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A Commentary on Savings and Mortgages
Paradox in Mortgage Interest
By J. David Lewis, NAPFA-Registered Financial Advisor, Resource Advisory Services, Inc., Knoxville, Tennessee
Recently, a client's lawyer gave me an excellent observation. He said something to the effect, "The family that stands in front of their home, knowing that they own it without debt, is free to take advantage of more opportunities than the family that knows the mortgage holder controls a part of their future income." This differs from the philosophy of many financial planners.
Periodically we are asked for advice on home mortgages and other forms of debt. By now most people seem to understand the math. If mortgage interest rates are 6% and we expect 9% long-term return from a well-diversified securities portfolio, we can earn the 3% difference. Logically, people should pay as little as possible on their home mortgage, using excess cash for a good securities portfolio instead of accelerating their mortgage payoff. Since home mortgage interest is tax deductible, it makes even more sense to build a securities portfolio instead of paying off the home mortgage quickly.
In my early financial planning days, I worked through the math several times for clients. The answer was always the same, but several clients did not act in the "rational" way. They could see the opportunity to earn from securities instead of paying debts, but they still wanted their homes debt free. Something besides the math was driving their decisions. When explaining the concept, I began to acknowledge that many people have strong personal preferences for minimal debt and owning a debt free home. I stopped trying to convince people to be logical.
Some people seemed to love the "slick" financial trick of using mortgage debt to make money from a securities portfolio. Others paid off their debts quickly and strongly resisted carrying debt in their net worth statements. In the face of the relevant math, people simply followed their personal preferences about debts.
How can we explain the differences in how people act? It seems that those people who resist debt may sometimes tend to have higher net worth and faster growing net worth than those who opt to maintain debts. At a minimum, we cannot show that people who use debt maneuvers fare better than those who avoid debts. How can this be? Is there a flaw in the reasoning?
We conclude that there is much more to building wealth than taking advantage of an interesting phenomenon. Building wealth seems to be more closely related to personal habits and lifestyle than it does to "smart maneuvers."
In a sense, building wealth is like weight management. Those people who understand the principles of nutrition and exercise, PLUS get on the scales often, seem to control weight better than those who don't.
There is no doubt that people should understand as many financial planning techniques as possible. At Resource Advisory Services Inc. (RASI), we spend a great deal of time in continuing education sessions, watching for techniques we have not seen before. However, those who monitor the broad picture of their financial situation seem to keep assets and liabilities in balance better than those who don't. Hence, RASI's financial planning services are built around the concepts that help people monitor their situations, to control the relationships between assets and liabilities for the comfortable balance that lets them take advantage of opportunities. It is not enough to understand and use the techniques. We need the tools to take control of the overall situation.