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Financial Freedom

Should you pay off your mortgage?

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Preparing to write the next installment in a series on achieving financial freedom, I ran some figures to compare the result of paying down a mortgage with extra monthly payments toward principal with investing the same amount monthly in a mutual fund. What I discovered runs against my theory that you’re well served to pay off a mortgage as fast as you can.

I still think that’s true if you’re getting close to retirement. In retirement, every debt should be wiped off your books, because you will need all your cash flow to live on. However, if you’re younger—say, anywhere between 20 and 45—and your mortgage rate is low compared to returns on equity investments, it would be to your advantage to invest extra dollars in a mutual fund earning around 8 percent. At today’s rates, this strategy allow you to accrue enough to pay off the principal faster than will throwing a monthly amount at the loan principal. Here’s how this shakes down:

M’hijito and I have a 30/15 mortgage at 4.3 percent. This means that for the first 15 years, we make payments at the 30-year amortization rate, but after the 15 years have passed, we either have to pay off the loan or we have to refinance it. The loan’s principal is $211,000.

We chose this mortgage because, at the time we bought the house, we believed the real estate market was nearing the bottom. We believed the house would drop in value another $4,000 or $5,000 and then begin to rise, probably at around 3 percent p/a. We figured that in five to ten years we could sell or rent the house and either break even or make a small profit. As everyone now knows, this was dead wrong: in fact, real estate was in free-fall, and the house is now worth at best $170,000, but more realistically around $150,000. This turns the loan into a real albatross. One strategy we are considering is to try to pay down principal with whatever extra monthly payment we can make (which ain’t much!), so that in 15 years, the amount to refinance might at least be no more than the house is actually worth, possibly allowing us to sell the house at that time.

In 15 years, with no extra payment toward principal, the loan balance will be $138,338. Monthly principal and interest payments are $1044; PITI comes to something over $1200.

Note that the projected loan balance is less than the most pessimistic present-day valuation. If the market finally has bottomed out and housing increases in value at 3% a year (a figure that is now being bandied about), in 15 years the house will be worth $233,695. That is less than we paid for it, but at least if we sold the house at that time we would walk away with a little cash in our pockets.

With me out of work, about the most we can afford to pay extra toward loan principal is about $100 a month.

Using Excel’s full value (=FV…) formula, I calculated the the return on a $100/month investment in a mutual fund earning 8% per annum. (Over at Vanguard, a number of stock funds and even a few bond funds are returning at this rate; one of them is Windsor II, in which I happen to already have a little cash.) I then used Quicken to run an amortization schedule, and compared the amount a $100/month investment would be worth in 15 years with the amount an extra $100/month principal payment would reduce the loan balance.

Assuming that our mutual fund investment averaged an 8 percent return, if we sent Vanguard $100 a month, in 15 years we would accrue $34,604 (full value =(.08/12,15*12,-100). If we paid an extra $100 a month toward the loan principal, in 15 years we would have paid the balance down by an extra $18,000 ($100 x 180 pay periods). According to Quicken, we would still owe $113,116.

With no extra payments, remember, we would still owe $138,338.

$138,338 – 113,116 = $25,220

Compare that with the $34,604 we would have earned in the mutual fund. Clearly, we would be ahead—by over $9,000!—by investing the money in a mutual fund with low overhead, such as Vanguard and Fidelity offer.

Well, now. Suppose you were not out of work, and so had plenty of cash to throw at the principal. Let’s suppose you really have plenty of cash and you decide to pay the equivalent of an entire P&I payment toward principal. Then what?

If you put $1,044 into a mutual fund every month, in 15 years you would have $361,264. If you paid $1044/month toward principal (in addition to your regular payment) on a $211,000 loan, you would pay off the loan in 10 years.

But by putting the cash into a mutual fund returning 8 percent, in 10 years you’d earn $190,995. Since in 10 years, with no extra payments, your loan balance would have dropped to $167,901, you’d still come out ahead:

$190,995 – $167,901 = $23,094

In other words, if you put the amount of an extra loan payment in an 8% investment, in ten years you would have enough to pay off the mortgage and still leave $23,000 in your pocket. If you used the same amount to pay toward the loan once a month, you would pay off the debt but would have no cash left over.

The conclusion is obvious: If your goal is to pay off your mortgage, you’re better off investing a regular payment in a decent mutual fund than paying the same amount toward principal.

