Wednesday, September 29, 2010

Gardening 101

Tuesday night is the evening before trash day, and hence the time when I take out the garbage. I also like to weed my lawn around this time - technically it's usually around 12-1am on Wednesday morning. When you weed the lawn when the trash can is already at the curb, you can avoid the decomposing yard waste stinking up your garage. It would be better to use those paper yard waste bags, I suppose, but I never seem to have those on hand, and I definitely wouldn't fill one up with just weeds. Even though I have a lot of weeds.

I have a wide variety of weeds, too. There are a few growing in the back that get to be almost two feet high in just a couple of weeks. When I pull them, it smells vaguely like something vegetable-y I've eaten in the past. Though, given what I like to eat, that doesn't mean what I'm remembering was a quality ingredient.

This is where my first rule of weeding comes in: Nothing worthwhile grows that quickly. If it's taller than the (living) grass after a week of growing, it gets pulled. Maybe these aromatic weeds are actually wonderful delicacies, but I doubt it. I would have taken pictures so someone out there could enlighten me as to their culinary uses, if any, but as I mentioned, I weed late at night. I think a flash would produce bad pictures and maybe even disturb the sleep of a neighbor or two. And my camera is locked in my car and is therefore too much of a hassle to get.

Monday, September 27, 2010

Trimming Expenses

After my friend Brian's post about trimming expenses, I've been thinking about my own complete lack of doing so. It's a bit of a problem, potentially.

I've been eating out a lot more than usual, lately. I've been driving more than usual, too, partially as a result of eating out more. I'll need to make repairs to my car pretty soon, and I'm not sure how much those will be yet. Speaking of repairs, I also repaired my file server, to an extent. I bought a couple 2TB hard drives for $99.99 each. I was able to save most of my files, and all of my important files, so that was good. Still, $200.

I'm also thinking of buying things that I really don't need at all. For example, I want to buy another digital camera. Why? Because I keep one in the car to take pictures of personalized license plates. Why does that mean I need two? Because I never have one with me when the cats are doing cute things, and taking videos of cute cats is the quickest way to youtube stardom! I fully recognize that this is not the best investment, but I'll probably end up doing it before too long.

Then there's utilities. The hot weather of late has skyrocketed my power bill along with everyone else's. I've also tried watering my lawn to get some grass seed to grow. That didn't really work, but I'm sure my next water bill will be higher than I've ever seen it. I also bought that new grass seed, some starter fertilizer, and a small spreader at The Home Depot using gift cards. And for the little remaining grass I have combined with the small amount of new grass that came up, I'll need a new lawnmower soon. I'd like a nice quiet electric one, which apparently means $300 or so. I'd also like to avoid the battery problems people have reported, which means $200 or so instead, but having to use an extension cord. So far, I'm leaning toward this cordless 36V mower. We'll see.

Finally, I've been donating (or pledging to donate) more to charity. If that isn't a stupid use of money, I don't know what is! Seriously, though, I'm going to try eating at home more often again. When I do, it tends to be really cheap. Hopefully the fall brings more reasonableness to my power bill, and whatever lawn mower I buy is reliable and durable. You all can hope that I don't buy that extra camera so that you're not flooded with videos of my cats. And you can also thank me for keeping the economy going these past few months!

Friday, September 24, 2010

Combining Two Food Posts

I have talked before of my love for macaroni and cheese. If my love for macaroni didn't come across in that post, rest assured that I love macaroni. I have also alluded to my worship of Parmesan cheese.

Imagine my joy, then, when inspiration struck to combine these two items into THE ULTIMATE CULINARY CREATION. I went about my usual macaroni and cheese process and wound up with a wonderful pot of macaroni for lunch. Oh no! I ate it all and forgot to add the Parmesan cheese!

No matter, I was having macaroni and cheese for lunch the very next day! How fortuitous! And unsurprising. This time, I set out the Parmesan right next to the butter so I wouldn't forget. And I didn't! After the usual preparation, I took a couple of bites and it was as excellent as always. I sprinkled a bit of Parmesan in a small area, and it was glorious! Well, it mostly tasted of Parmesan, but that's glorious! I sprinkled a bit more over the entire top and stirred it in. I sprinkled a bit more over the entire top and stirred it in. Eh, maybe one more time. Three is a good number, but it's definitely not an OCD thing.

