending. Be careful to not miss that opportunity to increase your saving.

On Home Values

  • Your home value will increase the same whether you have a mortgage or own it free and clear.
  • There are significant expenses in being a home owner which make it a poor investment, including property taxes, insurance, utilities, and repairs or improvements. These costs are not included in a home price index. Read more: Inflation and Real Estate
  • Selling costs can also be significant, such as a 6% realtor commission. I bought a house for $375,000 in 2006 and sold it in 2017. After paying closing expenses, I received $376,000. That’s not a good return, and those amounts don’t include the improvements I made to the house. 
  • If your primary goal is to grow your net worth, consider your home an expense and not an investment. If you aren’t going to stay for at least five years, rent.
  • After the Tax Cuts and Jobs Act, most people cannot deduct their property taxes and mortgage interest. This is especially true for married couples. So, forget about having a home as a great tax deduction; most taxpayers will take the standard deduction.

At best, you might consider home equity to be a substitute for a bond investment. Given today’s very low yields, you could reduce bond holdings to pay off a mortgage. Your home is significant part of your net worth statement. It’s often one of your biggest assets, liabilities, and expenses. Think carefully about how you manage those costs. Genuinely analyze how different decisions could impact your net worth over ten or more years. That’s the approach we want to use when asking, Should I pay off my mortgage?

Are Your Tax-Deductions Going Away?

Last week, we discussed the current tax reform proposal in Washington and discussed how it would reduce incentives for homeowners two ways: by increasing the standard deduction and by eliminating the deduction for state and local taxes, including the deduction for property taxes. Recall that itemized deductions only are a benefit if they exceed the amount of the standard deduction, currently $6,350 single or $12,700 married.

While the legislation has yet to be finalized, it appears increasingly likely that we are on the eve of the most significant tax changes in 30 years. The proposals are slated to take effect in 2018, which means that if they are approved, there is still several weeks in 2017 to make use of the old rules.

For many Americans, your taxes will be lower under the current proposal. The biggest tax cuts, however, would go to corporations, with a proposed reduction from 35% to a maximum of 20%. That’s the proposal, but the final version may be different. The advice below is based on the current GOP plan; we would not advocate taking any steps until the reforms are in their final version and passed.

1. Itemized Deductions. The proposal would increase the standard deduction from $6,350 (single) and $12,700 (married) to $12,000 and $24,000. As a result, it is believed that instead of 33%, the number of taxpayers who itemize will fall to only 10%. If you have itemized deductions below $12,000/$24,000, you will no longer receive any benefit from those expenses in 2018.

  • Consider accelerating any tax deductions into 2017, such as property taxes, charitable donations, or unreimbursed employee expenses.
  • Itemized deductions for casualty losses, gambling losses/expenses, and medical expenses will be repealed.
  • Many miscellaneous deductions will disappear, including: tax preparation fees, moving for work (over 50 miles), and unreimbursed employee expenses.
  • Investment advisory fees, such as those I charge to clients, will still be tax deductible. However, these miscellaneous deductions only count when they exceed 2% of AGI, which will be more difficult to achieve with so many other deductions disappearing.
  • The $7,500 tax credit for the purchase of a plug-in electric vehicle will be abolished. If you were thinking of buying a Chevy Bolt or Nissan Leaf, better do so now! If you are on the wait list for a Tesla Model 3, you probably will not receive one before the credit disappears. Read more: “Is Your Car Eligible for a $7,500 Tax Credit?”

2. Real Estate. The Senate version we discussed last week had completely eliminated the deduction for property taxes and state/local taxed paid. Luckily, this has been softened to a cap of $10,000 for property taxes.

  • If your property taxes exceed $10,000, you might want to pay those taxes in December as part of your 2017 tax year. If you pay in January 2018, you would not receive the full deduction.
  • The proposal also caps the mortgage interest deduction to $500,000, and for your primary residence only. This is a substantial reduction. Currently, you can deduct interest on a mortgage up to $1 million, and you can also deduct mortgage interest on a second home, including, in some cases, an RV or yacht.
  • Many owners of second homes will likely try to treat these as investment properties, if they are willing to rent them out. As a rental, you can deduct taxes and other costs as a business expense. See my article: “Can You Afford a Second Home?”