This assumes your mortgage interest rate is lower than the rate of return from an equity fund. Note also that my figures do not take into consideration the small tax advantage gained by paying mortgage interest; this factor also would tend to improve the picture if you invested in the market.

Risky? Sure. But we now know that investing in real estate is wildly risky, too: more so, it develops, than the stock  market. My stock investments are rapidly regaining their pre-crash value, but there’s no credible sign of any recovery in the real estate market here. Even if the value of the house starts to increase at 3% p.a. today, in 15 years it won’t be worth anything like what we paid for it. If property values remain flat for any length of time (as it appears they will), we will lose not only our shirt but our pants, socks, and underwear.

I used to think my father was crazy because he refused to buy a  house until after he had saved enough to pay for it in cash. All the time I was growing up, we lived either in company housing or in rentals. His reasoning indeed was crazy—he bought into The Protocols of Zion, an irrational tract that led him to believe all mortgage lenders were part of a hallucinatory international Jewish conspiracy. However, the effect was that when he retired at the age of 53, he had enough cash to buy a house and a car and to support himself and my mother in a middle-class lifestyle without having to work.

Crazy like a fox, that old boy was.

A rabid fox, but still…

Financial Freedom: Work

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This is the third post in a series about aspiring to Bumhood—that is, achieving financial freedom so you can get off the day-job treadmill and gain control over the way you spend your life. Today let’s talk about gainful employment.

One of my editors at Arizona Highways told me about the anguish he felt during a three- or four-month period of unemployment after he’d been laid off a job. His wife earned a good salary, so it wasn’t that they didn’t have enough to live on. But he felt devalued as a human being. The words he used—I remember them to this day—were “If you don’t have a job, you’re nothing.”

Well, no.

Paid work exists for one reason and one reason only: to put food on the table and a roof over your head. You are not your job!

Some of us feel a calling for certain kinds of work. From the time I was about six years old, I wanted to be an academic, for example (having no clue what that really meant); my ex- always wanted to be a lawyer. Many of these callings are none too profitable: teaching, for example, is poorly paid in relation to the actual number of hours a good teacher puts into the job, and I don’t imagine many clergy or social workers earn much. Some of us still have no idea what we want to do when we grow up, and so have to take whatever job comes along.

Truth to tell, unless we fall into a large inheritance or win the lottery, to achieve financial independence most of us will have to pass part of our adult lives in a day job. We need to earn enough to provide for our children and to establish our own permanent financial security. This will likely entail holding a job for at least 15 or 20 years while at the same time practicing some basic money management.

So…what to do to make a living? Whatever brings in some cash.

Do you need to earn a six-figure income to break free from wage slavery? I don’t think so. Certainly SDXB did not: he was a reporter, and although The Arizona Republic paid a decent wage compared to other publications in this right-to-work state, it still wasn’t great. The period in which he made good pay as a freelance PR man was brief, during the bubble that occurred right before the savings and loan crash, which led to a recession almost on a par with the one we’re seeing now. But he did have an income, and by dint of frugal living and steady investment, he managed to step off the treadmill at 47.

Similarly, the Adirondack Chimney Sweep passed most of his adult life in modestly paid work, but because he lived within his means and had built a small sideline, when the city offered him a buyout long before he’d reached retirement age, he was in a position to accept. A friend of mine cleaned carpets for a living. He retired a millionaire, gave the business to his son, built a beautiful house in the woods, and went fishing.

I believe if you live sensibly, stay out of debt, save regularly, and invest your savings, you can build financial freedom no matter what you earn. I know a corporate lawyer who earns a fine income, but because he never put a high priority on managing his money, he’s still trudging to an office every day—and he’ll be 70 next fall. Others who have held lower-paying jobs as teachers, tradesmen, nurses, or, like my father, merchant seamen have been able to quit working altogether or to start new careers that pay less or interest them more.

There are three tricks to converting a job, any job, into financial independence:

1. Live below your means.
2. Develop more than one income stream.
3. Save and invest all funds not needed to cover living expenses.

Living below your means is going “live within your means” one better: the trick here is to stay out of debt and to live sensibly enough that you don’t spend all your income. Then use your unspent income to build savings. If you have a 401(k) or 403(b) to which your employer is contributing, be sure to take advantage of that. But save more, above and beyond pre-tax contributions from your salary.