And then I ate it. And with the Parmesan stirred in, it tasted like my regular macaroni and cheese. Perhaps someone with a more refined palate could appreciate it more. I was disappointed. On the other hand, my macaroni and cheese preparation process doesn't have to change, and my minimal ingredient list increases the availability of my most common meal (see Single Point of Failure).

Wednesday, September 22, 2010

Looking For Conservative Facts

I like reading most of the articles on Media Matters for America. They have a nice format where they will outline the claim(s) of some conservative, then detail some facts in rebuttal. In addition to factual errors, they'll discuss biased reporting, misleading on-screen graphics, or anything else they take issue with. There is apparently enough misinformation out there for them to write several research articles and several blog posts a day.

The blog posts, incidentally, are less fun to read. They often use name calling in their arguments and are lighter on the facts. It's where the quicker and smaller updates happen, though, so I still give them a read most of the time.

Media Matters is definitely a liberal website. For example, almost all of their articles are debunking claims made on Fox News. I don't think this is a complete picture of the world. I'd really like to hear conservatives countering liberal reporting with supporting facts.

Unfortunately, I haven't been able to find those facts. The closest thing I've been able to find is the Media Research Center. Mostly, their articles are just reporting that some reporting was done, and we are supposed to recognize the liberal bias - somehow. They rarely counter with facts, which is a bit disappointing. There's also (a project of the Media Research Center), but that has the same problem of being light on facts.

Maybe that's just the way things are, currently. Perhaps liberals have facts to back up their positions - or at least tear down the opposition, and conservatives just complain that reporting they don't like is liberal. But there have to be some facts somewhere, right?

Amazingly enough, the best source I've found for "liberal-media" bashing is The Daily Show. However, most of their media bashing is showing the ridiculousness of the reporting and not usually an issue with the facts or arguments. Except when they cover Fox News. is useful in fact checking politicians, but they rarely cover the media directly, so they are usually only active around election time. They do an excellent job of remaining impartial, though. FiveThirtyEight does an excellent job of discussing political bias in polls, among other things, but this only helps indirectly. I know that Rasmussen tends to favor conservatives, so Fox News uses it a lot, but there aren't always matching polls from other institutions readily available to compare to.

Which is another problem entirely - facts themselves are often biased. People choose the poll with the results they want to report. Conservative think tanks will make certain assumptions in their studies to yield facts that support the conservative point of view. I imagine there are probably some liberal think tanks that are similarly biased in their studies, but there doesn't appear to be anyone calling them out on it. So, I humbly ask for help. Where do you go when you want to be informed (with facts) on the conservative side of things, and how can you trust those facts?

Monday, September 20, 2010


A few months ago, I was doing my regular shopping at Walmart. Among other things, I bought two cans of Parmesan cheese. I wasn't entirely sure I bought them at the time, though.

I wasn't paying all that much attention, but it looked like the kind lady at the register had put one of the cans in the bag without scanning it. I consider myself a pretty moral and honest person, but I didn't seriously consider pointing it out. It'd be nice if my subconscious had quickly ruled out that course of action as either unnecessary or inefficient; it'd be even nicer if I believed that to be true.

No, I immediately justified the unintentional discount in several ways. My subconscious was definitely thinking, but it was thinking greedily. But, when you think about it, they've overcharged me for a couple items in the past. And I definitely do way more than my fair share of correcting the product placements on the shelves. And when I take my shopping cart to the car, I always put it back in its designated area - and compact the carts already there, too! Why, I'll even go out of my way to remove shopping carts from the handicapped spaces when I see them. And I do give Walmart a lot of regular business. Retailers build these kinds of mistakes into their prices, after all.

In my defense, there were also a couple of points in Walmart's favor in the battle in my head. I fully appreciated that not ringing up the Parmesan cheese would throw off their inventory until their next manual recount. And, it is Parmesan cheese, and if there was ever a product that deserved to be paid for, it is cheese - especially Parmesan! But I've done cycle counting, and the mistake would be corrected remarkably shortly - if people were doing their jobs properly. And food does taste better when it's free.

Yeah, that Parmesan was going to stay mine. Guilt lasts until you forget about it, and that was likely to be before bed. Parmesan lasts all the way until you eat it (which wasn't actually all that much longer)!

