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Wednesday, July 14, 2010

Budgeting: Part 19: The Repayment Deferral Fallacy

"A man's indebtedness is not virtue; his repayment is."

- Ruth Benedict


(In this post and subsequent posts, I am walking though 12 different examples of household budgeting mistakes and how they can all be corrected with accrual accounting techniques. Accrual accounting recognizes income when it is earned and expenses when they are incurred. An alternate definition is that accrual accounting records events that change your net worth.)





The symptom:
Deferral of debt repayment feels like savings.

The examples:
1. In order to meet your monthly savings goal, you sometimes pay only part of your credit card bill. For example, last month you realized that if you paid off your entire $600 credit card bill, you would not be able to save any money that month. However, your goal is to save $500 per month. Hence, you only pay $100 of your credit card bill and save the other $500. You make a mental note to pay off the whole bill soon. This seems better than not saving money, but you feel uneasy about this approach for some reason.

2. While reading a magazine article about colleges, you are shocked to find out how much it's going to cost your 3-year-old to attend college in 15 years. The article suggests you should be saving $500 a month for the next 15 years in order to pay for college costs. You look at your budget, but you don't see any way you can come up with any savings. Then an idea strikes. When you bought your $200,000 house about six months ago, your bank gave you a choice of a 15-year mortgage or a 30-year mortgage. You remember that the difference in payments was about $500/month. At the time, you went with the 15-year mortgage because you could afford it and it seemed like a nice idea to pay it off sooner. Now you wish you had that extra $500/month to save for college. So why not switch? You call the bank and find out that for $1,500 you can refinance into the 30-year mortgage. So now with your mortgage payments lowered, you begin to put that $500 into a college savings fund every month. Everything is budgeted properly now, and you think you are quite clever to have thought up this idea.




Payments versus Repayments

This blog had a similar sounding article title a few posts ago, so let me explain the distinction I'm making between a "payment deferral" and a "repayment deferral". The earlier article discussed payment deferrals - the deferring of a legal obligation to pay a certain amount by a certain date. This could be a mortgage payment, a minimum credit card payment, or a simple bill like a utility bill. People sometimes delay these sorts of payments in order to have cash on hand for other things, but missing a payment is highly unwise unless you have absolutely no other options, as there are often serious legal and financial consequences. The indirect cost of not meeting a legal financial obligation can be very high, including interest, late fees, lawsuits, liens, repossession, loss of reputation, reduced credit, etc. And since a debt payment doesn't decrease your net worth worth, there is little reason NOT to make a payment obligation. You won't be any wealthier by withholding payments that you can make.

A repayment deferral is the act of deferring debt which you could otherwise repay now. In other words, it's a situation where you aren't legally obligated to pay money back yet, and although you have the money to repay it now, you choose not to do so. Again, the mere act of repayment doesn't change your net worth. You aren't any wealthier just because you prepaid $1,000 on your mortgage. However, there are ongoing ramifications to the transfer. By repaying debt, you save on interest you would otherwise have to pay on that debt, while simultaneously giving up the return you could have made elsewhere with that money. Thus, the attractiveness of repaying debt depends on your other alternatives for the money, so repayment deferral may or may not be a good idea.



Balancing Risk

Note the emphasized words in the last paragraph. The interest savings are certain ("you would") while the opportunity costs are uncertain ("you could"). Hence, we see the well known rule of thumb when considering a typical repayment scenario: The rate of return on your credit card balance or mortgage balance is known; the rate of return of most alternative investments is unknown. Borrowing at 18% on a credit card to fund a stock portfolio clearly does not make sense. In that case, you will certainly pay 18% for the funds, but it's very unlikely you will make that much in return.

But what about borrowing at 9% to fund a stock portfolio you think will return 9% over time? I'm surprised at how many people like the idea of borrowing money and then investing it in something with about the same expected rate of return. People often say they are comfortable with leverage or comfortable with the risk in this situation. Frankly, I don't think that risk has all that much to do with it. Yes, leverage does increase risk, but in this case, the return itself is not attractive because it's equal to the borrowing rate.

So why are people attracted to this scenario? I think there might be two reasons. The first reason is straightforward: A lot of people probably secretly hope that the return will be a lot higher than 9%. In other words, they like to gamble.

The second reason is more subtle, but perhaps equally common. The second possibility is that in the process of moving the money all around, people compartmentalize specific transactions and only focus on the gains. (I have mentioned in previous articles about how people like to frame choices to isolate gains and integrate losses. I believe people also like to frame outcomes this way.)

