Woud you rather...

[dczech09]

All things held equal, and with interest rates the way they are today...
Would you rather have $25,000 in CC debt or $100,000 on a mortgage?

I know most people would say "mortgage." However with mortgage interest rates being approximately 1/4 of CC interest rates, the interest being generated is about equal.

Also a credit card with a lower balance is easier to pay off, assuming that no other charges are being made.

So why is it that most people are not willing to take on $25,000 of CC debt at 16%, but they will be more than happy to take on a $100,000 mortgage at 4%? Aren't the two very similar to one another?

[jpg7n16]

All things held equal, and with interest rates the way they are today...
Would you rather have $25,000 in CC debt or $100,000 on a mortgage?

Mortgage. No question.

So why is it that most people are not willing to take on $25,000 of CC debt at 16%, but they will be more than happy to take on a $100,000 mortgage at 4%? Aren't the two very similar to one another?

Classic error of looking at debt: focusing on the $ amount of interest charges only.

There are two sides of every equation - like a scale. You are looking at the left half of the scale and ignoring the right side. So they have the same $ of interest charged (left side) - but what do you get for that interest?? (right side)

You get cash, or get to keep cash. Cash that can be used for investments. Investments are expected to earn between 7-11% long-term.

So:
$25,000 on CC = costs $4000/year interest
to pay it off, I'd have to liquidate $25k of investments
$25,000 investments = expected to earn $1,750 to $2,750/year

Would you give up $2500 of taxable income to reduce expenses $4000? I would!

But the mortgage:
$100,000 on mortgage = costs $4000/year interest
to pay it off, I'd have to liquidate $100k of investments
$100,000 investments = expected to earn $7,000 to $11,000/year

Would you give up $10,000 of taxable income to reduce expenses $4000? I wouldn't!

--------------------------------------------------------------

In addition, you have to consider what is backing the debt. The CC debt purcahsed consumer goods, food, vacations, etc. - ie. things with little (if any) residual value. On that $25k debt, you may have say $5k worth of goods left that you could sell and help pay down the debt if needed. That extra $20k will reduce your future lifestyle and income.

The $100k mortgage is backed by a piece of real estate. Usually keeps it's value (though not always). So if needed, you could sell the property and cover the debt owed. You may even turn a profit on the deal.

--------------------------------------------------------------

I guess the easiest answer would be:

For the cost of only $4000/year, would you rather get $25,000? or $100,000?? It costs the same!

I'd go with the $100,000.

[dczech09]

I follow your train of thought. More than anything, I'm just playing devils advocate because no one really thinks of things in this capacity.

One thing I wanted to mention though is that I view mortgages and houses separately, where as you view them as together.

To me, you did not borrow for a $100,000 house. The way I view it is that you borrowed $100,000 from the bank, period.

You mentioned the investment paradigm. However your explanation is a classic situation of leveraged investing, which does not always work out in the investors favor, especially over the short term. Just thought I would point that ou

So to me, the house aside, a $25,000 CC debt at 16% is the same as $100,000 of mortgage debt at 4%.

Don't forget that the CC will pay off in about 12 years (assuming minimum payments), whereas the mortgage would pay off in 15 or 30 years (assuming minimums, and subject to the term of the loan). The CC will also produce the smallest amout of interest over the long run:

CC debt- $12,155.28
30 yr mort- $71,867.94
15 yr mort- $33,143.70

If the mortgage were accelerated to 12 year payoff (holding all other things equal), the interest produced would be $26,076.32 which is still less than the CC debt interest.

Again, playing devils advocate and trying to provoke ORIGINAL thought. Not market hype or myth.

[MonkeyMama]

Mortgage, 100%.

Some other things to add:

I either have to pay rent or a mortgage, or something for some place to live. My mortgage has never bothered me at all because it is a lot cheaper than renting, around here. We also get a huge tax break for our mortgage. No, I Would not keep a mortgage for the tax break, but when comparing it to rent, it is significantly cheaper considering the tax breaks. (since credit card interest is not a deduction, I feel tax benefit it is worth mentioning).

The biggest point of all? My house is an asset that I can sell at any time. Homes sell fast where I live, so maybe another regional bias. Most of the time I have been a homeowner, average time to sell a home is one day.

So, if my house is worth $200k and I owe $100k, I don't consider that being 100% "in debt." I am in debt, definitely, but I can get out of that debt pretty easily if I need to. I am not *stuck.* Now, if I owe $100,000 on a $50,000 house? That's not much different than being in credit card debt, if you ask me. So, it just depends.

When it comes to credit card debt, it's usually used to buy things other than assets that hold their value. You get *stuck* pretty quickly in that situation.

Finally, mortgage rate is fixed and terms can not be changed. Credit card can decide to charge me 15% interest tomorrow, even if rate is lower today. That's pretty risky if you ask me.