3. Tax Brackets. The proposal reduces the tax brackets to four levels: 12%, 25%, 35%, and 39.6% (the current top bracket remains). These brackets are shifted to slightly higher income levels, so many taxpayers will be in a lower bracket than today or pay less tax. Those in the top bracket, 39.6%, who also make over $1 million, will have their income in the 12% range boosted to the 39.6% level. So don’t think this proposal is excessively generous to high earners – many will see higher taxes.

The Alternative Minimum Tax (AMT) will be abolished, so if you have any Minimum Tax Credit carryforwards, those credits will be released. The 3.8% Medicare Surtax will unfortunately remain in place, even though Trump has previously promised to repeal it. Capital Gains rates will remain at 0%, 15%, and 20% depending on your tax bracket, and curiously, these rates will be tied to the old income levels, and not to the new tax brackets.

If passed, the tax reform bill will substantially change how we deduct expenses from our taxes. Those with simple returns may find that their tax bill is lower, but for many investors with more complicated tax situations, the proposed changes may require that you rethink how you approach your taxes.

We will keep you posted of how this unfolds and will especially be looking for potential ways it may impact our financial plans. It has often been said that the definition of a “loophole” is a tax benefit that someone else gets. Unfortunately, simplifying the tax code and closing these deductions is bound to upset many people who will see their favorite tax benefits reduced or removed entirely.

Home Tax Deductions: Overrated and Getting Worse

If you ask virtually anyone about the benefits of home ownership, you will probably hear the phrase “great tax deductions” within 20 seconds. However, the reality is that for many taxpayers, owning real estate is not much of a tax deduction at all. And under the Trump-proposed tax reform bill currently in Congress, the actual tax benefits homeowners achieve will shrink vastly.

The two main tax benefits of being a homeowner are the mortgage interest deduction and the property tax deduction. These are claimed under “itemized deductions”, which also include charitable donations, medical expenses (exceeding 7.5% or 10% of income), and miscellaneous deductions such as unreimbursed employee expenses.

You have your choice of taking whichever is higher: the standard deduction or your itemized deductions (Schedule A). The standard deduction for 2017 is $6,350 (single) or $12,700 (married filing jointly). So, the first thing to realize about home tax deductions is that you only are getting a benefit if they exceed $6,350/$12,700.

If you are married and your mortgage interest, property tax, and other deductions only total $11,000, you will take the standard deduction. All those house expenses did not get you a penny of additional tax benefits. If your itemized deductions total $13,000, you would take the itemized deductions, but are only getting a benefit of $300 – the amount by which you exceeded the standard deduction.

The greatest proportion of tax benefits for homeowners go to those with very expensive homes and large mortgages. People with more modest homes may be getting little or no benefit relative to the standard deduction. But wealthy taxpayers can have their itemized deductions reduced by up to 80% under the Pease Restrictions. So, I have also seen high earning families who don’t get to count their home expenses either, and have to take the Standard Deduction!

The proposal in Congress today via President Trump would make two significant changes to tax deductions for homeowners:

1. The bill would almost double the standard deduction from $6,350 (single) and $12,700 (married) today to $12,000 and $24,000. This would reduce taxes and eliminate the need for itemized deductions for many American families. If you are married and your current itemized deductions are under $24,000, you would no longer be getting a deduction for those expenses.

2. Trump also proposes eliminating the deduction for State and Local Taxes (the so-called SALT deductions), which includes property taxes. Removing the SALT deduction from Schedule A would be devastating for high tax states like California, New York, Connecticut, and New Jersey. But it would also harm many homeowners right here in Texas, where our property taxes can be a significant expense.