As part of his strategy to quit his job at the earliest possible moment, my father never went into debt. Any debt. All the time I was growing up, we lived in rentals. He didn’t buy a house until he had the cash to pay for it in full. Now…he had some ugly reasons for this that had nothing to do with personal finance—I’m not giving his bigoted thinking enough credit to describe it here, except to say it was a symptom of the times in which he grew up—but the practical effect was that all the money that might have gone into house maintenance and mortgage insurance went into his savings, which he invested for the long term. The less debt you carry, so-called “good” debt included, the more you can save.

From my own experience, I can see that having a side income stream is crucial, especially if your day job is modestly paid. Teaching on the side allowed me to pay off the second mortgage on my home a year before the Great Desert University canned me. And, when my beloved employer kindly delivered six months’ notice that my office was to be shut down and I and all my staff thrown into the street, I landed a noonlighting job that allowed me to rack up a $10,000 cushion. It will keep the wolf from the door during this difficult 2010, when Social Security rules will bar me from earning more than a subsistence wage.

I feel extremely lucky (or maybe smart?) that over the years I’ve developed more than one set of marketable skills: I write, I edit, and I teach. Today the three of those allow me to earn salaried income and self-employed income: blogging, freelance editing, and part-time teaching in the community colleges. These will carry me over the period required for my investments to recover the $180,000 lost in the crash of the Bush economy.

At this point, I’m free of the day job, light part-time work will support me without having to draw down my savings, and I have enough independent income to deal with the other baleful result of the late, great economic mirage, an upside-down mortgage on a house my son and I mistakenly thought had fallen in value as far as it would fall at the time we bought it.

Things could be better: to be fully confident of having enough to carry me through old age, I would have preferred to work, save, and invest for another five or six years. But because I’ve lived below my means, invested everything in sight, and cranked extra money on the side, I’m far better off than most single women my age, and I’m clearly in a position to enjoy life without ever having to take on another full-time job.

Financial Freedom

• An Overview
• Education
• Work
• Debt
• The health insurance hurdle
The roof over your head

Financial Freedom: Education and training

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The other day, Funny about Money started a series on making your way toward financial freedom, the state where you find yourself independent of the day job and free to do what you want to do with your life. We identified several components in this project, all of them having to do with personal finance.

Today, let’s start with the first of those: Education

One issue we should bear in mind is the difference between true education and vocational training. A bachelor’s degree in business, engineering, or nursing (for example) may line you up to get a decent job, but it may not make you an educated person.

Education furnishes your mind. Broad reading, writing, thought, and discussion make you a wiser person and cultivate your ability to think logically, to recognize flim-flam, and to make good decisions. For that reason, a good undergraduate degree in the liberal arts is useful—maybe even indispensable—to anyone who hopes to take a leadership role in industry, government, education, and the  law. Those of us who aspire to high-powered careers in any of those need a strong undergraduate degree in the liberal arts followed by a graduate or professional degree in business, law, science, or technology.

Some graduate degrees are scams and should be avoided. A master of fine arts in writing, for example, will leave you fully unemployable while teaching you nothing that you wouldn’t have learned by spending the same amount of time applying your bottom to the seat of your desk chair. Graduate degrees in vague new pushmi-pullyu programs with no real entry requirements, such as Arizona State University’s “master of liberal studies,” are similarly suspect: if you want a degree in the liberal arts, take the GRE and get yourself into a solid program such as English, history, or mathematics.

Undergraduate technical degrees are useful in that they provide high-level vocational training for young people whose cast of mind is not especially academic. Often the resulting job opportunities are better paid, at least at the entry level, than a bachelor’s degree in the liberal or fine arts will generate. Over time, however, people with bachelor’s degrees in subjects like business, education, and technology may need master’s degrees or professional certifications to move up in their trades.

On the college level, vocational training—which defines a large number of undergraduate and graduate-level programs—will set you up to get a job, assuming jobs in your major are available by the time you graduate. Vocational education includes degree programs in business, nursing, medicine, engineering, computer sciences, graphic arts, education, and journalism, to name a few. It must be remembered that none of these guarantees high-paying work. To the contrary,  some, such as journalism and education, pretty much guarantee their graduates low pay. Some, such as accountancy, provide entrée to trades that make a good living but that may bore the pants off you.