It's remarkable how easy it was to justify an action I knew was wrong. Incidentally, this post is proof that I underestimated my memory when it comes to guilt. I'm sure I understated the awesomeness of Parmesan cheese, too, though. Also, I did check the receipt on my way out, so I didn't leave the store thinking I'd stolen cheese. I still like to think I would have gone back and paid for it had I seen that it was, in fact, missed.

Friday, September 17, 2010

I Think I Could Learn Something From Paige Worthy

It's hard for me to call my writing inspired, but this post was inspired by the wonderful writing of the always lovely Paige Worthy. The stories she tells have a way of making me feel like my life is lacking something, though. For example, compare a recent meal of hers with a recent eating experience of mine:

For the fourth meal in a row, I prepare to make a box of Great Value macaroni and cheese. During a commercial break in Modern Marvels, I pre-scrub my macaroni and cheese pot (its only purpose), a black plate, and a small spoon until they are all but clean. I carefully add two small drops of dish soap into the pot and clean and rinse the three required dishes. I let them dry until the next commercial break, when I fill the pot with water and turn the burner on high.

The busiest part of the meal has begun. As quickly as possible, the box of macaroni is opened, the cheese packed down into the bottom of its packet, and a sausage and a stick of butter extracted from the fridge.

A long slice down the length and another to complete the cut, and the sausage is perfectly halved on the plate. Three quick strokes cause two chunks to fall off the end, each pair not quite exactly a quarter of an inch thick - just to prove I don't have OCD. The sausage chunks enter the warming water. A lick of each side of the knife ensures no flavor goes to waste, and makes the blade clean of all sausage pieces before cutting the butter - two and two thirds tablespoons that will rest on the cheese packet.

Soon, the water reaches a boil and the macaroni cascades from the box. I stir in clockwise circles, counterclockwise circles, and then a nice grid pattern. This is repeated every couple of minutes: nary a noodle can stick to the bottom. At long last, it's time to drain the macaroni. Thus the plate returns as a pot lid, and the last of the water is shaken out.

The appropriate amount of milk is splashed over the noodles after the butter and cheese have been added. Stirring until the butter is melted hurts as the small spoon digs into my index finger, but I persevere! I place the pot on a couple of cork trivets I've had since college and eat on the couch. As I sit down and see today's wondrous engineering topic on the TV, I have a moment of pride in my own efficiency in cooking. However, I savor the Modern Marvels and barely notice when I reach the end of the macaroni and cheese.

And for dinner, four grilled cheese sandwiches consisting of nothing but eight pieces of bread and four slices of American cheese. All cooked with minimal entropy. And minimal spontaneity.

Wednesday, September 15, 2010

Q&A: How Many More Topics Do You Have?

Zero! The answer is zero! Wow, that was a quick blog post. Want more? If so, let me know what you want me to talk about! It can be about anything. Just because most of my recent posts have been financial in nature doesn't mean that's all I will discuss. So, give me some ideas!

Monday, September 13, 2010

Q&A: Should I Buy a Bigger House for Roommates?

Following last week's post on the ROI of rental properties, another interesting question is whether you should buy a small one-bedroom condo (for example) to keep expenses low, or a three- or four-bedroom house to gain some rental income. There are two main considerations: ROI and overall financial safety.

As far as ROI is concerned, I think it's very similar to last week's calculations. There are some differences in the details, though. Your principal and interest (P&I) payment will be higher, but when determining the ROI on the rental portion of your property, I think it should be specified as the difference between the large house's payment and the small home's P&I. You would have had the base P&I payment anyway, so it's not really a cost associated with the renters. Similarly for most of the expenses. Property taxes and insurance will be higher for a larger house, usually. Maintenance costs will be higher with the increased wear and tear, and you'll need a larger refrigerator, but maintenance costs haven't risen that much for me. Utilities will be higher, but probably not terribly so.

Your investment amount should be the increase in down payment, or the difference in overall home value. In this scenario, I am strongly inclined to use the overall home value in my calculations. This gets into the overall financial safety aspect. A pure rental property can be abandoned and sold off if you don't want to deal with renters anymore. If you get tired of having roommates, you can kick them out, but you still have to pay for the entire house. Lowering your expenses requires moving and the house-buying-and-selling process and headaches associated with it.

Consequently, I think it is very important to buy a house with many financial cushions included, even when you plan on having roommates. As I mentioned ages ago, I bought my home knowing I could afford the payments and other costs using just my base salary after all my preferred expenses had been taken out - 401(k) contributions, IRA contributions, miscellaneous spending money. Each of these expenses was a cushion, and any rental income was a nice bonus.

