In the past week two popular personal finance blogs have posted remarkably convoluted pieces on the relatively simple concept of mortgage interest.
Last Friday Free Money Finance posted an excerpt from The Sound Mind Investing Handbook – A Step-By-Step Guide To Managing Your Money From A Biblical Perspective 5th Ed. (You know it’s gotta be good, it’s in its 5th edition.) The entire post could have been replaced by the following sentence:
If you have the choice between investing with a guaranteed 8% return and paying down your 6% mortgage, choose the investment because it will make you richer.
If you are thinking that my sentence is lacking because it doesn’t explain why you are richer and assumes an unlikely risk-free return, I am not unsympathetic. But my goal was only to replace the FMF post, and that post has both those flaws as well. And a few more.
In a 953 word meandering journey through the topic of saving in a 401(k) versus paying down a mortgage, the author demonstrates nothing so much as that revising his book four times did nothing to increase his knowledge of the subject. For example, he shows obvious discomfort with the effects of taxes. If I was in a kind mood I might say that he assumes his readers are easily confused by it, but I am rarely in a kind mood. He discusses a man who decides to save an additional $273 a month in his 401(k) as follows.
Now here’s where it can really get confusing. To construct an accurate picture, we have to recognize that Rob gets a second tax deduction—this time for putting money into the retirement plan. Rob’s $273 contribution is worth another $85 tax savings, which he could then also put into his 401(k). But then that $85 contribution would save him an additional $26 in taxes, which he could also put into his 401(k). But then that $26 . . . well, you get the idea. If Rob took maximum advantage of this, he could ultimately put $396 into his company retirement plan….
Rob’s marginal tax rate is 31%. $273 / (1 – .31) = $396. Is that really that confusing? Really?
The post discusses Rob and Mort, guys in identical situations with 6% 15 year mortgages and a little extra money to either pay the mortgage down early or invest in a 401(k) at 8%. Mort pays down the mortgage, Rob socks it away in the 401(k). After 15 years Rob is richer. The author has no idea why.
Although they had both saved the same amount in taxes which could then be invested for retirement, Rob’s savings were “front-loaded.” That meant he could put them to work in his 401(k) earlier than Mort could. In this way, Rob was able to take greater advantage of the tax-deferred compounding of profits. …. Mort’s retirement account later came on strong, but Rob’s head start was too great.
Uh, no. It’s a good guess, but it turns out that “front-loading” has nothing to do with it. The author could have figured this out by setting the 401(k) return at 6%, which would have made Rob and Mort equally rich after 15 years. That would have been easy to do in Excel, but something tells me this guy worked the example out with pencil and paper.
But at least the FMF post had basically the right answer. The same cannot be said of a post on a similar topic by Pinyo at Moolanomy this Monday. That post discussed refinancing mortgages with the aid of a higher interest short term loan. He is in favor of it. Really.
The post starts out with the reasonable observation that just because you can lower your interest rate, refinancing is not necessarily a better deal because of the closing costs you may have to pay. Okay, that’s a fair point. Then Pinyo runs the whole thing off the rails by comparing the old and new mortgages based on the total dollar amount of interest and fees paid over the life of the loans. That’s intuitive, and if my 11-year-old suggested it as an approach I would pat her on the back for going the in right direction. But it’s wrong, and anybody who has signed a mortgage, never mind given advice to thousands of others about them, should know better.
(The right way is to adjust the interest rate on the potential refi. You can do this using the mortgage calculator that Moolanomy’s post links to. Use the actual monthly payment and an adjusted principal amount, i.e. the amount of the loan less the fees, and solve for the interest rate. Figuring a precise after-tax rate is harder, since for tax purposes this adjusted rate is not what you pay, but it is a good approximation. ARMs are more complicated.)
To me, it’s not a lot of effort to demonstrate that the total interest dollars paid method is flawed. Would you rather have a five year loan at 20% or a hundred year loan at 2%? The hundred year loan has more than twice the total interest.
I’m hoping most of you saw immediately that the hundred year loan is a much better deal. You could pay it off in five years if you really wanted to. (But you shouldn’t want to.) The proper measure of the cost of borrowing money is the interest rate you pay, not the total dollars paid. Interest is rent on money. Would you rather pay $500 to rent an apartment for a month or $1000 for a year?
This is all apparently too subtle for Pinyo, who concludes in his post that rather than refinancing the entire balance of a mortgage at 4.5%, it might be preferable to refinance a portion with a three year 9% loan and the rest with a 4.5% mortgage. Really. Here’s another link if you don’t believe me.
Just to be clear, I am completely aware that what is appallingly obvious to me is not always obvious to others. (Two days after going up, the Moolanomy post has only one comment, the entire text of which is “Whoa…good post.”) Nor do I think that these two authors are exceptional. Sadly, I think they are typical. Which is a bad thing. Really.