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Question re: best way to invest "extra cash"
Old 08-10-2011, 10:01 AM   #1
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Question re: best way to invest "extra cash"

...other than to give it to you!

The volatility of the market of late has me concerned so I re-ran some numbers in Firecalc which leads to my question.

The background:
Today we're investing all excess cash into index funds. A subset of the investment is $24k/year which is DCAed in VG on a bi-weekly basis. We also have 3 rentals, all of which have mortgages since we're in a high tax bracket and do not want to pay income tax on the rents received.

My question:
FireCalc says that we will have $5k more to spend per year in retirement if we have one of the rentals paid off in the year we retire (5 years from now). To do this would require channeling the $24k from Vanguard to paying extra on the mortgage (mortgage is 7%).

We paid $125k for the rental and have invested another $10k so we're in it for $135k. Total cash flow once paid off will be $10,392/year which includes the management fee and taxes which is a 7.7% return on our money. ($10392/$135,000 = 7.7%)

So, with a 7.7% return (if I've done the math right??) and with FireCalc saying that we'll have $5,000 more in retirement income than if we put the money into the market, is paying off the mortgage the right thing to do purely from an investment return decision?

My question boils down to: am I looking at the options for excess cash in the right way and are my return calculations being done correctly?

Thank you as always for your guidance.
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Old 08-10-2011, 10:15 AM   #2
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A guy they interviewed on Bloomberg radio this AM says hang on to your cash. If there is significant deflation, your purchasing power will increase. I'm not sure I buy into expecting deflation, but hanging onto cash isn't a bad idea right now. At least I hope it's not.

We have no mortgage on our rental and it generates between 7% and 8%, depending on what the real value is. I don't think we could sell it and get the same return on the proceeds.
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Old 08-10-2011, 10:20 AM   #3
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Originally Posted by 67walkon View Post
A guy they interviewed on Bloomberg radio this AM says hang on to your cash. If there is significant deflation, your purchasing power will increase. I'm not sure I buy into expecting deflation, but hanging onto cash isn't a bad idea right now. At least I hope it's not.

We have no mortgage on our rental and it generates between 7% and 8%, depending on what the real value is. I don't think we could sell it and get the same return on the proceeds.
In addition to our investments we have six months of living expenses in cash so we have plenty since we still work.

Return on proceeds is part of what I'm looking at. 4% SWR on $135k is $5400 vs $10392 net from the rent. Just want to make sure I'm looking at this right.
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Old 08-10-2011, 10:29 AM   #4
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your math seems to be right. Questions that need to be answered....do you need the extra $5k? What are the tax implications of the rental income showing on your tax return as a income given you no longer have the mortgage interest offset?

As for paying down mortgage now on a monthly basis I would say that makes sense given your loan is at 7% and you'll be hard pressed to find that return guaranteed on any other investment.
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Old 08-10-2011, 10:41 AM   #5
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Originally Posted by Lisa99 View Post
My question:
FireCalc says that we will have $5k more to spend per year in retirement if we have one of the rentals paid off in the year we retire (5 years from now). To do this would require channeling the $24k from Vanguard to paying extra on the mortgage (mortgage is 7%).

We paid $125k for the rental and have invested another $10k so we're in it for $135k. Total cash flow once paid off will be $10,392/year which includes the management fee and taxes which is a 7.7% return on our money. ($10392/$135,000 = 7.7%)

So, with a 7.7% return (if I've done the math right??) and with FireCalc saying that we'll have $5,000 more in retirement income than if we put the money into the market, is paying off the mortgage the right thing to do purely from an investment return decision?

My question boils down to: am I looking at the options for excess cash in the right way and are my return calculations being done correctly?
Hi Lisa99. If I understand, you have two options for your extra cash today: invest in index funds or pay down your mortgage. One gives you a guaranteed return of 7% before taxes, less after taxes if the mortgage interest is a deductible cost. If you think you are likely to get a higher after tax return by investing in stocks and can accept the risk, that is the preferred investment. One factor to consider how much of your retirement portfolio is already allocated to each of these assets. If you already have a large equity allocation, more may be too risky. Likewise, if the rental property component is high, you might want to put more cash into equities just to lower the overall risk.

Firecalc is showing you a difference between the two options that is based on return assumptions.
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Old 08-10-2011, 10:42 AM   #6
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On our rentals I use what I think (hope or suspect depending on mood) the property is currently worth when figuring the rate of return. If, for instance, your rental is worth $175K right now that would indicate a 5.9% rate of return vs. the 7.7% on what you have invested. Other times I use the amount I would have left after paying cost of sale and taxes on sale. On a fully depreciated $100k place that might be $75k, so I look to see what other investment I could get for $75k that pays as well as rents. Your 7.7% looks mighty good if that includes the cost of management - we don't do as well.