And there are other reasons why you may not have roommates anymore. I would guess that most people are single when they contemplate having roommates in a house they are buying. It's possible you meet that special someone that thinks you're a special someone, too. Roommates may get in the way then. It's possible that special someone comes with a second income that's much higher than that provided by roommates, but they might also be going (back) to school, or you might be having kids right away and one of you will be staying home. Either way, it'd be nice to be able to spend your first year together in wedded bliss, rather than struggling to downgrade your home.

For me, it seemed to make sense to buy a bit bigger. It's definitely worked out so far. On the other hand, I'd have a much lower debt than I have now, and might have purchased a standalone rental property already. It's hard to know exactly how things would have been different, but I can't say I've had any major regrets with my house and/or roommate situation.

Friday, September 10, 2010

Q&A: What's My ROI on My Rental Property

When evaluating the return on investment of a rental property, you have a few different options on which numbers to use. The numbers depend on what exactly you consider income, and/or what exactly you consider an expense, and what exactly you consider your initial investment.

On the income and expense side, you have the following:

  • (+) Rent.
  • (-) Principal and interest payment.
  • (-) Property taxes.
  • (-) Homeowner's insurance. The cost of homeowner's insurance will vary based on location, age of the house, construction type, environmental factors, etc. Mine costs 0.4% of my home value, so I've been using that as a starting point.
  • (-) Maintenance costs. For my house, I estimate 1% of my home value in maintenance costs each year. For a rental property, I think I'd estimate 2%. A common rule of thumb is to use 3%, and you can't really go wrong planning conservatively.
  • (-) Utilities. This depends on the setup you have for rent - utilities included, a fraction of utilities per room, or utilities in the name of the tenants. In other words, it might not be applicable, but it's not really optional.
  • (+ optional) Principal portion of P&I, because it is adding equity to your net worth, but it doesn't help your cash flow.
  • (+/- didn't forget about it) Taxes. The interest portion of your P&I isn't directly tax deductible like it is for your primary home, but it is a business expense that offsets your business income. (Your business in this case is being a slum lord.) This applies to all expenses above, plus depreciation of the house, if you go that route. Tax laws concerning business income and losses are somewhat complicated, so I'm not going to go into them.

The net income is fairly straightforward to calculate once you choose what exactly you're including. It's much harder to estimate before you buy the property, unfortunately. Other than the estimates I listed above for insurance and maintenance, many house listings include the previous year's tax amount. Some will also include a history of utility costs, but you usually have to talk to the listing agent and/or current owner. Estimating the rent you can charge requires looking at rooms and/or houses in the area. I use and Google Maps (with the "Real estate" overlay enabled under the "More" button/menu and the Listing type selected as "For rent"). Then, just to be safe, I assume I will rent to college students that move out every summer and leave me with a 25% vacancy rate.

After all that, you find yourself with a net monthly income. You then have to determine how you want to calculate your return on investment. It comes down to whether you consider your initial investment as the amount of cash you parted with - your down payment, or the amount that you're responsible for - the total property value. You can also reevaluate your return on investment at any time using your current equity as your investment amount.

Personally, I'm not a fan of using your current equity to reevaluate. The theory is that as your equity increases, you can increase your ROI by selling the house and using the increased equity to get a new house (or two) with higher income potential. To me, this seems like messing with a good thing. I also hate being in debt, so this might be an entirely emotional position on my part. I also don't view increased equity from home appreciation as an increase in your investment. It's more of an unrealized gain. The only equity I would count is principal reduction, but in that case I would definitely include the principal portion of the P&I as income. The amortization schedule, where the principal portion increases each month, will then take care of the principal reduction to some extent.

Naturally, I made a calculator for this. Utilities aren't included because of the complexity in options. "Maintenance Costs" is a good place to tack that on if you need to. It's fun to play with, if nothing else. I view my maintenance cost and vacancy rate assumptions as conservative. If I can have a positive ROI even with these estimates, I consider it a win. Any extra is a nice bonus. Plus, rent will increase with inflation while P&I should remain constant (until it goes away completely!).