You might wonder if this is a completely contrived scenario. Would rational people really borrow at the same rate as their investment due to obfuscation of the money flows? It does sound strange, but how else do we explain the following sort of talk I often hear from people buying a second (non-rental) home:

"I don't expect to get rich quickly from my property. I know property prices rise slowly. I'm only expecting the property to keep pace with inflation - maybe a tiny bit better if I'm lucky. I'm realistic about that. I'm only expecting an appreciation of 4% a year over a long period of time. So why invest in property returning 4%? Simple. One word: leverage. My 4% returns will be magnified 10 to 1 because I'm only putting 10% down. That's the beauty of leverage."


People who make such statements need a little math refresher. If your return is 4%, you cannot increase that with leverage unless your borrowing cost is less than 4%. I think people see a $200,000 house purchase turn into $650,000 over 30 years (that's a 4% annualized return) and frame the results positively. "Wow! My tiny $20,000 down payment turned into $650,000 worth of equity over 30 years!" But unfortunately this leaves out the enormous principal and interest payments that were slowly paid out over 30 years, to say nothing of property taxes and maintenance costs. The (annualized) internal rate of return will only be about 2.8% for a non-rental property with a 30-year fully amortizing 5% mortgage and a 4% annualized property gain. And again, that's before property taxes, insurance, and maintenance costs!

(The point of this example is not to trash all real estate investing, but rather to underscore how investments with cash flows into different accounts over long periods of time can fool people into thinking they are making a lot of money. It also illustrates that leverage does not always increase your returns, even when your returns are positive.)

Now what about borrowing at 4% to fund a stock portfolio? Here is where it gets tricky. In the abstract, this is a scenario where it's likely that your investment will return more than your borrowing costs over time. However, the risk is also quite high - perhaps higher than a lot of people recognize. We'll look at that in more detail later with the college savings example.



Liquidity

An alternative rational for borrowing money can be constructed based on the need for liquidity. It can be argued that borrowing money and depositing it into a checking account decreases liquidity risk, because a new credit line can be denied (and an unaccessed credit line can be revoked). Thus, the argument is that borrowing the money now (or deferring the payment of already borrowed funds) leaves one in a better position during a crisis. For example, one could borrow $5,000 for an emergency fund. This would not increase your net worth, and you would incur ongoing interest costs on the borrowed money. However, this money would then be available in a crisis where you lost your job and were also unable to borrow money, either due to credit rating problems or general credit market lockup.

This is not an irrational argument, and in a few situations, it may be a reasonable course of action. However, I would caution that the costs are relatively high to guard against such an outlier event. Additionally, I would point out that the drivers for liquidity problems can be highly complex. It may not really be possible to guarantee that this sort of approach won't break down due to other unforeseen reasons.



Accrual Accounting and the First Example

Now let's return to the original examples and look at them from an accrual accounting perspective.

The first example is straightforward. A $500 balance is deferred on a credit card in order to have $500 more in a savings account. A lot of people are reluctant to pay off their credit card debt because they are focused on the amount of money in their checking account. They feel less wealthy if they take $500 out of their checking account and pay down their credit card balance. But when did they become less wealthy? They didn't become less wealthy on the day they paid their credit card balance! They became less wealthy when they incurred the expenses on their credit card. For most items, this occurred on the day the items were purchased. Net worth decreased when the items were purchased, not when the bill is paid.

The act of paying the credit card bill doesn't change your net worth, and neither does the act of contributing to your savings account (or simply retaining the money in your checking account). These are investment decisions, not savings decisions. However, in this case, borrowing money at a high rate on a credit card only to put it in a low-yielding savings account is a very poor investment decision!

This procedure also does not help very much with liquidity. If a small emergency happens, you'll have an extra $500 in the bank to deal with it. But if you fully paid the credit bill, you'll have an additional $500 that you could borrow in an emergency. The certain interest costs are much too high compared to the potential benefit of slightly higher liquidity of the funds.




Accrual Accounting and the Second Example

The second example is less straightforward, but we can quickly bound the problem by making a few observations. First of all, the original problem was framed as a cash flow problem and so that's exactly what was solved - the person was not able to contribute $500 to a college savings account and by readjusting their mortgage terms, they were able to do that. But does that make sense? Is the root problem not being able to contribute $500 each month? Or is the root problem really that college is a huge expense compared to the income and assets of the person?

