Paying Off Your Mortgage Early

 We did it! We paid off our mortgage... but why?

Just like the name of this blog would suggest we LOVE looking at the math behind our decisions. The problem is that there are factors that are hard to work into the math. Of course, the specific factor that I'm talking about is risk. 

As a simple example lets say you have a $200k mortgage at a 2.5% interest rate BUT, your friend tells you: "The stock market gives you ~8% returns annually. Therefore you could pocket the difference (in this case 5.5%)". With this logic why would one ever pay off their mortgage? In fact, with this logic you should take out as many loans as you possibly can and put it all in the stock market. Obviously this does not make any sense and the reason is very simply, because of risk. Now does this mean that there aren't people that have gotten rich out of pulling stunts like this? Of course there are, but what is being put on the line for a chance at said riches (or to be clear 5.5%, in the example) is often not worth the effort. To put this in a single question: Would you really risk your home for the chance at 5.5% returns? Maybe, but we did not think it was worth it. 

It's hard to put a dollar value on certain things but the security and stability of owning our own home as-well as knowing that even if one of us were to lose our jobs that we would be able to, comfortably stay in our home (along with all the benefits that come along with that) in our opinion is priceless. 

Apart from an increase in stability the other benefit we are now enjoying is a significantly lower monthly obligation. We now have an additional monthly mortgage payment that historically we wouldn't otherwise paid to the bank. We plan to aggressively invest this money into VOO & VT to rebuilt our investment portfolio outside of our 401k in order to continue to work our way to financial independence. 

Next time you are presented with a decision really ask yourself if the potential gains are worth the risk. In my personal experience growing our wealth has been a slow and boring process. Next time you come by an opportunity that seems too good to pass make sure you understand what you are risking. 

Becoming financially independent is all about taking a lot of little calculated decisions that will lead you to success.  

Roth vs Traditional IRA

Roth vs Traditional, the answer my shock you!

The answer is that there is now right answer. It is all circumstantial. The answer to this question would be very different for a person who is 18 years old earning minimum wage than for a 10 year career veteran making over 6 figures. If the answer was simple the question would be commonplace and we would not be here talking about it. 

What is an IRA?

An IRA is an Individual Investment Account. It is essentially a savings vehicle that allow you to invest your money in a variety of investments such as stocks, bond etfs, mutual funds and so on. The big benefit of an IRA is that it has tax incentives that amplify the impact of your savings. 

What are Tax Incentives? 

The first question that we need to address is what is income tax. Income tax is money that the government charges all income earning individuals in a country to fund all kinds of things (such as schools, roads $4M dollar public restrooms). Why are we even talking about this? Well the amount you pay in taxes directly affects the the potential size of your "Tax Incentive" we mentioned earlier (stick with me I'll bring all this together soon).

So how much am I paying in Income Tax?

Now the US government works in a progressive tax system. Meaning that the more you earn the more you pay in taxes. Looking at the tax bracket table next to us we see that an individual would pay $0 for the first $9,875 earned annually BUT the very next dollar ($9,875 + $1 = $9,876) would be charged 12% tax. In other words for every dollar over $9,875 you are paying Uncle Sam $0.12. The same happens over and over again until you reach you total annual pay. Meaning that someone who make $100k a year would pay nothing on the first $9,875. The she/he would pay 22% on the next $30,250 ($6,655 in taxes for this part) and so on until he/she reaches $100k. This mean that our friend making $100k a year would pay 32% on his/hers last $15,000 (or $4,800 ouch). 

What sort of tax incentives can I get from an IRA?

Glad you asked. There are essentially 2 types of tax incentives you can get from an IRA. This is were the whole Roth vs Traditional comes in. To make this easier let's talk about these two vehicles independently. 

What is a Traditional IRA

A traditional IRA allows you to contribute PRE-tax dollars. This means that you can subtract the amount you contributed to your traditional IRA from your annual income for tax purposes. Going back to our example of the person making $100k a year, if he/she were to contribute $5000 to a traditional IRA it would be as if his/her income was actually $95,000 for tax purposes. Meaning that  Angelina (I'm tiered of using pronouns) would save $1,600 in taxes for the year she made this contribution. That's about 800 tacos. So, whats the catch? You can't touch the money until you turn 59 and a half, unless you want to pay penalties (why not a whole number? Our government is full of geniuses). You are also on the hook when you do finally withdraw the money. This means that when you are 60 and you withdraw that money from your IRA Uncle Sam will sum up all your money from any income source (IRA, pay check, lottery, inheritance) and charge you per the income table above. You are essentially delaying when you pay your taxes. 