Many people truly are not suited for higher education. Sometimes this has to do with the student’s level of maturity—some should delay college until they are focused enough to profit from it. Having to earn a living for a while speeds maturity and creates a much better college student. Others are more likely to succeed in the trades than in low-level white-collar jobs; in the case of young people who are not interested in school or who find study painfully difficult and discouraging, a short stint in a community college and a decent apprenticeship may be a smarter strategy. A person with skills in the trades is likely to earn as much as or more than an ill-educated college graduate. Remember that most millionaires in the United States are owners of businesses that provide services like pest control and plumbing. The beauty of the trades is that the work can’t easily be offshored. Even though some of these jobs pay little more than minimum wage, an ambitious young person can learn the trade well and then build his or her own business. Once you’re hiring someone else for minimum wage, you’re in a position to make a good living.

Choose wisely and choose well: consider first what you really want to do; then whether you want to do that for the rest of your life; and finally what you can earn with the credentials the degree provides.

None of this, as we all know, is likely to be cheap. A young person who’s savvy to personal finance or an older but wiser person who’s going back to school can find ways to minimize the damage. The idea should be to avoid a heavy burden of student loans, which can saddle a young person for years—even, possibly, for the rest of one’s life.

One obvious strategy that many people overlook is simply to take your first two years of undergraduate work at a community college. These schools are much cheaper than universities and are often close enough to home that you can live with your parents for an extra couple of years. Yeah, we know: what a drag! But have you priced apartments lately? Lower-division courses at community colleges are usually staffed with professionals who are dedicated to teaching, in contrast to universities, which often foist the scutwork courses onto exploited graduate students, underpaid junior faculty distracted by the grinding quest to attain tenure, or senior faculty more interested in their research than in teaching.

It’s important to be sure that courses you take in a community college will transfer to the university of your choice. Many state universities have articulation programs with local colleges, and some state legislatures have mandated that their universities accept credit from community colleges; however, these rules may not apply to out-of-state colleges.

If you’re an excellent student but can’t afford an expensive private college, seek “Ivy League public schools,” such as Michigan or Berkeley. If you’re fortunate enough to live in a state that hosts one of these institutions, by all means try to get in. Savings can be huge, and the quality of education is good. If you have to go out of state, consider living and working there for a year or two to establish residency before enrolling—most state schools require a local driver’s license and evidence that you or (if you’re still a minor) your parents have paid state taxes.

Whether you go to a community college or an in-state university, living at home can save a great deal of money, lightening the load of student loan debt by many thousands of dollars.

Working your way through school is a hard row to hoe, but the reward can be huge: freedom from student debt. The federal government has a work-study program designed for students in need. If your family’s relative affluence renders you ineligible for this program, most universities and colleges have their own work-study programs or part-time job opportunities that provide a small salary and enough flexibility to work around class hours.

Summers offer you the chance either to take on full-time work temporarily, racking up some savings for the following school year, or to speed your way toward graduation by taking coursework. Two summer sessions of six credits adds up to twelve credits, the equivalent of a full semester. In your lower-division years, consider a community college for summer school—just be sure, before you sign up, that your university will accept transfer credits for the classes you take.

An alternative to work-study is a regular 50% FTE job at a university or college. Most institutions provide a tuition waiver for employees. Pay, especially in public schools, is usually abysmal, but it should cover studenty lodging and help pay the other bills. Jobs not considered part of a work-study program may have rigid hours that preclude attending certain classes. However, schools are famously flexible (it’s part of political correctness), and so you often can obtain work on campus that will allow time to take your courses. Pay, though poor, is usually better than student work, and you get a full range of benefits.

Look for scholarships, fellowships, and grants to help underwrite the cost of college or vocational training. A surprising amount of free money goes unused, simply because people are unaware of the opportunities. Some are offered by local groups, service clubs, communities, and churches and are so specific that even candidates who qualify for them don’t think of looking for them. Check websites that aggregate information on scholarships, and ask at college and public library reference desks for leads to funding opportunities.

Some students come up with enterprises to help underwrite costs, such as the guy who realized he could make a profit buying back students’ used books for more than the bookstore paid for them and then reselling them for less than the bookstore charged. Find a need and fill it: this requires some ingenuity, but a microbusiness run out of a dorm room or an apartment can go a long way toward defraying the cost of education.