We've always liked paying debt down, though we did take out a mortgage on our house @3.875% that I'm resisting paying down, and I do notice the increased monthly cash, so can see the attraction in carrying a loan balance. OTOH, we have money loaned out at 10-12%, so that helps our decision.
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Old 08-10-2011, 10:45 AM   #7
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Originally Posted by RockyMtn View Post
your math seems to be right. Questions that need to be answered....do you need the extra $5k? What are the tax implications of the rental income showing on your tax return as a income given you no longer have the mortgage interest offset?

As for paying down mortgage now on a monthly basis I would say that makes sense given your loan is at 7% and you'll be hard pressed to find that return guaranteed on any other investment.
We plan extensive travel in the first stages of retirement so any extra money is good.
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Old 08-10-2011, 10:56 AM   #8
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One factor to consider how much of your retirement portfolio is already allocated to each of these assets. If you already have a large equity allocation, more may be too risky. Likewise, if the rental property component is high, you might want to put more cash into equities just to lower the overall risk.
Our AA is 60/40 but right now we don't include the real estate in that number. We hadn't included because we were considering liquidating within the next 1 -2 years but all three properties are in Texas communities that are appreciating so we are considering keeping them.

I will rerun the allocations to include the real estate but we have sufficient market investments that it won't change the AA numbers by much.
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Old 08-10-2011, 11:02 AM   #9
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Originally Posted by Lisa99 View Post
...other than to give it to you!

The volatility of the market of late has me concerned so I re-ran some numbers in Firecalc which leads to my question.

The background:
Today we're investing all excess cash into index funds. A subset of the investment is $24k/year which is DCAed in VG on a bi-weekly basis. We also have 3 rentals, all of which have mortgages since we're in a high tax bracket and do not want to pay income tax on the rents received.

My question:
FireCalc says that we will have $5k more to spend per year in retirement if we have one of the rentals paid off in the year we retire (5 years from now). To do this would require channeling the $24k from Vanguard to paying extra on the mortgage (mortgage is 7%).

We paid $125k for the rental and have invested another $10k so we're in it for $135k. Total cash flow once paid off will be $10,392/year which includes the management fee and taxes which is a 7.7% return on our money. ($10392/$135,000 = 7.7%)

So, with a 7.7% return (if I've done the math right??) and with FireCalc saying that we'll have $5,000 more in retirement income than if we put the money into the market, is paying off the mortgage the right thing to do purely from an investment return decision?

My question boils down to: am I looking at the options for excess cash in the right way and are my return calculations being done correctly?

Thank you as always for your guidance.
Lisa99...if someone hasn't already said this....why not refinance that 7% mortgage? 30 year fixed is at 4.2% at this time and 5/5 ARMS can be had somewhere in the 3%+ range. If you plan to pay it off in 5 years...the 5/5 ARM is cheap money. I'll be looking at this 5/5 ARM if we buy the 2nd home as I plan to have it paid off in 5 years. It means the rate is fixed for 5 years...and can not go up more than 2% and never more than 10% over the life of the loan. The key is when you expect to pay it off. 3% money for 5 years..is pretty good.

At a 7% mortgage, it might make sense to pay off the mortgage as ...not sure where to get 7% yields in the stock market anymore. At 3ish % on your mortgage, it might make more sense to keep your cash...IMHO.
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Old 08-10-2011, 11:05 AM   #10
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Originally Posted by Lisa99 View Post
Our AA is 60/40 but right now we don't include the real estate in that number. We hadn't included because we were considering liquidating within the next 1 -2 years but all three properties are in Texas communities that are appreciating so we are considering keeping them.

I will rerun the allocations to include the real estate but we have sufficient market investments that it won't change the AA numbers by much.
From your description it sounds like part of your portfolio, just one that is illiquid.

One thing that is difficult to value but still important is risk. Mortgaged rental property means there is the risk of no rental income but still the need for cash to make the payments. Reducing this debt lowers the risk but is not part of the return analysis.
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Old 08-10-2011, 11:16 AM   #11
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Originally Posted by Lisa99 View Post
Return on proceeds is part of what I'm looking at. 4% SWR on $135k is $5400 vs $10392 net from the rent. Just want to make sure I'm looking at this right.
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your math seems to be right.
The math (well, application of the math) actually might need a bit of tweaking.

Remember that the 4% SWR number adjusts for inflation each year. A non-inflation adjusted number is 'worth' about half as much over a 30-40 year retirement.

Now, if you think rents/returns will rise with inflation, then it's more apples-to-apples.

Secondly, I don't think you are framing the 'investment return' properly for a 'pay off the debt' question. The way you frame it is asking ' should we invest in real estate or our AA? (7.7% real(?) versus 4% real)'. But... if the question is pay off the debt or not, then look at the cost of borrowing money versus the expected portfolio real return. It is two separate questions, it seems to me.