Of course there are a million things that could happen, such as the tax brackets changing or you not retiring with as much money as you originally thought you would (usually ending up with a lot less than you originally thought, unless you read my blog often).  Alright before we start talking about strategy or things to take into consideration let's talk about Roth.

What is a Roth IRA?

This is essentially the opposite of the traditional IRA. Instead of paying taxes on your money later you pay taxes on your money now or post-tax dollars. Using post-tax dollars to contribute to a Roth IRA mean that you no longer see that $1,600 tax deduction from investing $5,000 into a Roth IRA with a $100k income. So why would you do it? The answer is Tax Free Withdrawals. Now there are a few more complicated and edge case benefits to Roth IRA's but at the moment we will benefit on the big one. Those $5k dollars invested in your Roth IRA could easily turn into $19,348.42 growing at a 7% rate over 20 years. And you would pay $0 in taxes when you withdraw that money. One is still subject to restrictions such as penalties for early withdrawal like in the traditional IRA. 

Okay but what am I suppose to do?

It all comes down to the following question. Do you think you would pay more taxes now or later? If you are a teenager making minimum wage, chances are you will probably earn more money in the future. This means that you should probably pay the cheaper taxes now (Roth) and when you are in a higher tax bracket in the future withdraw the money tax free. What about the opposite? Let's say you are at the top of your career and you don't think you would ever earn more than you are earning now even after retirement (maybe a sign you did not save enough for retirement, but hey it happens) then you might want to skip out on paying taxes now and you might want to pay them later when you are in a lower tax bracket. 

Let me make a generalization here. If you don't have a good idea of what your earning potential is check out sites like glassdoor.com or payscale.com to see what you could hope to earn one day and take decision based on that. If you plan on being a doctor but you are currently in school waiting tables then you might want to pay your taxes now (Roth) since your taxes are cheaper rather then when you are earning $200k+ and paying 35% in taxes. This example holds true specially for those of us earning less than $9,875 a year since you are not paying any taxes on that money and putting it in a Roth account would mean you NEVER end up paying taxes on that money, which is pretty great. 

If you happen to be in a place in your life where you simply don't know what the future holds you can use the median American house hold income as a guideline (Currently at ~$63,179). If you are under it you might want to pay taxes on it now (Roth) if you are over it maybe take the tax break and go Traditional. 

Becoming financially independent is all about taking a lot of little calculated decisions that will lead you to success.  

Saving hierarchy - Maximize saving vehicles

Saving hierarchy - Maximize saving vehicles

One of the best work experiences I had was when I started working at VMware. They had just recently hired a large number of young talent and the group would often get together after work. One of our favorite activities was getting together to play poker. At first it was just one or two fo us but it quickly turned into a very popular event where we often had to tell people they could watch but the table was full. 

I distinctly remember one of the first times we got together. We started arguing about the rules. Of course, being the professionals, we had all carefully studied the rules meaning that we were all quite opinionated. All in all this was a great group of folks, most of these guys ended up starting their own businesses or climbing up the corporate ladder at their respective companies. 

The point I'm trying to drive is that you have to know the rules in order to win the game. The sad thing is that you don't need to know the rules in order to play. That is when you lose, we used to love those player, easy money.

This is a very similar situation to than the one most people find themselves in, except the game is financial independence and the rules are math and saving vehicles. If you don't know how to take advantage of them, the sad reality is that you wont fare well. 

The government does not do a lot of things right but when it comes to collecting taxes they are the best. You have to pay taxes no matter what (unless you want to go to jail). So when government makes investment vehicles that allow you and I to avoid paying said taxes we should jump at the opportunity. 

Things might get a bit complicated with all the different names and lingos. This is why I put this graphic together in order to help us have a general idea of the different available vehicles ordered from the most beneficial to the least. I personally use this method when it comes to investing my money and I've had great results. 