If the root problem is affordability, then unfortunately the entire mortgage maneuver did little to help. Why? Let's look at net worth. Extending the mortgage payments and contributing the extra money to a college savings account is very likely to be a complete wash in terms of net worth. By dragging out the payments, you're effectively just borrowing money for a longer period of time. If you invest that money in something completely safe (e.g. short-term U.S. treasuries or money market funds), your rate of return will almost certainly be less than your mortgage terms.

Let's take a look at the two scenarios: paying the 15-year mortgage and not contributing to the college fund versus paying the 30-year mortgage and contributing to the college fund. In both cases, we start with a $200,000 mortgage debt and no college savings. (We don't need to worry about the price of the house or any other assets or debts because we only care about what will be different between the two scenarios.) After 15 years, here's how things stack up:



The beginning and final net worth of both scenarios are exactly the same! Both start with a combined total of -$200,000 for mortgage balance and college savings, and both end with a combined total of $0. As you can vividly see in the spreadsheet, all the second scenario did was to move $135,767.82 from one account to another. So if the fundamental problem was that college was not affordable, this did not help. Repayment deferral is not the magic savings bullet some imagine it to be.



Risk Reprise

Of course the reason the totals are exactly the same is because I used the same interest rate for borrowing (i.e. the mortgage rate) and investing (i.e. the college savings rate of return). This is certainly a reasonable rate to use if you want to keep the risk of the above two scenarios the same. Paying off the mortgage is a guaranteed rate of return, and no lender is going to give you long-term mortgage terms that are less that the risk-free rate of return in the markets.

But what about investing the college savings fund in something more risky? Don't stocks usually return more than 5% over longer periods of time? Yes, they certainly do. Historical statistics would be on your side to suggest that you have a very good chance of making more than 5% over the 15-year time frame. However, consider the extra risks and rewards available by changing the rate of return. In the following spreadsheet, I've shown the results for rates of return of 5%, 8%, 2%, and 0%.



As you can see, an 8% annualized rate will net you an extra $40,000. (And in some circumstances, you may also receive some tax savings.) I agree that is a fairly significant amount of money. But it came with risk. Note how a
2% annualized rate will set your net worth back about $29,000, while a flat market sets you back more than $44,000. In the abstract, perhaps these scenarios don't look all that risky - you might make some money, you might lose some money.

To get a true feeling of the risk, you could try to imagine being in that situation. You might imagine how you would actually feel if your child was entering college right now and you ended up with $30,000 or $40,000 less than if you had just paid your original 15-year mortgage. Also, you now still have another 15 years to pay on the mortgage. Will this scenario be acceptable, or will it be a huge problem? Only you can determine your risk tolerance.



Liquidity Reprise

Let's return to the liquidity issue again. Maybe you accept the fact that funding the college savings account by deferring mortgage payments is simply moving money around. Good. But what if moving the money around is in itself helpful? It's possible that may be the case. Will your liquidity position (and overall financial position) be better or worse by having your mortgage paid off and no college savings, or by having $135,000 in college savings and still owing that same amount on your mortgage?

I'm afraid there is no single correct answer to that question. It will depend on other factors in your life, and ultimately on which kinds of risk you are more comfortable assuming. The only help I can offer is to delineate some of the factors that could favor one scenario over the other.

Factors favoring the first scenario

  • Having the money in home equity may possibly increase your eligibility for certain kinds of student aid.
  • Your starting cash flow will be less because your mortgage is paid off. This will make it easier to pay any student loan or new mortgage loan.
  • It would be impossible to be underwater on your mortgage, so you would have the flexibility to move if that would help in any way. (i.e. new job, downsize house, etc)
  • Your credit position may be higher because you will have little debt.


Factors favoring the second scenario

  • You might not be able to obtain an equivalent mortgage loan due to market conditions.
  • You might save time if you don't need to apply for a student loan.
  • Since the college savings payments are not obligations, you could cut them back if you had a personal financial crisis.
  • Having the money in a qualified college savings plan may possibly increase your eligibility for certain other kinds of student aid.




Budgeting Reprise

This has been a really long post, and it might be appropriate to step back and ask what this all has to do with household budgeting. Even if you did not understand the math and the accounting in this article, you should be able to fall back on your common sense if the scenarios are appropriately framed.

Items such as college tuition are huge financial outlays. If there's not room for everything in your budget, you can't magically make it all better just by changing the financing terms on some items in your life. Deferral of debt may increase your cash flow temporarily, but it doesn't change your overall wealth position. If you really need an additional hundred thousand dollars, you're going to have to earn more or spend less.