A few years ago, an attorney came to me with a dilemma that had clearly been weighing on her mind for a long time. She sat in the back of one of my tax and estate planning classes and had heard me discuss the analysis paralysis that I had seen many of my clients face when their loved one passed away and they received a large amount of cash – either from the estate itself or from a life insurance payout.
I relayed to my class how often my clients were not sure where to put the money they received. This had often led to a situation where what had been intended as a gift had somehow morphed over time into a burden. In fact, I observed that the longer the timeframe since the receipt of the money, the heavier the albatross I observed weighing on the client.
As this officer closed the door to my office, she told me that she had been facing the same situation as what I had discussed in my tax and estate planning seminar. In her situation, the circumstances were very similar: a grandfather had left her approximately $250,000 as part of his estate. That money had been sitting in a low interest saving account for several years and was beginning to weigh on her.
So, I invited her to sit down, and we talked through the financial aspects of her life, including assets like this cash in a savings account and her house. I I then informed her that I considered family homes to be a liability in general, but especially when they have significant mortgage debt like hers did. Her home, purchased without a deposit by using a VA Loan that enabled her to buy the home without having to pay Private Mortgage Insurance, had about $20,000 in equity built up and $220,000 in debt. She had 25 more years to pay off her 30 year mortgage at 4% interest. This meant that she would pay roughly $128,000 in interest.
To avoid paying $348,000 for her house, she could simply write a check for $220,000 and own the home outright. She had no other major debt, unlike many in our age group who have significant student loans at higher interest rates than mortgage loans,* so this seemed like a quick kill. I asked her why she did not want to simply use the money that was left to her to pay off the remainder of mortgage.
The client told me that her grandfather was a World War II veteran, and that she had decided to join the military because of his service. She felt a tremendous sense of gratitude for all that he had accomplished in his life and his impact on her. Therefore, she wasn’t sure that paying off a house was the best way to honor his memory.
The client suggested that she could get better returns in stocks, and yet, when I asked her why the cash had not been invested in the market, again the response returned to what amounted to an overwhelming sense of pressure to make the best call possible. She had clearly been suffering from paralysis by analysis for a long time, so I asked her if she had also considered the math behind what inflation was doing to her cash nest egg. She had not.
I talked to her about the Federal Reserve’s goal of 2% inflation per year, and what that compounded over time meant. Roughly speaking, $1,000 in November, 1994 is now worth $1,718.16 as of November, 2019. That is the same 25 year period as the remainder of my client’s mortgage. Over many decades of one’s life, sitting in cash can be disastrous due to the reverse compounding deprecation one has sitting in cash. In case it’s of interest, the Bureau of Labor Statistics offers an accurate Inflation Calculator (Available through this link: https://www.bls.gov/data/inflation_calculator.htm/) that dates back to 1913, so you can see the erosion of the Dollar’s purchasing power over time.
As an asset class, homes theoretically keep up with inflation, but each real estate market is affected by regional economic headwinds and tailwinds. Sure, there’s San Francisco or Washington, D.C. housing markets where prices have far outpaced inflation. There is also Youngstown, Ohio or Detroit, Michigan where housing has dramatically underperformed even inflation-adjusted expected returns.
I advised the client that paying off her home was a prudent course of action because a mortgage is the same as a negative bond. Paying it off has a guaranteed return, both in terms of the $128,000 in interest she will save as well as the avoidance of the erosion of purchasing power via inflation. Another possible option she could consider was creating a CD ladder, though I pointed out that the interest on CDs at that time was below her mortgage interest rate (but at least they were above her nominal savings account rate).
Some will argue that there are ways to do better than paying off debt, such as stock market returns or real estate business ventures, and I absolutely agree with them in a vacuum. That does not mean that those courses of action would be better for this client.
Math and behavioral psychology are often at odds with one another. For many, low cost index funds compounded over many decades are the most likely path to wealth. For those who are suffering analysis paralysis and sitting for an extended period of time in cash, they are far less likely to have buyer’s remorse paying off debt than they are if they put their money in the market it goes down for an extended period of time.
Finally, I pointed out to my client that the last thing her grandfather would have wanted was for this gift to become an albatross. Whatever course of action she chose, as long as it was informed (looking at the math and the risks associated with each possibility), she should not second guess herself or look back. In the end, those who love us and leave us assets when they die hope those assets will bring enjoyment and security, not guilt-induced inaction or regret.
*Higher interest rates are only one consideration when paying of student loans. Similarly, the nature of the loan (public vs. private), whether you will get loan forgiveness etc. are all relevant data points when deciding what order to pay off debt.