Starting from the top. If someone offers you free money you take it. Most companies offer an employee match, figure out how much that is and make sure you are taking full advantage of it. This should be your number one priority. There simply does not exist another way to double your savings so quickly. With regards to the Traditional vs Roth question I will be writing a separate post about this since there are so many caveats around it. 

Next up is the HSA. The HSA (Health Savings Plan) is the only savings vehicle that offers triple tax incentives. Money is tax free going in, tax free growth and tax free withdrawn (for qualified reasons). It should also be noted that the HSA can be used for anything after the age of 65 but only for medical expenses before then (reference). Short of getting free money, the HSA is the next best thing. 

We next move to our IRAs. Why would we not go back to the 401k you ask? Well the 401k is defined by your employer. This means that your employer gets to chose what sort of funds will be available for your investments as well as what sort of fees these funds will charge you. In an IRA you still get the tax benefits AND you get greater flexibility on where you can invest your money. The only issue that that IRAs have very small annual investment limit. So once you've maxed out your IRA you should go back to your 401k and max that out as well. 

Now we are getting into the advance topics section of this post. After tax contributions and roll over. Did you know you can invest more than $19k to your 401k? You can invest up to $55k in after tax contributions. After tax contributions have no tax benefit BUT you can automatically roll that money over into a Roth and have it grow tax free (don't ask me why, congress makes the rules)!

I have left educational saving vehicles to the end for several reasons. The first reason is because, in my opinion, one of the best gifts you can give your children is you being financially independent. They will see the benefits in your stress levels and the time you'll have to be able to spend with them. It will also mean that as you get older they would not have to worry about you and your needs and they can focus on their families (I don't want to be a burden). The other major reason why I leave educational vehicles towards the end is because the money gets tied up on educational expenses and life can be a rollercoaster. Lastly, IRA's can be used for educational expenses as well (reference). That fact greatly reduces the appeal of locking money in a coverdell or 529 plan.

It's important to note that all the vehicles we've discussed so far will essentially tie your money up for retirement. If you withdraw before retirement you will be subject to penalties. This is why I included individual investment account on the side. Because you should be investing on an individual account at any point to ensure you do have money for the shorter term. 

Just to bring it all together here is the 2019 tax brackets.  Any of these vehicles mentioned above could save you anywhere between 37-10% in taxes. So get saving.

Becoming financially independent is all about taking a lot of little calculated decisions that will lead you to success.  

Eating as if at a michelin star restaurant without the cost - Thrifty living

Eating as if at a michelin star restaurant without the cost - Thrifty living

Often is the case that articles appear on my news feed talking about how millennials would rather do just about anything except save money. I personally feel attacked when I read such articles because of the blatant generalization the media goes out of its was to write about. 

It should not be a surprise that becoming financially independent does not mean riding in limos, flying first class, going to Michelin star restaurants and partying it up every chance you get. In fact it's quite the opposite. Being rich, or financially independent, is essentially when you have enough money in the bank to so that you can decide what to do with your time instead of being at the mercy of your impulsion and the job you use to finance them.

My attempt at creating Chick Fil A's Chicken Sandwich

A big part of achieving financial independence is trimming out the things/activities that are slowing you down on your path. One of the major culprits standing in our way is spending too much money on going out to eat. Reading a book about the FIRE movement I came a cross an idea that I really liked and I quickly implemented it into my life. The idea was "Learn to cook so well that you don't want to eat anywhere but home". 

Mozzarella stuffed pepperoni Pizza

Cooking is one of those skills that is easy to continue to push to the back burner but once you have it it is awesome to have. The ability to be able to quickly put something together that taste great will not only make you happy but also bring joy to the people around you. Specially if you consider that most restaurants mark up their food 300%.

Breakfast Souffle

What I'm trying to say here, specially with the title, is that you don't need to deprive yourself from the delicacies of life. You just need to learn how to make them yourself and you'll be in for a real treat. Let me give you an example. You go to a nice restaurants let's say Ruth's Chris and you order a nice piece of steak. The website does not have the price but I can guarantee that this plate (with no sides) costs at least $50. But hey we didn't come here to cheap out on the side right? And how about the wine? You have to paid a nice juicy steak with a glass of cabernet sauvignon. All of a sudden the meal for you and your significant other cost nearly $200 including tip.

