Finance Your Liberty Rotating Header Image

Pitfalls

Home Refinancing Part 3 – Drawbacks

Last post, we covered how to refinance your home.

With a reduced interest rate, you have the ability to either pay down your mortgage at the same speed as before but with a lower payment, or (the much smarter alternative in our opinion) you can keep the same payment, and pay off your mortgage much, much faster.

So why isn’t everyone refinancing their mortgage everytime that the Fed announces they’re pushing back their interest rate hike schedule? Two reasons… one, the average Joe is not interested in the slightest. TV news refuses to cover it, because important events directly affecting your life isn’t their job. Getting eyeballs on advertisements is. Which means down with Ben Bernake, and up with Lady Gaga.

The second reason people aren’t refinancing left, right, and center is that your mortgage almost certainly came along with an early payment penalty. If it didn’t you would almost certainly have been penalized with a much higher interest rate, which you wouldn’t have accepted. When you refiance your mortgage, you are not simply changing the terms of your current mortgage, you are paying off your current mortgage and beginning a new one, which will incur your early payment penalty, which is in the thousands of dollars range.

So when is it a good time to refinance and eat the penalty? When you can reasonably expect to make back the money on the penalty via reduced payments within a few years. It takes a little bit of calculator time to figure out, (If my payment reduces by $100 per month, that’s $1200 a year, it will take 3 years to pay a $3600 early payment penalty) but it can definitely be worth the effort.

Home Refinancing – Part 2 Should I Refinance to Consolidate My Debt?

Another reason one may wish to refinance their mortgage is to consolidate debt.  If you have $10,000 of credit card debt that you’re paying, for example, 20% interest on, then that means that you’re paying $167 in interest every month, before you even touch the principal.  Ouch!   But if you roll that debt into your home mortgage that is being charged at, say, 5% interest, that $167 of monthly interest becomes $42.

Wow, that sounds great!  So what’s the drawback?  Well, the $10,000 of credit card debt in the first place.  How did that happen?  If it was for a one-time expense like a medical bill, no problem. 

But if that debt was racked up by a big screen TV or a 2 week vacation, you’ve got a leak in that wallet.  In which case, refinancing isn’t going to help.  The most common scenario in this case is that $167 payment goes down to $42, exactly as planned.  But then another vacation creeps into the mix before the debt is paid down.  A new video game system is released, and new games to go with it.  Aw!  Look at that puppy in the pet shop!  

Next thing you know, that $10,000 credit card debt has reared its ugly head again, and now you have an extra $10,000 of mortgage debt to boot!  So instead of $167 down to $42 a month, you’ve gone from $167 to $209!

The solution to this is to cut up that credit card and not apply for another one.  Anything shows up in the mail that feels like there’s another card inside gets thrown out without being opened.  But even that is only fixing the symptom and not the underlying problem.  We would highly recommend getting your financial house in order (become accustomed to spending less than you earn) before refinancing your home to consolidate debt.

 

Inflation… Someone’s Got Their Hands on my Money!

As we’ve talked about before, one of the biggest, if not the biggest downward drag on your savings and/or portfolio is inflation.  Sure, you’ll be sitting on a big pile of dollar bills, but they’ll be worth about half as much as they are now 15 years from now.

Before we can talk about inflation-beating, it’s important to have at least a basic understanding of what inflation is, and why it exists.

Imagine you and three and your friends at work have chipped in and bought a pie.  You each plan on having an equal sized slice… one third of the pie.  Then your boss comes along and decides that he’s going to take a share, too.  Now, even though only three of you paid for the pie, you still have to cut it in four pieces.

Well, that’s what inflation is.   A dollar represents one share in everything that comes under the influence of that currency.   Everything that is owned by US dollars (land, possessions, services in places that use the currency) is the pie.    When more dollars come into existence, but the pie stays the same size, the amount of pie each previously existing dollar is able to buy is reduced accordingly.

And guess who the boss is.

For every dollar that the government spends that it does not have revenue to pay for (which is close to one trillion in the US this year), it has to issue a dollar of debt.  Debt that is bought up by anyone that wants the interest rate that is paid out.  Banks, individuals, corporations… and more increasingly, the Federal Reserve, the institution that controls the money supply. 

