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It's all about "cost of funds" and "return on investment." If you can earn more with your capital than you pay out in debt, you're getting richer even though you're in debt. So, yes, debt adds to your net worth if you manage debt correctly.
 
It is essentially financial leverage and diversification. But leverage is good only if you do not need to worry about mark-to-market risk or you have a very sustainable cashflow stream to pay the fix cost.



Nonetheless, lower debt balance with higher coupon is better than a higher debt balance with a lower coupon holding all else equal.
 
<p>SCG,</p>

<p>You are confusing net worth and net income. Net worth can only be defined by assets minus liabilities... that's debt, not income. Net income may add to net worth, but debt cannot. Just because you finance 5 homes does not mean you are worth more, it means you owe more.</p>
 
<p>"I'm sorry IPO, I'm wracking my brain and for the life of me can't figure out how debt adds to one's net worth."</p>

<p>Well, let me give you a simple example. Say for instance you can choose to either pay down $500 in extra principle per month, or put $500 in a savings account that yields 4% pre-tax income... You do each of these for 10 years (120 months)...</p>

<p>With option 1, you have $60K less in debt since you have paid down extra principal on your mortgage. Hooray, good for you! Your interest payments have stayed the same as day 1 as most mortgages don't re-amortize when you pay down extra principal.</p>

<p>With option #2, putting that $500 into a simple savings account at only 4% with no preferential tax treatment (the 4% figure is considerably below historical stock market returns) you have $69K at the end of the 10-year period.</p>

<p>Your net worth would be $9K greater by going with option #2 and NOT paying down your mortgage early. You have more debt than you might have had otherwise, but you have even greater assets. Net worth = Assets - Liabilities. </p>

<p>Imagine if your investment vehicle of choice was the stock market and you averaged 8% appreciation over those 10 years? Well, you'd be $20K better off from a net worth perspective. Imagine if your investment vehicle of choice has preferential tax treatment (401k, IRAs, etc.), and earned 6-8% in nominal return as well? The improvement in net worth would be even greater...</p>

<p>Or think of it this way, at the end of year ten, you could pay down your mortgage the same $60K you would have and still have $10K left-over to take a fabulous vacation, buy half a car, pay for a year of state college for your kid, etc.</p>
 
<i>"put $500 in a savings account that yields 4% pre-tax income."</i><p>

<i>"Imagine if your investment vehicle of choice was the stock market and you averaged 8% appreciation over those 10 years?"</i><p>




And if the bank goes bankrupt and you lose the money or you lose money in the stock market?<p>

Have you checked on the FDIC's and FDLIC's reserves lately? I think the FDLIC's went negative a week or so ago.
 
What Ipoplaya is explaining is basically financial leverage. Financial leverage creates wealth if you can get an after tax GUARANTEED RETURN greater than your after tax financing costs. This is the same NPV or FV analysis companies do all the time.



The issue is that the returns are not guaranteed. Yes, returns on average for the stock market has been pretty good but over the last twenty years - interest rates have fallen, risk premium has fallen, and inflation rate has fallen. Do you guys remember 15% type mortgages? Well, with interest rates this low today, it is unlikely that stock market returns will be as great as they were over the last 10 +years...



Please show me where I can get after tax savings rates greater than 4%!! I would like to know where. My marginal tax rate is 30% or so.
 
ipoplaya,





You are forgetting the compounding effect of interest goes both ways. As you pay down your mortgage, the interest charges decline as well. You will have paid off more than 60K on the mortgage because with each additional payment you are paying down even more principal. I just ran a spreadsheet, and if you are paying 6% interest, you will have lowered your mortgage balance by over $80K by making the additional $500 payment, not the $60K you mentioned in your example.





In fact, I would argue your whole idea is totally bogus unless you are making the investment in a tax deferred account where you get to compound the tax savings <em>and </em>you are getting a better return than the interest rate on your mortgage.





Interesting that the CFO and the mortgage broker missed that little detail...
 
<p>I totally agree that you need to be getting a higher return than the interest rate on your mortgage for this to make sense. You're right in that I overlooked the compounding effect that creates accelerated reduction in principal. My 4% example wouldn't work if you were paying 6-7% on your mortgage. Since I am only paying 3.875% right now, 4% was the first round number that worked for me... Personally, I'd rather be slamming more money into my wife's 403(b) and taking the marginal tax savings today vs. reducing my debt load a little quicker. </p>
 
I know about muni bonds. IPO was referring to a savings account or CD.



I just recently bot a boat load of discount muni closed end funds. With an average discount of 10 percent and dividend yield of 5.5 %. Pretty sweet if you ask me. If you want to play it safe just go buy the vanguard CALI muni market find and earn 3% after tax with minimal fees. That is where I out my rainy day money in.
 
I know about muni bonds. IPO was referring to a savings account or CD.



I just recently bot a boat load of discount muni closed end funds. With an average discount of 10 percent and dividend yield of 5.5 %. Pretty sweet if you ask me. If you want to play it safe just go buy the vanguard CALI muni market find and earn 3% after tax with minimal fees. That is where I out my rainy day money in.
 
Not only do you need to beat after tax return, but you must be compensated for risk. And 99 out of 100 people misjudge risk.
 
<< Interesting that the CFO and the mortgage broker missed that little detail... >>



No one ever got fabulously wealthy by paying off debt. :-)
 
<i>"No one ever got fabulously wealthy by paying off debt. :-)"</i><p>


Is this what they say at "No Money Down" seminars? ;-)
 
Okay... the math here disturbs me. Despite the fact of a 4% return being taxed, and the compound calculation equaling about $75k for the $500 a month saved, it is the actual net worth calculations that IR mentioned , that are way off. After 10 years, on a $400k loan, at 6.5% looks more like this...





Home value $500k


Minus $333.5k loan balance


Plus $75k saved


Equals a net worth of $241.5k





Home value $500k


Minus $252.1k loan balance


Equals a net worth of 247.9k





Wow, looks like the extra payment gets you a big $6400. Now, here is where it gets good, after 19 years, the extra payments mean there is no more loan. So, lets fast forward 19 years, and still save or pay an extra $500...





Home value $1mil


Minus $231.7k loan balance


Minus $420.8k interest paid


Plus $186.9 saved


Equals a net worth of $534.4k





Home value $1mil


Minus $304.6k interest paid


Equals a net worth of $695.4k





So... paying debt, not only makes your net worth $161k more, but you have no more mortgage payments. The saver would still have almost eleven more years of mortgage payments, and another $89.7k of interest.


<em>


No one ever got fabulously wealthy by paying off debt. :-)





</em>Nope, but they sure as hell have a larger net worth than those who don't.
 
Well, my goodness, I'm certainly not going to lecture this erudite group on the power of leverage. Why bother--your mind's made up. < teasing >
 
For me personal finance does not equal corporate finance. I'm gonna pay off my mortgage early and enjoy the serenity it brings to know my home is paid for. Will I miss out cuz I didn't play things like Ipo did? Sure...but we're all dead in the end ;)
 
<em>"I'm certainly not going to lecture this erudite group on the power of leverage."</em>





Leverage has tremendous power to magnify returns when the value of the asset being levered is going up; however, it has the same power to magnify losses when values are declining. You do realize that real estate does not always go up, right?
 
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