While the increase in the standard deduction would offset the loss of SALT deductions for many Americans, it is still an elimination of a key benefit of being a homeowner. The current tax reform bill has narrowly passed in the House of Representatives and will be taken up by the Senate after November 6, where it requires only a simple majority to pass under budget reconciliation rules.

The fact is that real estate tax deductions were already overstated when you recognize that you only benefit when you exceed the Standard Deduction. The first $12,700 in itemized deductions achieve no reduction in taxes whatsoever. Now, if Congress acts to increase the Standard Deduction and to eliminate the ability to deduct property taxes, most people will not be getting any tax break from being a homeowner.

Depending on your situation, your overall tax bill may still go down. The current proposal will simplify the tax brackets to just three levels: 12%, 25%, and 35%. Your taxes may also go down because of the increase in the Standard Deduction, provided the Standard Deduction is higher than your Schedule A.

Tax policy has a profound influence on public behavior. If you know that you are not getting any additional tax benefit from being a homeowner, you may prefer to rent. If you are retired and see your income taxes go up, you may decide to sell your home and downsize to save money. This change in policy may have the unintended consequence of hurting home values, too, because it certainly make being a homeowner less appealing.

Tracking Home Improvements

When you eventually sell your home, it may be helpful to have a record of your home improvement expenses. Because people often own their homes for decades, this is an area where a lot of records and receipts are lost. Here is what you need to know about tracking home improvements.

Primary Residence Exclusion

At the time of a home sale, the difference between your purchase price and your sale price is a taxable capital gain. Luckily for most people, there is a significant capital gains exclusion from the IRS: $250,000 (single) or $500,000 (married), for your primary residence. If your gain falls below this amount, you will not owe any taxes. In order to qualify, the property must have been your primary residence for at least two of the previous five years, and you must not have taken this exclusion for another property for two years.

If you make a capital improvement (described below), that expense increases your cost basis in the home. But because of the large exclusion ($250,000 or $500,000), many people don’t even bother to keep track of their home improvement expenses. That may be a mistake. Here are a number of scenarios which could be a problem:

  • If you get divorced or your spouse passes away, your exclusion will decrease from $500,000 to $250,000.
  • Should you move and make another property your primary residence for four years, you will lose the tax exclusion on the previous property.
  • If you own your property for the next 30 years, it is possible your capital gain ends up being higher than the $250/$500k limits. These amounts are not indexed for inflation.
  • Congress could reduce this tax break, although it would be very unpopular to do so. They are not likely to change the definition of cost basis and capital gains.

Capital Improvements

What constitutes a Capital Improvement which would increase your cost basis? In general, the improvement must be permanent (lasting more than one year), attached to the property (not removable or decorative), and add to the value, use, or function of the property. Maintenance and repairs are generally not capital improvements unless they prolong your home’s useful life. The IRS provides the following specific examples of expenses that are Capital Improvements:

  • Additions, such as a new bathroom, bedroom, deck, garage, porch, or patio.
  • Permanent outdoor improvements, including paved driveways, fences, retaining walls, landscaping, or a swimming pool.
  • Exterior features, such as new windows, doors, siding, or a roof.
  • Insulation for your attic, walls, floors, or plumbing.
  • Home systems, including heat/central air, wiring, sprinkler, or alarm systems.
  • Plumbing upgrades such as septic systems, hot water heaters, filtration systems, etc.
  • Interior improvements, including built-in appliances, flooring, carpet, kitchen remodeling, or a new fireplace.

While there are many expenses which count as improvements, repairs and upkeep do not. Painting, replacing broken fixtures, patching a roof, or fixing plumbing leaks are not improvements. Also, if you install something and later remove it, that expense may not be counted. For example, if you install new carpet and then later replace the carpet with wood floors, you cannot include the carpet expense in your cost basis.

Gain or Loss?