Speaking of dorm rooms and apartments, refrain from regular drinking, partying, or drug use. These cost a ton of money. You’re already spending enough to keep you in the traces for the rest of your life. Why make things harder on yourself?

Book publishers, seeing a captive audience, have turned textbook publishing into assembly-line fleecing of the sheep. Textbooks are so expensive that some colleges are seriously considering abandoning books altogether and having students use websites. This is a recipe for further dumbing-down of America’s already dumbed down educational system, but that’s another topic…  Consider ways to keep at least some of the wool on your back.

First and foremost: buy books anywhere but at the campus bookstore. Amazon.com is almost invariably cheaper than college bookstores. Try to get your books used, and sell them back through Amazon, using the bookstore’s repurchasing program as your last resort. Look online for sellers and buyers; some online outfits offer a better deal than either Amazon or the bookstore.

A cheaper but less convenient alternative is to use the library. Many texts are put on reserve and so can be accessed during library hours; others are available for check-out and often can be re-checked for the better part of a semester. If a course’s texts are not on reserve, ask the professor if she or he will put them in reserve.

I don’t recommend asking the professor if you really need to buy the book. It’s extremely annoying. Faculty know about and dislike the cost of textbooks. If the professor didn’t think you needed the book for the course, he or she wouldn’t have put it on the syllabus! This strategy flags you in the professor’s mind as someone who’s in school for a rubber-stamp degree and who doesn’t care about the course, its content, or its value. It starts you off on the wrong foot: avoid!

Starting off on the right foot, though, is what adequate education or vocational training will do for you. Even if you have to go back to school later in life to obtain the training you need, a degree, a certificate, or an apprenticeship will help you to earn enough to position yourself for your future of financial independence.

Financial Freedom

• An Overview
• Education
• Work
• Debt
• The health insurance hurdle
The roof over your head

Financial Freedom: An Overview

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Having finally arrived at financial freedom, I’d like to write a series for Funny about Money on how to achieve financial freedom before you drop in the traces. We’ve seen that SDXB managed to escape in early middle age and that he’s never had to go back to a day job. So we know that with luck and smart financial management, it can be done.

If and when reasonably priced universal health care coverage becomes available in this country, quite a few Americans will be in a position to get off the treadmill. Too many of us work in miserable day jobs, pushing paper or waiting on other people who are in equally miserable day jobs, for no other reason than that we must have health insurance and there’s no other way to get it. When we’re freed from that trap, the possibility of running our own daily lives becomes a realistic choice…but only if we can achieve financial freedom: freedom from debt and from the pervasive cultural and psychological influences that herd us toward debt.

To engineer financial freedom, several components of personal finance need to be dealt with and brought under control:

• Education
• Work
• Debt
• Housing
• Transportation
• Savings
• The health insurance hurdle
• Strategies to maintain financial freedom

Though none of this is nuclear physics, it’s a process takes several years. Short of inheriting a fortune or winning the lottery, you can’t achieve financial freedom overnight.

To begin with, you need some education or training that will allow you to earn something more than minimum wage. While you don’t need to earn big bucks to find your way to financial freedom, you do need to earn above the bare subsistence level. You need enough income to pay off debt that can’t be avoided (such as student loans and mortgages), to stay out of credit-card debt, and to build savings.

Then you need to find housing that’s affordable, not only in terms of what you earn but within the framework of your goal to escape the rat race. The cost of your roof, whether it’s rent or mortgage payments, has to be low enough to leave something to put into savings.

The same is true of your personal mode of transportation. If you live in one of the few U.S. cities that provides good public transport, you’re in luck. The rest of us have to own a car. We need to find ways to keep the cost of car ownership from consuming funds that could keep us out of debt or be invested in savings.

The foundation of financial freedom is freedom from debt. All debt, including mortgage and car loans. This is tightly linked with another key component of Bumhood, building and investing a fund of cash. Debt and savings have been talked to death on the personal finance blogs, but we’ll review those issues in the coming series.

Finally, there’s the question of how you manage to stay free once you’ve managed to break free. Any number of issues bear on your continued financial freedom, ranging from adult children who need help to the lifestyle you want to (or can) sustain. Since that exploration is about to become the subject of FaM, over the next few months we should make plenty of discoveries along that line.

Financial Freedom

• An Overview
• Education
• Work
• Debt
• The health insurance hurdle
The roof over your head