OK, re-read your OP and I see the mortgage interest rate is 7% fixed (I lost that in the other '7' numbers). You still need to compare that (fixed, after-tax) to 4% real (after-tax). 7% is not great, I don't know if you could do better with a re-fi in these low interest (but tight credit) conditions? And consider liquidity.

-ERD50
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Old 08-10-2011, 11:36 AM   #12
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We plan extensive travel in the first stages of retirement...
Why are you waiting?
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Old 08-10-2011, 11:39 AM   #13
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Thanks for everyone's input. A couple of people have asked if we can refinance to a lower rate.

The mortgage is specifically for an 'investment property'. We might could get a slightly lower rate but it wouldn't be low enough to make refi worth it.
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Old 08-10-2011, 11:41 AM   #14
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Why are you waiting?
We travel a lot now. Have done about 15 cruises, been to Russia, all over Europe and will be in Panama in November and China next March...so I should have said "we will continue to travel extensively in retirement."
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Old 08-10-2011, 11:45 AM   #15
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Why are you waiting?
Yesterday I found out that a couple that has a local appliance store both died in a car crash on Sunday. These are folks I spoke with now and again and that were doing the same sort of rental real estate thing as us for the last 15-20 years or so. Boom. Gone. Makes watching the Portfolio Manager on M* or scheming interest points feel kind of silly.
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Old 08-10-2011, 11:46 AM   #16
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We travel a lot now. Have done about 15 cruises, been to Russia, all over Europe and will be in Panama in November and China next March...so I should have said "we will continue to travel extensively in retirement."
OK, I understand.

We did the same in our accumulation years and continue to do so in my (DW could be any day) retirement.

Travel is too important (IMHO) to wait till sometime in the future, when your health (and finances) may not be as good as you planned for.
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Old 08-10-2011, 11:47 AM   #17
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The math (well, application of the math) actually might need a bit of tweaking.

Remember that the 4% SWR number adjusts for inflation each year. A non-inflation adjusted number is 'worth' about half as much over a 30-40 year retirement.

Now, if you think rents/returns will rise with inflation, then it's more apples-to-apples.

Secondly, I don't think you are framing the 'investment return' properly for a 'pay off the debt' question. The way you frame it is asking ' should we invest in real estate or our AA? (7.7% real(?) versus 4% real)'. But... if the question is pay off the debt or not, then look at the cost of borrowing money versus the expected portfolio real return. It is two separate questions, it seems to me.

OK, re-read your OP and I see the mortgage interest rate is 7% fixed (I lost that in the other '7' numbers). You still need to compare that (fixed, after-tax) to 4% real (after-tax). 7% is not great, I don't know if you could do better with a re-fi in these low interest (but tight credit) conditions? And consider liquidity.

-ERD50
Rents in the area go up about $50/year so at current rentals that's about 3.86%/year.

Understand now from a couple of responses that part of what I should be looking at is can I do better than 7% in the market. Right now I think the answer is no.

Even with that answer we'll still be putting about $100k a year into the market via maxing 401ks and selling ESPP and RSUs as they mature, but that extra $24k will probably shift over to paying off the mortgage.
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Old 08-10-2011, 12:09 PM   #18
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Thanks for everyone's input. A couple of people have asked if we can refinance to a lower rate.

The mortgage is specifically for an 'investment property'. We might could get a slightly lower rate but it wouldn't be low enough to make refi worth it.
In my first post, I had forgotten "investment property" rates might be a bit higher...but it still may be worth a couple of call because I don't think they are at 7%...(but I could also be wrong since i haven't checked these rates).
You could satisfy yourself..that you are making the right decision. In these times...it could be one year you put extra $$ against the mortgage and another against your AA.
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Old 08-10-2011, 12:11 PM   #19
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Yesterday I found out that a couple that has a local appliance store both died in a car crash on Sunday. These are folks I spoke with now and again and that were doing the same sort of rental real estate thing as us for the last 15-20 years or so. Boom. Gone. Makes watching the Portfolio Manager on M* or scheming interest points feel kind of silly.
This really puts things into perspective calmloki. So sad...
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Old 08-10-2011, 02:31 PM   #20
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In my first post, I had forgotten "investment property" rates might be a bit higher...but it still may be worth a couple of call because I don't think they are at 7%...(but I could also be wrong since i haven't checked these rates).
You could satisfy yourself..that you are making the right decision. In these times...it could be one year you put extra $$ against the mortgage and another against your AA.

We took out a loan on our home to pay off a loan on some apartments - money owed is money owed, think that's a part of money being fungible. Back then the interest on the apartments was 9% and after a few refis we are at 3.875% on our home.
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