Home made humus

What if on the other hand you bought yourself a couple of bottles of wine from your local liqueur store. Made some humus or bruschettas as an appetizer while the $25 steaks you purchased from the local butcher were slow cooking in the over while you chat it up with your significant other while drinking some wine. Believe that the steak that you take out of your over and then sear will have been the same if not better than that of Ruth's Chris and you would have spend perhaps a bit more than a quarter of what you did at the restaurant. And arguably had a better time while simultaneously impressing your guest. 

Home made donuts

I'll end with a few thoughts. It's not about being cheap, it's about getting the best out of life without leaving you in financial ruin. If you've eaten out most of your life and this is the first time you'll start cooking it might not be great from the very beginning but as with all things practice makes perfect. The money you would save, specially in your 20s (as described by the Money Guy Show),  is worth at least 80 times that should you invest it. Meaning that making these small changes here and there and saving a buck here an there will set you well on your way towards financial independence. 

Home made meat empanadas

And if nothing else it will give you a great skill that you can share with your friends and family.

Becoming financially independent is all about taking a lot of little calculated decisions that will lead you to success.

Paying down loans multiple times per month?

Should one pay down loans multiple times per month?

Most Americans get paid either bi-weekly or semi-monthly. That means that most people either get paid every 2 weeks or 2 times a month. Why is this important? It is important because of compounding interest. I've yet to discuss compounding interest in this blog but compounding interest can work for you or it can work against you. If we are talking about investments say like to a mutual fund, then compounding is great. If we are talking about student loans, credit cards or mortgages then compounding is working against us. 

When we look at loans we see something called an APY. APY stands for Annual Percentage Yield. This is essentially the interest you would expect from an investment vehicle (savings account, money market account, CD...) if you were to leave your money AND ITS GAINS there for a whole year. Whats actually happening is that each monthly disbursement of interest will be added to the compounding and at the end of the year your principal PLUS the compounding interest through out the year will equal to your APY. 

The magic here is the fact that the money gets compounded daily. Meaning that every single day that your money sits there you are gaining interest. The issues happens when you are on the other side of the equation and you are the one paying the interest. 

As an example imagine that you put $1,000 into a savings account. And you are told that the APY for the savings account is 3%. One would assume then that the monthly rate (since a bank pays and compounds it on a monthly basis). But if you divide 3% by 12 months that is 0.25%. But notice how the monthly rate is actually 0.246%. The reason why the monthly rate is lower than our calculated 0.25% is because the bank is counting on a monthly compounding to make up the difference. When you are the saver then it literally pays to keep your money in the bank. But when you are talking about a loan you don't want it to take advantage of daily compounding. Therefor, if you get paid more than once a month you should be trying to put money towards your loan just as often to minimize the compounding therefore decreasing your own APY.

Implementing this little hack equates to a non trivial amount of money being saved without having to use additional dollars... Just pay them more frequently. To see how much you would save checkout this calculator https://www.mortgagecalculator.org/calcs/biweekly.php

So should we pay down our loan more than once a month? YES! You should pay down your loan the second you have money to do so, don't wait till the end of the month, don't wait for the loan to compound.

Becoming financially independent is all about taking a lot of little calculated decisions that will lead you to success.  

Snowball vs Avalanche - Paying off $100k+

Snowball vs Avalanche - Paying off $100k+

Let's start by defining both strategies and then discuss which one is best for you.

Snowball Method for Paying Off Your Loans

I hope everyone enjoys my amazing graphics. The Snowball approach only take into consideration debt size and nothing else. The strategy involves paying the minimum amount on all other debts except the smallest debt. The smallest debt will become your primary objective and any extra money you have will be thrown at the smallest debt. Once you've finished paying off the smallest debt you will then move on to attacking the next smallest until you pay off all your loans. This is not the most cost effective way to pay back your loans since the Avalanche method, as we will see, in the next section will actually end up costing you less. 

Knowing that the Avalanche method will cost you less money, why are we even discussing the Snowball method? The reason is because a lot of people believe that psychologically this is an approach that will give you quick small wins that will continue to encourage you to keep pay off your debt.  

Let's drive this point home with an example. Let's say that every month you had $1500 left over to distribute among your loans and you had a total of 5 loans of different sizes and interest rates.