For full information on calculating your gain or loss on a home, see IRS Publication 523. While most homeowners are focused on mitigating taxable gains, I should add that if your capital improvements are significant enough to make your home sale into a loss, that loss would be a valuable tax benefit as it could offset other income. Here’s an example:

Purchase Price: $240,000
Capital Improvements: $37,400
Cost Basis: $277,400

Sale Price: $279,000
Minus 6% Realtor Commission: -$16,740
Closing Costs: -$1,250
Net Proceeds: $261,010

LOSS = $16,390

If you just looked at your purchase price and sales price, you might think that you would have a small gain (under the exclusion amount), and there was no need to keep track of your improvements. However, in this example, you don’t have any gain at all.

Unlike other receipts, which you only need to keep for seven years, you do need to keep records of your capital improvements for as long as you own the home, and then seven years after you file your tax return after the sale. Even if you think you are going to be under the $500,000 tax exclusion, I’d highly recommend you keep track of these capital improvements which increase your cost basis.

Can You Afford a Second Home?

When asked to describe their idea of living The Good Life, many investors tell me that they have a special place – a lake, mountain, beach, or city – that is near and dear to their heart. Their dream is to have a get away, not at retirement, but now to spend with their families and build the memories that will last a lifetime. If you find yourself constantly dreaming about that perfect Florida beach or the stillness of a snow-capped Colorado peak, it won’t be long before you find yourself Googling home prices in your favorite vacation town and thinking about the possibilities.

Having a second home is a wonderful thing, when done properly. It can also be stressful, time-consuming, and an enormous financial drain which can impact your financial stability and even your solvency. When the financial crisis hit, buyers of vacation properties disappeared, leaving cash-strapped owners in a tragic process of liquidating properties at enormous losses.

Today, prices have recovered and in many areas are back to fresh highs. Not only have bargains largely disappeared, prices have been driven up in popular locations by foreign investors who want to get money out of their own country and into the stability of US dollars. For many international investors, it is easier to buy US real estate than it would be to open a brokerage account in the US.

If you are contemplating buying a second home, be smart and make sure your decisions are based on a thorough and comprehensive examination of the financial details involved. For our financial planning process, that would mean adding in the realistic costs of a second home into our software and examining the results. Would the drain of a second home crowd out other cash flow goals such as retirement? Would you have to delay retirement by several years to keep your retirement success above 80 or 90 percent?

I own a second home, and have spoken with dozens of clients about their experiences over the years. Here’s my advice if you’re thinking of taking the plunge:

1) A second home is not an investment. It’s great if your Uncle made millions off the property he bought in Beaver Creek in 1976, but this is 2016. Very few people make money off their vacation properties, and even fewer actually consider their total costs of interest, taxes, insurance, upkeep, and utilities, when making a profit calculation. In other words, buying a condo for $400,000 and selling it for $450,000 five years later means you probably lost money. A 6% real estate commission would immediately reduce your proceeds from $450,000 to $423,000. Take out your other costs and you almost certainly have a negative return, even if you have a capital gain for tax purposes.

When we want something, our mind will go to great lengths to rationalize why it is a good idea. I once had a client bring me a spreadsheet showing the value of a condo in Hawaii increasing by 9% a year for the next 40 years. Why? Because he said it was a fact that condos in Hawaii increase by 9% every year.

I’m not saying a second home is a bad idea, but it’s best to not start with rose-colored glasses thinking that it will be a killer investment. Instead, examine the costs of a second home and calculate if you can afford this expense as part of your lifestyle. If, after many years of enjoyment, you were to turn an actual profit, consider yourself fortunate to have had such good luck.

2) If you are only going to be there two weeks a year, you will probably be better off staying at a hotel or rental rather than buying a property. This is not only likely to be the less expensive route, it also frees you from the mental and emotional drain of having a second home. Besides paying more bills, you have the difficulty and hassle of maintaining a property that is hundreds or thousands of miles away.