Basically, the Fed has the power to create money, or shares of US influence, out of thin air, without adding anything to the pie to make up for it.   And at the moment, the Federal Reserve is buying up about half of the debt that USgov prints up.  (For the sake of comparison, Chinese interests hold about 7%.)

But doesn’t that basically leave the government at the mercy of their debt?  Not really.  Here’s the clever bit.

Let’s say that you buy $1000 of US debt with a 1% interest rate for a period of 1 year.   If the rate of inflation (the rate at which the Fed has increased the amount of money over and above the growth of the US pie) is above 1%, THE GOVERNMENT MADE MONEY.

Well, not exactly money, but they made value.   They paid you $10 a year later.  But a year later at 3% inflation, that $1,010 of 2019 dollars is now only worth $979.70 of 2018 dollars.   The value of the debt has been shrunk.   Anyone

So does that mean the Federal Reserve is being ripped off?  No… they just made the money to buy the debt out of thin air in the first place.  But it DOES mean that everyone that bought US debt with real money IS losing value every year that inflation outpaces their interest rates.    So who sets the interest rates?   Again, the Federal Reserve. 

Which basically amounts to a tax on every dollar you save every year.   

And people simply holding dollars in savings accounts don’t even get the courtesy of an interest rate, so the value of their money declines even faster.  If the rate of inflation is 3%, then the value of a dollar in a chequing account goes from $1 to .97.  The next year, it goes down to .941.   And on, and on.  Pull up a calculator and type 1 x .97.  then hit the equal sign.  Hit the equal again, 19 more times.  That’s what your money is worth after 20 years.

And THAT is probably the single biggest reason why saving doesn’t work worth a damn.  Because the Federal Reserve is going to sneaky-tax the holy hell out of it.  Every.  Single.  Year.  Aaaaaaaah!

So what can we do?   For now, two things…  a)  Don’t go spending everything you’ve saved because it’s all hopeless.  It isn’t.     b)  Stay tuned.  It’s about to get good.

How Counting Chickens Before They Hatch Can Kill You

I recently found out that a house that I had bought in a small town for my mother to run a small business in has since tripled in value since I bought it 12 years ago. (It’s not in America.)

Does that mean I’ve made three times my money? Not even close.

There seems to be a prevailing myth out there that a home is a terrific investment. While it can be ok, it’s certainly not a no brainer. In fact, it is not unusual to only break even on a house EV-wise (expected value… in this case, inflation adjusted profit) even when you haven’t lived through a massive housing correction like America just has.

There are all sorts of expenses that go into the care and maintenence of a house that eat into your “profits”.

For example’s sake, let’s say I purchased the house at 33k, and is now “valued” at 100k. “Gross profit”: 67k.

First, before you even walk in the door, there’s taxes. Depending on what state or province you live in, you are probably going to have to pay 5-15% sales tax to get ahold of a piece of property. Selling with a real estate agent? Tack on an extra 4-7% in commission. Then there’s property taxes and homeowner’s insurance. Typically around 1-2% of the home’s value combined. Paid every year. 12 years. Ouch. Home maintenence. Say another 1% per year to keep everything in shape and keep up curb appeal. Most years will be less, but some will be a lot more.

Finally, you didn’t buy that house cash, did you? Uh oh. Then you’re paying interest, and a lot of it. With a 20 year loan at 4% interest, expect to pay more than 40% than the value of your loan over the period of the loan. Want 30 years? Better bump that up to 75%. And if you need 30 years to pay off a mortgage, believe me, you can’t afford whatever home you’re looking at. You’ll be paying so much interest that even a small increase in interest rate is going to have your mortgage underwater. That’s how the American housing crisis got started in the first place.

Now the wild card in all of this is inflation. It works on several variables of the equation. Let us assume that we will see an average of 3% inflation per year, which over 12 years means that the value of a dollar declines by one third. Your yearly expenses keep up with inflation, which means that every 12 years, you’re going to be paying 50% more for them. So does the value of the house. In fact, it’s a major driver of the appreciation of real estate. If a $33k house is worth $50k 12 years later, it may have “made money”, but it hasn’t appreciated a single iota in real value. So in EV terms, my gross profit is only twice what I paid for the house (before expenses), not triple.