As can be seen from the image above each loan has its own minimum payment which is part of the Snowball strategy. You should still be paying those minimum amounts (as depicted by the green boxes on top of each loan) on every loan. The money that remains should be thrown directly towards the loan with the smallest amount (our loans have conveniently been arranged from smallest to largest). This additional payment is the larger green box with the $1,251.55 currently being payed to Loan 4.

As you pay off Loan 4 you then would move all your remaining money to the next smallest loan.

Avalanche Method for Paying Off Your Loans

As was mentioned earlier this method will be the most cost effective and will also allow you to pay off your debts earlier. What it will not give you is that psychological incentive of having paid off a loan very quickly keeping you motivated. If you are the type of person that is less emotional and more calculative then this is really the way to go. If you are the type of person that performance better with instant gratification the snowball method may be best for you. 

For the Avalanche method let's show the same example but notice that the loans are now in different order. The loans are now arranged from highest interest rate to lowest, completely independent from the actual loan amount.   

Other than the order by which we will tackle these loans all the other rules still apply. We will continue to apply minimum payments and apply the rest of our money towards the smallest interest loan.

You can think of the interest rate as the cost of keeping a loan. The higher the interest rate the more expensive the loan will be. The Avalanche method is more cost effective because it gets rid of these loans the fastest. 

As I had mentioned in my +$100k of Student loans post when I graduated from college I have a little over $100k worth of student debt.  I remember writing code in python for me to simulate all the different ways I could attack my loans so that I would pay as little as possible. It turned out that by choosing the pay off my debt using the Avalanche method rather than the Snowball method would save me a few thousands of dollars, so I quickly started doing so. 

Unbury.me has a create calculator on its website that allows you to put your specific situation and it will tell you exactly how much money you would save by going with Avalanche instead of Snowball do check it out. 

It is fascinating to me how financial institutions or even universities don't teach students about these concepts essentially dooming the students to over pay.

Becoming financially independent is all about taking a lot of little calculated decisions that will lead you to success.

Investing or paying off debt?

Investing or paying off debt?

This is an age old question. While some will lead you to believe that the answer is a very simple "As long as you can out earn your debt then yes!" it is actually not that straight forward. This specific scenario is something that I will likely be writing about frequently to ensure folks take smart and calculated decisions when it comes to handling their money.

Let's pose the following scenario. Let's say you had no debt and no investments, would you go to the bank and ask for a loan so that you can start investing in the stock market? If the answer is not an immediate "NO!" then we have other issues. 

The biggest problem with the question of "Should I invest or pay off my debt" is that, from a mathematical perspective (depending on your interests rates), the math might superficially show that if you invest instead of paying back your loans you might come up ahead. But it's not that simple.

Let's look at a quick example. 

Let's say John has a car loan with the details as described above and he has been trying to aggressively pay that loan down. But one day when discussing his plan with a friend (let's call the friend bad@money) John is told that since the stock market earns, on average, 7.5% annually and his car loan is 4.5% he could be making an additional 3% on his investment. Bad@money then suggest that he could then use those gains to pay off the loan even faster.

What is often not discussed is that the 4.5% in the car loan is guaranteed while VOO's (Vanguard's S&O 500 ETF) 7.5% is an average. Meaning that you are taking a risk. I would even call it a double risk one from the accumulating interest on your car loan and the other from the money you would loose in the stock market should the market take a dive for a few years.

Chart Gathered from www.barchart.com

I am a big fan of the stock market, and will discuss trading strategies at greater length in future posts, but using the market as a strategy for pay off debt is never a good idea. Just image the hit you would have received had you made this decision right before the Dot-com bubble in the 2000s or the housing bubble in 2008. Though both time the market rebounded it took roughly around 7 years to get back to its original price you would have bought in at. 7 years being the magic number here because that his longer than your car loan term was. 

To sum it all up. Does it mathematically make more sense to invest rather than to pay-off your loans? NO! There is simply too much risk that is not being taken into consideration when one simply subtracts the loan interest and the expected returns from the VOO. To put it another way, I rather take a % that is guaranteed versus one that fluctuates. 

Becoming financially independent is all about taking a lot of little calculated decisions that will lead you to success.