To sum up - I need a place to live, and a mortgage is the cheapest route to that end, in my own situation. I'd agree that owing $100k on a mortgage that is upside down is a bad situation. I don't mind a mortgage, but only on a home with ample equity. If I Was upside down on my home, I would personally consider that an emergency situation - debt to be paid off ASAP. Same as if it were credit card debt. Though slightly advantageous due to low interest rate and tax write off.

For reference, mortgage debt is the only kind of debt I have ever had (besides 0% arbitrage, that kind of thing). I am pretty anti-debt in general. Mortgage is just a completely different animal - though my experience is very regional/unique I am sure. If I could have just bought a house for $100k, I might have just paid cash. Around here, $100k is merely a down payment, and rent is absurd.

[jpg7n16]

One thing I wanted to mention though is that I view mortgages and houses separately, where as you view them as together.

If you've seen some of my other posts on this topic (in other threads), you'd know there could be nothing further from the truth. The mortgage and the property are completely separate. The mortgage is not the house, and the house is not the mortgage.

Having said that, the presence of an outstanding mortgage implies real property is owned. That property can be sold to satisfy the obligation, or most of it. The presence of CC debt does not imply any remaining assets that could be sold.

To me, you did not borrow for a $100,000 house. The way I view it is that you borrowed $100,000 from the bank, period.

The term mortgage necessitates property. You borrowed $100,000 cash, and used it to buy a piece of real estate. You owe the bank $100k either way, but you still have an asset worth $100k if needed. (Effect on net worth = +$100,000 asset -$100,000 liability = $0)

On the $25k CC debt, you borrowed $25k and used it to buy things that have no residual value. People would pay you for the house. People MAY pay you for a used computer you bought on the CC, but at a significantly reduced price. But people can't pay you for your vacation experiences, or your meals last month. In other words, your net worth loses (effect on net worth = +5,000 residual assets -$25,000 liability = loss of $20k)

Also imagine you have $300k of investments and were considering buying a $100k house. If financing rates are low enough, it would be to your benefit to take a $100k mortgage rather than sell $100k of investments. The same cannot be said of CC debt.

You mentioned the investment paradigm. However your explanation is a classic situation of leveraged investing, which does not always work out in the investors favor, especially over the short term. Just thought I would point that ou :P

Sure. But why would a long term investor care about short term variation? Especially when considering vs a 30 year mortgage? That's not short term either.

But let's consider the two over the same timeframe: 4% on the house, and an average return of just 7% on the corresponding $100k of investments

Over the 30 year period, the 4% house costs interest of $71,869.51 (which is tax deductible, reducing it further.)

Over the same 30 year period, if the investments return only 7%, your $100k investment becomes $811,649.75 - a gain of 711,649.75! (which is admittedly taxable, but still)

The "short term" difference of just 3%, created income nearly 10 times the cost of the interest. Clearly, it's better to think long term.

Don't forget that the CC will pay off in about 12 years (assuming minimum payments), whereas the mortgage would pay off in 15 or 30 years (assuming minimums, and subject to the term of the loan). The CC will also produce the smallest amout of interest over the long run:

CC debt- $12,155.28
30 yr mort- $71,867.94
15 yr mort- $33,143.70

If the mortgage were accelerated to 12 year payoff (holding all other things equal), the interest produced would be $26,076.32 which is still less than the CC debt interest.

Why are you focusing only on the total of interest and ignoring the other implications? Namely, that yes you paid more long term, because you had debt an extra 18 years. Also, you got $100k for your troubles instead of only $25k.

And your math is off. Paying off a $25k CC @ 16% in 12 years costs more interest than paying off a $100k mortgage @ 4% in 12 years.

$25k CC debt @ 16%
To pay off in 12 years, requires 144 monthly payments of $391.46
144 * 391.46 = 56,369.71 paid to remove $25k debt
56,369.71 - 25,000 = 31,369.71 interest paid (not deductible)

$100k mortgage @ 4%
To pay off in 12 years, requires 144 monthly payments of $875.53
144 * 875.53 = 126,076.09 paid to remove $100k debt
126,076.09 - 100,000 = 26,076.09 interest paid (tax deductible)

Where did your $12k figure come from??

[dczech09]

And your math is off. Paying off a $25k CC @ 16% in 12 years costs more interest than paying off a $100k mortgage @ 4% in 12 years.

$25k CC debt @ 16%
To pay off in 12 years, requires 144 monthly payments of $391.46
144 * 391.46 = 56,369.71 paid to remove $25k debt
56,369.71 - 25,000 = 31,369.71 interest paid (not deductible)

$100k mortgage @ 4%
To pay off in 12 years, requires 144 monthly payments of $875.53
144 * 875.53 = 126,076.09 paid to remove $100k debt
126,076.09 - 100,000 = 26,076.09 interest paid (tax deductible)

Where did your $12k figure come from??