Don’t worry, there are management companies to look after your property, right? Yes, for a cost. Thinking that you can effortlessly rent out your vacation property when you are not there and it will pay for itself? While you may be able to offset your management fees and some other expenses, I have yet to meet anyone who actually pays their whole mortgage through renting. Instead, many drop out of the rental process altogether, citing time, added stress, damages, and wear and tear on their property, with minimal rent to show for it.

You should budget 1-2% of the purchase price per year to spend on repairs and maintenance. Some years you will spend less, but in other years, you may need to replace a roof, furnace, or other major item. Is your emergency fund big enough to cover two homes? There will be days when having two homes feels like you are trying to prove Murphy’s Law – if something can go wrong, it will!

If you want to save yourself the headache of getting that 11 pm call in December that the hot water heater is out, don’t be an absentee owner. Just take vacations. If after five years at the same beach, you decide you’d rather go to Europe next summer, you can change your plans and not feel like you are obligated to go to your second home year after year. In fact, behavioral finance suggests that you may have more memories and find more fulfillment from taking 10 different vacations rather than going to the same place for 10 summers in a row.

3) On taxes and finances, a few points to consider:

  • You can deduct mortgage interest and property taxes on a second home. These are itemized deductions.
  • Only your primary residence is eligible for a capital gains exclusion of $250,000 ($500,000 if married). For a second home, keep records of any capital improvements which would increase your cost basis. If you have a very large potential capital gain, you can receive the primary residence capital gains exclusion by making the property your primary residence for two years. As long as a property was your primary residence for two of the past five years, you are eligible. Keep capital gains records until seven years after the sale.
  • You can rent out a primary or second home for 14 days a year tax-free. You don’t even have to report this income!
  • If you use the property personally for more than 14 days or more than 10% of the total rental days per year, it is considered a personal residence and you can only deduct rental expenses up to the amount of rental income.
  • If your personal use of the property is less than 14 days AND less than 10% of the total rental days, the property is considered a rental property (a business), and not a second home. You can deduct losses and may depreciate the property. Note that days you spend full-time on repairs and maintenance (but not improvements) are not considered personal use days, even if the rest of your family is enjoying recreation that day.
  • If you let others stay for free, or below fair rental price, or give away days (even to a charity auction), those are considered personal use days.
  • Before you rent, make sure your insurance covers renting. Talk with owners of similar properties if you want a realistic idea of how many days of your property might be rented each season. Do your homework before you buy.
  • In Texas, primary residences are creditor protected, 1 acre in town or 100 acres rural, with no limit on value. These are doubled for married couples. Second homes are not creditor protected. Which mortgage should you pay off first? Probably your primary residence.

Link: IRS Publication 527, Residential Rental Property Including Rental of Vacation Homes.

If all this makes your head hurt, you may be happier keeping your life simple and just enjoying your vacations without owning a second home. You cannot ask your accountant to sort this all out at the end of the year if you haven’t kept complete records of use/rental days and expenses.

4) When it comes to affordability, don’t let a mortgage broker tell you how much you can afford. They calculate the maximum the bank is willing to lend you; they don’t care about your other priorities like contributing to your 401(k) or paying for your kid’s college. If you want to know what you can afford and still accomplish your other goals, you need to do a financial plan. That’s where I can help.

5) Not surprisingly, the vast majority of people I have met who purchased a timeshare have been frustrated and regretted the decision. Similarly, friends who purchase property together often find things become less than cordial when disagreements arise over use, expenses, or maintenance.

Link: HGTV Top 10 Things to Know About Buying a Second Home

Avoiding Capital Gains in Real Estate

I’ve gotten a number of questions about Capital Gains and Real Estate recently, so I thought it was time for a post. While many home sellers do not have to pay any tax on the sale of their home, for others, capital gains taxes can be significant, even hundreds of thousands of dollars. Here are five ways to reduce capital gains when you sell real estate.

Tax Comparison of 15 and 30 Year Mortgages

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I received a tremendous response from readers about last week’s article comparing 15 and 30 year mortgages (read it here). A number of readers astutely asked how the mortgage interest tax deduction would impact the decision of choosing between the 15 and 30 year note. Here is your answer!

