Monday, June 11, 2007

Betting the Farm

During the Great Depression, when banks were going belly-up, they "called" their outstanding loans, which means that people who had mortgaged their houses were suddenly required to pay the loans in full or lose their homes. As a result there's a persistent belief out there even today that if you have a mortgage against your house, you don't actually "own" it -- the bank does. But that just isn't true. The bank doesn't own your house. And trust me, the bank doesn't want to own your house either.

This "depression mentality" is the origin of the old adage, "don't bet the farm." But today lenders can not require you to pay your loan in full before it matures, no matter what predicament they find themselves in. And as a result, when mortgage interests rates are relatively low, "betting the farm" can be a useful tool in accomplishing your financial goals, like sending your kids to college or saving for retirement.

Another psychological aspect to how we save, spend and invest money has to do with where the money came from and how long we've had it. This is a fascinating topic explored in the book Why Smart People Make Big Money Mistakes, and it explains why some people would choose to pay down a mortgage loan that is costing them 5.5% instead of investing the same money in an asset that could earn them an 8% return.

This psychological issue comes into play often with 401Ks. Everyone can pretty painlessly save money in a 401K, because they never see the money. It's easier to just have someone not give it to you, then it is to touch it, feel it and then put it away somewhere and not touch it again.

For me, my mortgage payment has this interesting psychological aspect. For instance, I might think, should I put this $50 in my kids' college funds this week, or should I take them to the movies instead? But I never think, gosh should I take the kids to Disneyland or should I make the mortgage payment? It can be hard to save as much as we should, but we don't generally put our family's immediate well-being at risk.

A year ago, we had a client who had enough equity in a rental property that he refinanced it and pulled enough cash out to fully fund his kids' college accounts, by calculating how much he needed to put in them now for them to grow to the projected amount that will be needed. So instead of socking away a certain amount every month into college funds, he has a mortgage that he doesn't notice (because his renter makes the payment and the college fund return is greater than the interest he pays on the loan).

Some financial advisors might disagree, as some believe that paying interest is always negative, but tax deductible interest can actually help you achieve your longterm financial goals while maximizing your current cash-flow. If you have equity in your home, you might as well let it work for you.

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