So take a 100% gross profit, and take off say 10% for commission and taxes. Then 3% (proerty taxes, insurance, maintenence) times 12 years, reduced to 1/2 to account for appreciation/inflation (because 3% when it was worth 33k is not as much as now that it’s worth 100k). No, that’s not the exact math. It’s just ballparking, but it’s close enough. That’s another 18%.

Then there’s the interest on your loan. Your payment does not go up over time unless interest rates do. But inflation marches on regardless. A $200 payment per $30k of loan may suck now, (it will really suck), but 12 years from now, it’s going to feel like a $100 payment. Of course, you’re paying an inflated price for your home because of the interest you pay. But when your interest rate and inflation are equal, (which is pretty close to the case these days) they effectively cancel each other out.

But when the interest rate you pay is higher than inflation (most of the time), then you’re losing value by paying more interest than inflation shrinks the value of your payments. Which means you’re losing EV via interest.

So I haven’t really tripled my money. I’ve made anywhere from 20-70% in EV based on how big my loan was.
Wow, what a letdown. I could have made more money just buying 25k worth of gold and hiding it under my bed.
And I GOT LUCKY. If the house was in America, I would have lost a boatload of EV.

So what’s the good news? Well, it’s twofold.

How many assets do you know that would have even kept up with inflation over the last 12 years (50%)? Stocks? Nope. Bonds? Sorry. And did you have 25k just laying around 12 years ago to buy gold with?

Here’s the beauty of home-ownership. It doesn’t have to keep up with inflation. It has function above and beyond that of an investment, unlike gold.

We all need a roof over our heads. Our physical bodies, at least in a financial sense, are liabilities. We have to pay money each month to keep them going. If you didn’t own a house, you’d have to pay rent. That money is going out the door regardless. And let’s say you bought a house 12 years ago, saw it appreciate 3% a year (which works out to a 50% increase… a 50k house would be worth 75k twelve years later), but then lost it all in the housing correction in 2008. Sure, you lost value, because your house is worth the same money as 12 years ago, and a dollar is worth only 2/3 as much as 12 years ago, but you would have had to pay that much EV in rent anyways. It was actually a breakeven situation, not a loss!

But if you were counting on a gain to balance out bad spending habits…. you are effectively floating up Shit Creek.  Paddle sold seperately.  Basically, buying a house is not really an investment. It is ideally a way to turn a liability (needing a place to live) into less of a liability, or hopefully breakeven or even make a little bit of EV over time if you’re lucky.  But if you’re buying a house assuming it’s going to make you money down the road, make no mistake… you are not investing, you are gambling.

Not only that, but if you’re counting on making money on your house, you are almost certainly going to buy more house than you need, (or can afford) and thus unwittingly be taking risk on par with that of derivative traders.

And you ain’t getting no bailout.

What is a WOW worth?

Humans can habituate anything.  Even things that feel bad, like the feeling you get after slugging down too much McDonald’s.  So you better believe we can do it with good things.

Why is that important?  Think of it like this.

Say you buy a brand new, 60″ plasma, high-definition, (insert other bells and whistles here) TV, to replace your tiny, dull 32″ LCD.     You bring it home, hook it up, and voila!  Instant happiness!  It’s so clear, it’s so crisp!  I can see every individual pockmark on Deniro’s face!

OK.  Now ask yourself.  The last time you bought something like that… how long did it take before that became normal?  Before it was standard?  Before you didn’t even notice it?

One week?  Two?  You would be a highly unusual individual if it was longer than two.  If it was, odds are you aren’t actually using it very much.

Now take however long that is, and divide the price of the item by the number of days that you thought of it as special as opposed to normal.   If it was a $1,000 TV, say you would have thought to yourself “man, this TV is so damn great” for a week before other things (you know, family, work, friends) took higher precedence and forced the TV into the background of your life.  That’s $1,000 / 7 or $143 per day.   Of course, if television is the most important aspect of your life, maybe it was a lot longer than 7 days, so your price per “Wow” would drop accodingly.

So, the question is, how much is a “Wow” worth to you?  $143?  $70?  $50?

Wait, you weren’t in jaw-dropping awe of the TV in the first place?  OK, how much is a “Cool.” worth?  $20?  $10?

If you think that’s scary… apply it to a 2010 Escape because you’ve gotten tired of your ’92 Civic.