For our example, we are looking at buying a $250,000 home, putting 20% down and assuming a mortgage of $200,000. At today’s interest rates, we’d be choosing between a 15 year mortgage at 3.00% or a 30-year at 3.75%. Here are the monthly payments, not including insurance or property taxes.

15 Year Mortgage @ 3.00% 30 Year Mortgage @ 3.75%
payment $1381.16 payment $926.23
difference = $454.93

Over the full term of the mortgages, you will pay the following amounts of principal and interest:

15 Year Mortgage @ 3.00% 30 Year Mortgage @ 3.75%
principal $200,000.00 principal $200,000.00
interest $48,609.39 interest $133,443.23
total payments $248,609.39 total payments $333,443.23

You will pay a significantly higher amount of interest over the life of a 30 year mortgage. The interest payment of $133,443.23 increases your total payments by 67% over the amount you have borrowed. And that’s at today’s rock bottom mortgage rates! I should point out that above 5.325%, the interest portion on a 30 year mortgage exceeds the original principal. In other words, the interest would double your cost from $200,000 to $400,000.

You can deduct the mortgage interest expense from your taxes, but the amount of the benefit you will receive depends on your marginal federal income tax rate. Here is the value of the tax benefit for six tax brackets.

15 Year Mortgage @ 3.00% 30 Year Mortgage @ 3.75%
interest $48,609.39 interest $133,443.23
15%: $7,291.41 15%: $20,016.48
25%: $12,152.35 25%: $33,360.81
28%: $13,610.63 28%: $37,364.10
33%: $16,041.10 33%: $44,036.27
35%: $17,013.29 35%: $46,705.13
39.6% $19.249.32 39.6%: $52,843.52

Obviously, the 30 year mortgage provides much higher tax deductions, although they are spread over twice as long as the 15 year mortgage. If we subtract the tax savings from the total payments of the mortgage, we end up with the following costs per tax bracket.

Total Cost, after the tax savings
15 Year Mortgage @ 3.00% 30 Year Mortgage @ 3.75%
15%: $241,317.98 15%: $313,426.75
25%: $236,457.04 25%: $300,082.42
28%: $234,998.76 28%: $296,079.13
33%: $232,568.29 33%: $289,406.96
35%: $231,596.10 35%: $286,738.10
39.6%: $229,360.07 39.6%: $280,599.71

It should not be a surprise that even though the 30-year mortgage provides higher tax deductions, that it is still more expensive than a 15-year mortgage, even when we consider it on an after-tax basis.

For most Americans, the actual tax benefit they will receive is much, much less than described above. That’s because in order to deduct mortgage interest, taxpayers have to itemize their tax return and forgo the standard deduction. As a reminder, itemized deductions also include state and local taxes, casualty, theft, and gambling losses, health expenses over 10% of AGI, and charitable contributions.

For 2015, the standard deduction is $6,300 for single taxpayers and $12,600 for married couples filing jointly. So, if you are a married couple and your itemized deductions total $13,000, you’re actually only receiving $400 more in deductions than if you had no mortgage at all and claimed the standard deduction. And of course, if your itemized deductions fall below $12,600, you would take the standard deduction and you would not be getting any tax savings from the mortgage whatsoever.

While the mortgage interest deduction is very popular with the public, economists dislike the policy because it is a regressive tax benefit. It largely helps those with a big mortgage and a high income. For many middle class taxpayers, the tax benefits of mortgage interest is a red herring. With our example of 3.75% on a $200,000 mortgage, even in the first year, the interest is only $7,437. That’s well under the standard deduction of $12,600 for a married couple, and the interest expense will drop in each subsequent year.

Compare that to someone who takes out a $1 million mortgage: their first year interest deduction would be $37,186 on a 30 year note. Simply looking at the amount of the mortgage interest will not determine how much tax savings you will actually reap, without looking at your other deductions, and comparing these amounts to the standard deduction.