Home Value ($):
Down Payment ($):
Interest Rate (%):
Property Taxes / Year ($):
Homeowner's Insurance / Year ($):
Rent Income / Month ($):
Vacancy Rate (%):
Maintenance Costs / Year ($):
Count Principal as Income?
Yearly ROI?
P&I Monthly Costs Monthly Income Net Income ROI down payment ROI total value

Wednesday, September 8, 2010

Divisibility by Nine

When I was a GTA at The University of Kansas, I once taught a proof for a number being divisible by nine if and only if the sum of its digits is divisible by nine. I stumbled across the proof the other day and thought I'd go ahead and share it. It's one of my favorites, though I've since learned that it is by no means the simplest. The pdf linked to at the bottom includes multiple proofs related to divisibility rules. It uses modular arithmetic, though, and I've never had an intuitive grasp of that. This proof makes more sense to me, even if it is hard to read. Let me tell you, it was even harder to write in HTML, as I recall - so many subscripts and superscripts!


If a number is divisible by 9, then the sum of its digits is divisible by 9

A number n with digits [most significant] dk, dk-1, ... , d1, d0 [least significant] can be rewitten as dk*10k + dk-1*10k-1 + ... + d1*10 + d0

We start by observing that 10x = 10x - 1 + 1

Note: 10x - 1     =     9*10x-1 + 9*10x-2 + ... + 9*102 + 9*10 + 9     =     9*(10x-1 + 10x-2 + ... + 102 + 10 + 1)

Thus, our number in convoluted form is:
dk*(9*(10k-1 + ... + 1) + 1) + dk-1*(9*(10k-2 + ... + 1) + 1) + ... + d1*(9*(1) + 1) + d0*(1)

If we factor out everything with a 9 in it, we are left with:
9*(dk(10k-1 + ... + 1) + dk-1(10k-2 + ... + 1) + ... + d1(1)) + [dk + dk-1 + ... + d2 + d1 + d0]

We can see from here that if a number is divisible by 9, then a 9 must be able to be factored out of the part in []'s (a 9 is already factored from the left part. Note that if the digits are divisible by 9, then the number is divisible by 9, too. This follows since we did direct algebraic manipulation of the number without any implications (which are only one way). Thus, a number is divisible by 9 IF AND ONLY IF the sum of its digits is divisible by 9

The same proof except for the last paragraph is used to prove the same about divisibility by 3, since 9 is divisible by 3 on the left side.

------------------------------------ [pdf]

Monday, September 6, 2010

Q&A: What's a good down payment size?

This is actually quite a complicated question. For one, things can change rapidly. For example, the interest rate penalties for high loan to value (LTV) ratios used to be higher. I believe they have been reduced in many cases as part of the effort to improve the housing market. On the other hand, a lot of loan regulations have gotten stricter to avoid bad loans entering the market again. Basically, rate changes related to your LTV need to be discussed with your lender.

Private Mortgage Insurance (PMI) still needs to be purchased when your LTV is greater than 80%. PMI is typically equivalent to a 0.50% to 0.75% interest rate hike for the period it needs to be paid. Some lenders advertise PMI-free loans even when your LTV is greater than 80%. The PMI still has to be purchased, but for these loans the lender buys it. They will pass this cost on to you via a higher interest rate - there is no such thing as a free lunch. Because your interest rate won't change for the life of a standard 30-year fixed rate mortgage, this interest rate, even if it results in lower monthly costs than buying PMI, could very well cost you more in the long run. Again, go over the details with your lender.

When it comes to deciding between making a larger down payment and buying PMI (or accepting a higher interest rate to cover PMI expenses), you have to look at the best use of your money. My previous post on whether or not to prepay your mortgage could be helpful in evaluating your options. Personally, I would rather avoid PMI than invest a few thousand dollars, say. Whatever you invest that money in would have to earn you more than the PMI payments and extra principal and interest payment amount (minus taxes on the interest and PMI, since PMI is tax deductible like mortgage interest). In fact, this should be considered an addendum to my previous post: The return needed to overcome PMI probably warrants paying extra principal at least until you reach 80% LTV. Psychologically, I just hate the idea of paying private mortgage insurance because it only benefits the lender.

Paying extra principal at the beginning such that you have less than 80% LTV ratio mostly follows my previous post's recommendations. The only difference is that the extra principal in this case does reduce your minimum monthly payment. When determining the terms of your loan, though, you have another option to reduce your payment: you can pay points to reduce your interest rate. As you can see using my refinancing calculator, reducing your interest rate can reduce the interest portion of your payment more than the total monthly payment amount in some cases. You have a choice in which number you use in determining your break even point, but obviously the total monthly payment might be all you care about.