Your math is off. You are assuming that the credit card debt is paid off "straight-line" just like the mortgage. It is not.

Most credit cards, per regulation, are required to subject a minimum payment of either 4% of the balance or a minimum figure determined by the bank. I ran an amortization schedule assuming a payment of 4% of the outstanding balance, or $50, whichever is higher.

The first payment was about $1,000, and the table ran all the way down until the payment hit the $50 minimum. It took 142 payments, the last one being $22.02.

I totalled the interest column to equal $12,155.28.

The new CC regulations passed a while back changed it so that credit cards had to charge 4% of balance instead of 2%. The reason why is that some credit cards actually had negative amortization due to the 2% minimum. It also reduced the amount of time people were in credit card debt, assuming they did not continue to charge and rack up a higher balance.

[disneysteve]

I would absolutely take the 100K mortgage over the 25K CC debt for the reasons already stated and more.

[jpg7n16]

Your math is off. You are assuming that the credit card debt is paid off "straight-line" just like the mortgage. It is not.

Most credit cards, per regulation, are required to subject a minimum payment of either 4% of the balance or a minimum figure determined by the bank. I ran an amortization schedule assuming a payment of 4% of the outstanding balance, or $50, whichever is higher.

Fair enough, I'm not aware of a 4% rule. Yes I did do straight line. Why on earth would you reduce your payment each month on 16% debt and only pay the minimum?

I don't know why it matters - if you have the $1000/month in the 1st place, why wouldn't you keep paying $1000 every month? You'd be done much quicker.

Let's make a scenario that levels the playing field of these two options.

-----------------------------------------------------------------

This scenario has other implications.

1) The $25k CC debt has no assets to sell to satisfy debt if needed; the $100k mortgage has a $100k piece of real estate (ie. you could sell the property on day 1 and pay $0 interest, that's not an option on the CC) - but let's ignore this for now
2) The $25k CC debt has no home to live in, so you also have to consider rent expense in addition to the CC payments he's making (or get to add in rental income for the property owner)


Let's give both persons $1,477.42/month of excess income - assuming the CC debtor can rent at the exact mortgage payment of the mortgage holder (ignoring taxes and insurance as we'd just add that amount to the rental expense)

CC Holder
Each month pays $477.42 of rent, and pays excess $1000 to CC debt
After 30.61 months, CC balance is gone and person is free to invest his $1000/month at 7% (interest paid $5,612.17)
In the remaining 329.39 months, his investment of $1000/month becomes $993,032. Not bad, but still has no property.

Mortgage holder
Each month pays $477.42 mortgage, and invests excess $1000 @ 7%
After 360 months, has no debt (interest paid $71,870 - deductible) and built a portfolio of $1,219,971 and has a property originally $100,000 + 30 years of real estate value growth

Even though he paid over $65k more interest during those 30 years, the mortgage holder comes out at least $300k ahead (after accounting for the interest paid)


Does he care that he paid more interest than the other guy? Not at all.

[dczech09]

Excellent point!

So in other words in this scenario, it comes down to basically the opportunity costs. For instance, the CC person would have to rent instead of having the house. By leveling the playing field, things still come out ahead for the mortgage guy.

So that is a good point and everything.

However, my point earlier on was that leaving everything else out of the picture, if we ignored the house and everything, then the mortgage option and CC option would produce the same amount of interest in year 1. However over time the CC would pay out less interest. Again that is of course ignoring everything else and just comparing the debts themselves.

The house and property makes up that difference and makes the mortgage more appealing than the CC debt. I know that if I were to ask my original question to people on the street, most people would say "mortgage." However I think a lot of people would say mortgage because of the cultural perceptions and group think.

[disneysteve]

leaving everything else out of the picture, if we ignored the house and everything, then the mortgage option and CC option would produce the same amount of interest in year 1. However over time the CC would pay out less interest. Again that is of course ignoring everything else and just comparing the debts themselves.

Yes, ignoring everything else, your question comes down to would you rather be 25K in debt or 100K in debt? Obviously, the answer to that question is that I'd rather be 25K in debt, even with a higher interest rate. But as we've seen, you really can't ignore everything else.

Now, just to throw another twist into the scenario, we have been assuming that the CC debt was spent on frivolous stuff. What if it wasn't? We've also been assuming that the person with the CC debt would be paying rent. What if he wasn't? What if the 25K was spent on start-up costs for a new business or on stock that would bring in twice that much once sold? What if the person has a paid off house so no mortgage or rent costs to deal with?

[dczech09]

Nice wrench to throw in!