Even if you are one of those high earners with a substantial mortgage, you have another problem: your itemized deductions can be reduced under the so-called “Pease limitations”. These limitations were reintroduced in 2013. For 2015, itemized deductions are phased out for tax payers making over $258,250 (single) or $309,900 (married).

Bottom line: If your mortgage is modest, your interest deduction may not be more than your standard deduction. And if you are a high earner, you are likely to have your deductions reduced. All of which means that the tax benefit of real estate is being highly overvalued by most calculations. There is a substantial floor and ceiling on the mortgage interest deduction and it provides no benefit for taxpayers who are below or above those thresholds.

Ceiling: Pease limits on tax payers making over $258,250 (single) or $309,900 (married).
Middle: receive a tax benefit between these two levels.
Floor: no benefit on deductions below the standard deduction of $6,300 (single) or $12,600 (married).

The 15 Year Mortgage: Myth and Reality

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Everyone seems to be talking about Real Estate again. This month, I sat with three friends, and remarkably, all three were looking at moving and buying a new house. Real Estate is hot right now in Dallas, and almost everywhere else, too. The losses from 2009 have been erased and prices are making new highs. Even if you aren’t looking to move, chances are good that your property tax assessment has moved up significantly in the past two years.

Major corporate offices are being built in North Dallas, bringing tens of thousands of jobs to the area. And those relatively well-paid corporate employees are going to want to live in close commuting distance to work. Home owners have equity in their property, and interest rates, which have remained low, are expected to start creeping up. Many feel like right now is the perfect time to move up to their dream house. It has been a seller’s market, with many houses being sold quickly and often meeting or exceeding asking prices.

Anyone who has read this blog or my book, knows that I recommend home buyers consider a 15 year rather than a 30 year mortgage. Let’s go through those numbers in detail and consider the myths and reality of your mortgage decision.

For our example, let’s assume you are buying a $250,000 house and putting 20%, or $50,000, down. You will finance $200,000 through a mortgage.

At an average current rate of 3%, your monthly payment on a 15 year mortgage (not including taxes or insurance) is $1381.16. The 30 year mortgage will cost you approximately 3.75%, but your monthly payment will be only $926.23.

15 Year Mortgage @ 3.00% 30 Year Mortgage @ 3.75%
payment $1381.16 payment $926.23
difference = $454.93

A lot of people will look at the 30 year mortgage and will say that it “saves” them $454.93 a month. Let’s break that down. On the 15 year mortgage, your first payment consists of $500 interest and $881.16 in principal. On the 30 year note, the first payment includes $625 in interest while only $301.23 is applied towards interest. Most of your payment on the 15 year note is going towards principal, building your equity, where as most of the 30 year payment goes towards interest. So, even though the 15 year note costs $454.93 more, in the first month, it applies $579.93 more towards your principal.

15 Year Mortgage 30 Year Mortgage
payment $1381.16 payment $926.23
principal $881.16 principal $301.23
difference = $579.93

After making 10 years of payments, your remaining balance on the 15 year note would be $76,864.99 and you will have paid $42,604.59 in total interest. On the 30 year, $200,000 mortgage, your balance after 10 years is still $156,223.55, and you will have paid $67,371.29 in total interest. At this point, the person who chose the 15 year note has paid off most of their loan and has the end in sight.

15 Year Mortgage @ 10 years 30 Year Mortgage @ 10 years
Balance $76,864.99 Balance $156,223.55
Interest Paid $42,604.59 Interest Paid $67,371.29

Assuming your home value increases a modest 1% a year, here’s a look at how your home equity would compare after 10 years under both mortgages.

15 Year Mortgage @ 10 years 30 Year Mortgage @ 10 years
Home Value $276,156 Home Value $276,156
Balance $76,865 Balance $156,224
Equity $199,291 Equity $119,932
Difference = $79,359

The nearly $80,000 difference in equity after 10 years shows how the 15 year mortgage is a really another way of “forced savings”. You would have equity to buy another house if you should want or need to move. Or if you’d like to retire, a 15 year mortgage may enable you to have no house payment when you reach retirement age.