I would make a point-paying calculator, but the cost of each interest rate reduction isn't always the same. For example, it may cost you half a point to move from 5.000% to 4.750%, but another half a point to move from 4.750% to just 4.625%. The user interface of such a calculator would be clunky at best. You can use the refinancing calculator fairly easily to get individual values and compile your own table of break-even times, though. Just find a payment amount for a 0-point loan and plug that into the current loan information fields. Then zero out the closing costs and adjust the points value and find the resulting interest rate entry.

Overall, I would tend toward a 20% down payment if you can afford it so you can avoid PMI. After that 20%, paying points will usually reduce your monthly payments more than extra principal. I paid half a point on my first loan, I think, and zero points on my refinance, other than the quarter-point fee I paid to waive escrow. For the most part, it comes down to what you feel comfortable paying up front versus owing later. I'm not sure there's ever a clearly wrong decision!

Friday, September 3, 2010

Q&A: Should I Pay Down Extra Principal Each Month?

Whether or not to pay down extra principal each month is a complicated question, and one that doesn't have a universal answer by any means. For the purposes of this discussion, we'll assume that an extra payment fits in your budget. Otherwise, the question is a bit moot.

Paying down principal has two primary effects. First, it takes money out of your pocket. Second, it increases your equity. Increasing your equity has the effects of reducing the interest you pay over the life of your loan and increasing your borrowing power. We'll go backwards through these effects this time around.

The borrowing power I'm referring to here will usually take the form of a home equity line of credit (HELOC). If you make a larger down payment, your monthly expenses can be lower, which can increase your borrowing power for a new loan, but if you're just getting a mortgage, chances are you're not looking for many other new loans. (Indeed, you shouldn't be, as new loan credit inquiries can negatively affect your credit score! Wait for your mortgage to be finalized before looking at car loans, for example.) The only thing I would use a HELOC for is an emergency fund. It's a great way to be able to pay down principal and still have access to that money in a pinch. If the pinch comes and you don't already have a HELOC, you're unlikely to be able to get a HELOC, so it's important to plan ahead. HELOCs are usually restricted to whatever equity you've built beyond 20%, so that your combined LTV remains at 80% or less. They also usually require a recent appraisal, so even the no-fee HELOCs aren't entirely cost-free to set up.

To me, though, this benefit of paying down principal isn't a major selling point, as evidenced by the fact that I do not have a HELOC. For emergency funds beyond my cash on hand, I would rely on loans from my family. I haven't formalized that line of credit in any way, and maybe I should do so rather than taking it for granted. At the same time, I can make sure my family knows that I would be there for them, too.

I view principal reduction as an investment that returns a savings in interest payments. Unfortunately, the rate of return on that investment isn't always just the interest rate of your mortgage. I included a simple calculator in my post on your effective mortgage interest rate, but that doesn't give a complete picture of your investment.

First, just as in my discussion on S&P 500 growth, values were not inflation adjusted. When it comes to the returns of the S&P 500, you have to subtract the inflation rate to get an inflation-adjusted return (approximately, anyway). Your mortgage works much the same way except that inflation helps debt, so you get to subtract the inflation rate from the interest rate you pay and get an inflation-adjusted interest rate. You get a benefit now (the home) and pay for it with less and less valuable dollars. Not a bad deal for the purchase, but it lowers the rate of return on principal payments. For the default values in the calculator above, the effective interest rate is 3.75%. After adjusting for inflation by subtracting 3.3% (though recent inflation has been lower), you're left with a nice low 0.45% inflation-adjusted effective interest rate.

Second, paying down principal now takes off interest from the very end of the loan. Your minimum payment doesn't go down and you can't readily access that money except through a HELOC. It is definitely a long-term investment, and the rate of return is locked for that entire period. It's similar to buying a multi-year CD with a rather - even ridiculously - low rate, given the current interest rate environment.

