Writes Jack (as I’ll call him):
Recently my Sunday paper’s real estate section guru-consultant-wizard-know-it-all trotted out the old ‘pay a few bucks principal a month more, and save gazillions!’ This was then followed with a nice little table showing all the money you get to ‘save’ by making your 30 yr mortgage a 20 yr one instead (or a 15 yr one). I see this advice at least once a year in his column.
WELL, this is always stated as an absolute truth, and is very misleading. The ultimate extreme of this technique would (obviously) be: buy your home for cash & save a fortune! Yet compare mortgage rates the last couple of years with Vanguard 500 fund, and I know where I would want my money to be.
A personal story to illustrate the point:
I bought an ‘income’ property near Hughes Aircraft 8 years ago ($250,000 then, $160,000 today — something to do with the disappearance of my ‘endless’ supply of aerospace engineers to rent to after all the plants closed). Global peace can be hard on the pocketbook. Thank goodness I went for maximum leverage (smallest possible downpayment), and put my monthly disposable income into MSFT, instead of HOUSE!
Ultimately, the 30-yr fixed mortgage I had was so far ‘upside down’, that it made no financial sense to keep it alive. The real estate market would have had to rocket up for the next decade or two for me to come even close to break-even. I did a ‘short-pay’ instead (essentially walking away from the property), even though I could have sold my MSFT and paid the loan off in cash. I was ABLE to do so, because I had so LITTLE of my money into the deal. Had I made accelerated payments (or, God forbid, paid cash), I would have taken a bath.
Well. Clearly it would have been brilliant to buy Microsoft (MSFT) or even just the Vanguard Index Trust eight years ago rather than put that money into a larger downpayment. As described yesterday, you can’t count on this always to be the case — especially if you don’t have the luxury of walking away from a debt you’ve incurred, and not paying the piper, as Jack did. (Someplace in here there’s a great pickled pepper possibility, but I’ll spare you.)
Technically, Jack didn’t default. He got the bank to take the property back without the bank’s going to the considerable expense of foreclosure, in return for its agreeing not to pursue him for whatever they lost on the loan. Maybe they didn’t know he owned all that Microsoft. Technically, too, Jack should declare as taxable income the amount by which the loan balance was forgiven, but he says he’s hoping the bank will forget to report it, in which case he will feel no obligation to do so.
I was curious whether Jack had any qualms about any of this. He explained his reasoning:
If the bank wants to be nasty, they can report the ‘forgiven’ amount to the IRS as income. So, instead of owing the entire amount to the bank, I may owe TAX on it instead. Still a lot better than owing the entire amount. As best I can tell, this tax liability reporting is done inconsistently, depending on the lender & admin procedures. Haven’t heard anything yet regarding any tax liability (it has been a while — and I’m not about to ask the bank & remind them!).
For a while, there were even some outfits in So. Cal. you could deed your property to first (for a fee), and then they will default on the loan on your behalf — this loophole took the tax liability away from the original loan holder. It sounded a bit too shady for my liking — and I know the authorities are prodding & poking at this loophole as well.
Credit-wise, my ‘short pay’ is better than a ‘foreclosure’ which is better than a ‘bankruptcy.’ It also stays on your record shorter. I agonized for a while, but then how much money should one be willing to pour into a black hole to keep a perfect credit record? There must be SOME limit, right?
- I had a partner in all of this who disappeared (back to India, I think), leaving me to hold the bag & make mortgage payments for the last two years. Since my credit record is spotless (including mortgages on other properties I have), I will play up the ‘abandoned by business partner’ angle in a letter to explain this one particular ding if it ever comes up.
- Since so many thousands of aerospace folks lost their jobs in So. Cal. & lost their homes, a ‘short-pay’ is pretty common in these parts, and not the sudden death & stigma it used to be to your credit rating a decade ago.
- I’m young (well, – late thirties), have a six-figure income, AND been socking almost 40% of my gross earnings (living below my means — I read your book!) into equities for the last decade (and boy, oh boy, those MSFT leaps I’ve been buying the last couple of years…), and have no foreseeable need for credit (other than my existing mortgages; and credit cards – which I pay off in full every month – also from your book!).
All of the above just to say, yes, there may be consequences to “short pays,” so, if you have a CHOICE in the matter, like I did, be sure to take all of the above into account.
My own old-fashioned feeling is that, if you have a choice in the matter, make good your debts — and declare all your taxable income. But I found Jack’s perspective informative, at the very least.