So far this is pretty simple. But you may be wondering, what if I were to choose the 30 year mortgage and invest the difference of $454.93 per month? If you did this for 10 years, and earned 7%, you would have an investment account with $78,740. That’s almost the same as the difference in equity in the chart above.

Let’s take this further and assume that you invest the $454.93 for the full 30 years. How would this compare to paying the 15 year mortgage and then investing $1381.16 for the following 15 years?

15 Year Mortgage 30 Year Mortgage
Pay mortgage for 15 years, then invest $1381.16

for the next 15 years, at 7%

Invest the difference of $454.93 for 30 years, at 7%
Investment Value $437,760 Investment Value $554,959

This shows that choosing the 30 year mortgage and investing the difference versus a 15 year mortgage could generate a better outcome over 30 years. So then why would I suggest that home buyers choose the 15 year product instead? Here are two reasons:

1) If you go to a bank, mortgage broker, or realtor and say that you can afford a $1381 per month payment, they are not likely to help you decide between a 15 or 30 year mortgage. Rather, they will assume you will choose the 30 year note and then tell you how much house you can “afford”.

Instead of looking at the $250,000 house in our example, you could afford a $370,000 house with a 30 year note. And you will not be investing the $454 per month difference as in the theoretical example. With the more expensive house comes more expensive costs, including taxes, insurance, utilities, and maintenance.

People who become wealthy look at their housing as a cost, not as an investment. While you can afford a more expensive house under a 30 year mortgage, that doesn’t mean that it is in your best interest to do so, if you have other financial goals such as retirement.

It is vitally important to remember that there is a conflict of interest throughout most the real estate industry. People who are paid commissions have an incentive to put you in the most expensive house and mortgage that the bank will allow them to sell. They do not get paid to help you retire, save in your 401(k), or send your kids to college. It’s remarkable to me that six years after the sub-prime crisis that there has been so little change to the fundamental conflicts of interest in the real estate industry.

2) I don’t know very many people who actually have the discipline to invest the $454.93 a month they would “save” with a 30 year mortgage. More likely, they will increase their other discretionary spending (cars, vacations, furnishings, etc.) that accompany “keeping up with the Joneses” in a nice neighborhood.

The only way someone would be able to make it work would be automate the process and establish a recurring monthly deposit of $454 into a mutual fund or IRA. By the way, the 30 year example above only showed a good outcome because I assumed the investment was made into stocks and earn 7% for 30 years. If you put that money in cash and only earn 3%, the 15 year mortgage produces the superior outcome. The 30 year mortgage only produces a better outcome if you can greatly exceed the cost of borrowing (3.75% in our example). Here’s what it looks like if returns are only 3% over 30 years:

15 Year Mortgage 30 Year Mortgage
Pay mortgage for 15 years, then invest $1381.16

for the next 15 years, at 3%

Invest the difference of $454.93 for 30 years, at 3%
Investment Value $313,486 Investment Value $265,105

My fear of the 30 year mortgage is that it is not used by consumers or real estate professionals to maximize saving and growth investing. If it was, it would be a good tool for increasing your net worth. Rather it is used to maximize the amount of home you can purchase today.

For professions where career income is expected to rise only at the rate of inflation (such as teachers and musicians), your income is not going to increase fast enough to enable future saving when you take on a jumbo-sized mortgage. The result is that all your disposable income will go towards the house, with very little towards retirement, saving, or investment.

If today’s real estate market has you excited, be careful. It’s great that your home value has shot up 20% or more in the past couple of years. That makes it a great time to downsize, but actually an expensive time to buy a bigger house. We are lucky in Dallas that Real Estate prices have remained affordable; in many cities on the coasts, home buyers have no choice but to use the 30 year mortgage because prices are so high. If you start with the 15 year mortgage in mind when you are considering how much house you can afford, it can help you increase your net worth faster.