Third, paying down principal really shows the nature of compounding. Every payment that goes by, the principal you pay down saves you one fewer compounding of interest. Take a look at a monthly amortization schedule (my favorite calculator). You'll notice that the principal you pay goes up each month, while the interest paid goes down. Where you are in the schedule depends entirely on the principal outstanding, so to move up the schedule by a month (and in effect take a payment off the back end), you just have to pay the principal for the next month ahead of time. Thus, the extra payment required to gain a month goes up each time. The rate of return doesn't go down, but the time horizon is shortened and the compounding reduced. If that shortening of the time horizon is your goal, there are definitely diminishing returns.

As mentioned above, paying principal takes money out of your pocket. Whether or not paying principal is a good investment really depends on which pocket the money comes from. If it's coming from a cash account, chances are good that you will get a larger return by eliminating interest. If you are paying extra principal instead of making an IRA or 401(k) contribution or otherwise investing, then you are missing out on what is very likely to be a higher return in the stock market. Remember that it is important to compare inflation-adjusted rates to each other, and non-inflation-adjusted rates to each other. Mixing and matching is not a valid comparison.

Basically, as near as I can tell, prepaying principal doesn't make financial sense unless mortgage interest rates are over ten percent or so. I don't think many people today would pay down their mortgage if it weren't for the psychological benefits. Being in debt just doesn't feel very good - especially when it's tens or hundreds of thousands of dollars and can result in being homeless. Conversely, there's no feeling quite like knocking another month off the end of your mortgage. It's also a lot of fun to reduce your principal by the first $1,000; the first $10,000; the first $100,000 (I imagine). I'm also really looking forward to the day (soon, I think!) when my various investment and cash accounts could pay off my mortgage if I liquidated them. That would mean I could pay off the house if I had to, significantly lowering my monthly expenses so that I could live off a minimum wage job, for example. However, when I get close to the end of my mortgage, I imagine that I will pay it off simply for the monthly cash flow improvement, whether I need it or not.

In the end, I pay a couple hundred extra each month despite the logic behind investing it instead. I guess that's the price I put on the psychological benefits above. Pretty cheap therapy, actually.

Wednesday, September 1, 2010

Q&A: What's My Effective Mortgage Interest Rate?

When you sign and initial the hundred or so times required to purchase a home, chances are good that you wind up with a mortgage to go along with the property. That mortgage has an associated interest rate that is used to calculate how much you're charged each month, but it isn't always an accurate measure of how much you pay, in the end. (The mortgage also has an advertised APR that includes points, lender fees, and any applicable PMI thanks to the Truth in Lending Act. Honestly, I've never found the APR that helpful, and it definitely isn't helpful in this discussion - we need to look at the base interest rate.) The net interest you pay depends on your tax situation, and results in what I call your effective interest rate (not to be confused with the more official effective annual interest rate - new name suggestions are appreciated!).

Mortgage interest is tax deductible, which is great in theory, but it doesn't always help very much, if at all. Individuals get a standard deduction of $5,700, and married couples filing jointly get $11,400. If your mortgage interest isn't greater than whatever standard deduction applies to you, then the mortgage interest deduction doesn't help you on its own. You may have other deductions like qualified medical expenses, 401(k) contributions, charitable giving, and the like. If you have a mortgage, chances are good that you have an income and pay state and/or local income taxes, and chances are even better that you have property and are paying real-estate taxes, both of which are deductible. With these deductions, the mortgage interest deduction can be more beneficial.

My medical expenses are well below 7.5% of my adjusted gross income, so those are not deductible. My 401(k) contributions go into a 401(k) ROTH account, so they are not deductible. I have some donations and the occasional miscellaneous deduction, but my main deductions are the state income and property taxes I pay. In the end, most of my mortgage interest winds up being deductible. That means I pay a lot of state and local taxes, though, so that's not entirely a good thing.... It doesn't apply to me this year, but your deduction can also span tax brackets, making the calculation that much more complicated. Some of the deduction may save you 28%, while some may save you 25%, for example.

The amount actually deducted (we can call it the effective deduction until a better suggestion comes in) affects the effective interest rate you pay. For a 5% mortgage with outstanding principal of $200,000, your interest payments will be around $10,000. Say you contribute to a 401(k) and so can deduct all your interest and are in the 25% tax bracket. You effectively reduced the interest paid by 25% * $10,000 = $2,500. You are now paying a net of $7,500 for an effective interest rate of around 3.75%.

Because I'm such a fan of calculators, I just couldn't resist making another one!

Interest Rate (%):
Interest Paid ($):
Interest Deducted ($):
Tax Bracket (%):