In that situation, both sides are essentially doing "leveraged investing." If you were to ask regular everyday people, or a loan officer, they would all say that the mortgage is better still. Afterall, the widespread perception is that stocks are bad and go down in value, while real estate is good and goes up in value.

Obviously we know that is not necessarily true. Actually stocks and real estate have about the same level of risk, while stocks historically produce higher returns over the long run. Interestingly, every since the 2008 stock market and real estate crash, stocks have returned to their pre-crash levels a while ago. However real estate in most markets is still down about 10%-13%.

So the choice is...
A)$100,000 mortgage at 4% with a house
B)$25,000 CC debt at 16% with stock

I think I would choose the CC side because of the underlying asset being a little better long run. Also there would be less interest overall, and the mortgage tax deduction won't make up the spread. Even so, the mortgage tax deduction has a diminishing marginal utility and is only available if I were to itemize.

And I am not stupid enough to keep charging on a credit card, so we can rule an increasing balance out of the question.

So based on this, we come to the same conclusion that it comes down to the "other stuff" so yeah we cannot just rule out the "other stuff" and look at interest alone. We have to level the playing field, which we have done in two scenarios here.

[disneysteve]

Actually, I should have been clearer. When I said "stock" I meant business stock, not investment stock. It was following on the idea of the CC debt being from starting a business. I sell collectibles, for example. If I spent 25K on merchandise to turn around and resell at a profit, that's different (or is it) than if I spent the 25K on concert tickets, clothing and travel. It does give me a hard asset that can be sold to repay the debt, and most likely at a profit assuming I know what I'm doing in my business.

[MonkeyMama]

Nice wrench to throw in!

Actually stocks and real estate have about the same level of risk, while stocks historically produce higher returns over the long run.

I don't agree with this statement. Yes, stocks produce higher returns in the long run. They also tend do be more volatile. This could be somewhat regional bias. (Lord knows real estate has been crazy volatile where I live, but housing in California will always hold a chunk of its value - people have been migrating here for centuries - I think that is a safe assumption that it alweays will hold its value, in my lifetime). OF course, I am thinking maybe more to one stock versus one house. A well-diversified portfolio may be about the same risk in the end? I'd be curious to see the statistics on that. Like a graph comparing real estate versus stock volatility over several decades? Logically, higher returns means more risk.

All of the above said, I totally get what you are trying to say. Almost everyone I know has made some pretty stupid moves when it comes to real estate and mortgages. Clearly the blind idea that "mortgage debt is always good" has been proven wrong these past few years. It was like sheep to the slaughter.

[dczech09]

Stocks in the short run are definitely more volatile. There is more trades occuring and more volume, so logically there is room for more variation in price.

I should do a study in my spare time and compare a well diversified portfolio versus real estate values. That would be interesting to see the correlations and deviations.

But yeah I absolutely agree it is like sheep to the slaughter. Most people just follow what everyone else does. I mean my parents bought a house on a mortgage, so why wouldn't I, right?

[jpg7n16]

However, my point earlier on was that leaving everything else out of the picture, if we ignored the house and everything, then the mortgage option and CC option would produce the same amount of interest in year 1. However over time the CC would pay out less interest. Again that is of course ignoring everything else and just comparing the debts themselves.

Essentially, that's the point I've been trying to make. You can't evaluate the debt, without considering what you did with the money you borrowed.

You can't just look at cost. Imagine 2 people went to the mall. One spent $500, and the other spent $1000. Financially speaking, who had the more successful shopping trip? To figure that out, you have to ask "well what exactly did the buy?" That will make all the difference.

Now, just to throw another twist into the scenario, we have been assuming that the CC debt was spent on frivolous stuff. What if it wasn't?

What if the 25K was spent on start-up costs for a new business or on stock that would bring in twice that much once sold?

That's a pretty good twist. If that were the case, and the goods could be sold within 1 year. I'd prob take the business CC debt. I could afford to still take out a $100k mortgage, and end the year ahead of my competition.

Sell $50k of goods, pay off $25k debt, keep approx $23k profit after interest. Which I'd prob reinvest into my double your money business

We've also been assuming that the person with the CC debt would be paying rent. What if he wasn't?
What if the person has a paid off house so no mortgage or rent costs to deal with?

IMO, you have to start the scenario with 2 identical people in every respect(same income, same credit score, same net worth, etc.) - then add in the debt to see how it changes things.

If the CC debtor started with a paid off home, and the mortgage debtor started from scratch - that gives the CC debtor an unfair advantage. CC just needs to take a home equity loan out for $25k, and the question becomes, "if you have a $100k value home, would you rather have $25k mortgage, or $100k mortgage?" Obv just a $25k.

If both start with a paid off home, then you have to consider rental income from the 2nd property the $100k mortgage represents, etc.