Is FANG overvalued?

28 Jun

Is FANG Overvalued?

Question:  The hot stock combo right now is FANG (Facebook, Amazon, Netflix and Google.)   What is the PE ratio of a portfolio equally weighted in these four stocks?

Provide an opinion about whether future earnings of prospects for FANG justify this valuation?

Calculation of the FANG PE ratio:

All FANG stocks have positive earning and positive PE ratios so it is appropriate to average PE ratios of the four stocks to obtain the PE ratio for the portfolio.  (I use a weight of 0.250 for each stock and SUMPRODUCT weight vector with PE ratio vector)

PE ratio Dividend EPS Price
Facebook 38.29 0 3.93 150.58
Amazon 183.95 0 5.31 976.78
Netflix 195.38 0 0.77 151.03
Google 31.34 0 29.59 927.33
FANG 112.24

This gives me a PE ratio of 112.24 for FANG.

It is instructive to compare the recent growth of EPS and stock price for the FANG companies

Comparison of growth of EPS and stock price for FANG Stocks
6/29/16 3/30/17 % Change
FB EPS 0.97 1.04 7.2%
Price 114.28 142.05 24.3%
AMZN EPS 1.78 1.48 -16.9%
Price 725.68 886.54 22.2%
NFLIX EPS 0.09 0.4 344.4%
Price 96.67 147.8 52.9%
GOOG EPS 8.42 7.73 -8.2%
Price 699.2 829.56 18.6%

Some Observations:

In three of the four companies the growth of stock prices exceeded the growth of earnings per share.

In two of the four companies, earnings fell while the stock prices rose.

In Netflix, the one company where EPS growth exceeded stock price, the initial period stock price was near zero.   The initial low level of earnings is why the PE ratio of Netflix is going down.   When earnings are near zero the PE ratio can be astronomic.

Concluding thoughts:  Basically FANG stock price is rising because of expectations of future growth not concrete earnings growth.   The one exception Netflix is because of really low earnings in a base period.    Netflix has done a great job but it is in a competitive industry and unlike the other three companies has no monopoly power.

These four companies will face challenges going forward.   The PE of Amazon seems especially high because there is going to be a lot of competition in the cloud sector a lot of costs integrating Whole foods and low margins in the on-line grocery business.

Investors who own FANG should consider taking some profits.

Featured Policy Blog Post:

I have created a list of 11 pragmatic progressive education policies.   These posts will be part of a book on economically feasible policies that might improve the world.   Here is a link to this important work.





Are Tech Stocks Overvalued?

28 May

Are Tech Stocks Overvalued?

Issue:   Professor Jeremy Siegel maintains that the stock market and tech stocks are still fairly value.

He supports this argument with the observation that the PE ratio of Tech stocks in the S&P 500 is still under 20.

What are the limitations of using the PE ratio for a basket of stocks to measure the valuation of the portfolio when some stocks in the portfolio have negative earnings?

Does an analysis of the PE ratios of the stocks in the Vanguard Information Technology ETF support or contradict Professor Siegel’s view on the valuation of Tech stocks?

Is Professor Siegel correct in his assertion that tech stocks are valued correctly?

Discussion of ETF PE Ratios: 

Professor Siegel pointing to a PE ratio for a basket of tech stocks in the S&P 500 has argued that the sector is valued fairly.   My problem with this argument is that published statistics on ETF PE ratios often fail to accurately include information on firms with negative earnings.

Firms with negative earnings have negative PE ratios.  These firms often have a lot in common with high PE firms.   Often startups have negative or low earnings.   If earnings are negative the PE is negative.  If earnings are slightly positive the PE is large.

It would be incorrect to average negative PE firms with positive PE firm because the result would be to reduce the PE of the portfolio even though the negative PE firms have high valuations compared to their income.     Some web sites including yahoo finance report and include negative PE ratios.   Most analysts omit negative PE ratios from their calculation of the portfolio PE.   However, this procedure will also understate valuation relative to income because firms with negative PE ratios have high valuation compared to earnings.

PE ratios have no clear economic interpretation when earnings are negative.  When earnings are slightly below zero (a small loss) the PE ratio is a very large negative number.   When a company has a larger loss the PE ratio is a smaller negative number.

Why PE ratios make no sense for firms

 with negative earnings

Earnings per share

Price per share PE ratio


3.00 (30.00)
(5.50) 3.00


In short, PE ratios incorrectly rank firm valuation when earnings are negative.

It would be incorrect to average negative PE firms with positive PE firm because the result would be to reduce the PE of the portfolio even though the negative PE firms have high valuations compared to their income.     Some web sites including yahoo finance report and include negative PE ratios.

Most analysts omit negative PE ratios from their calculation of the portfolio PE.   However, this procedure will also understate valuation relative to income because the firm with a negative PE ratio has a high valuation compared to earnings.

I am not the first to write about the problem of measuring ETF PE ratios.  Here are some additional resources.

Why ETF Price/Earning Ratios Lie.

Understanding Negative PE Ratios for ETFs

Data used in this study:

I obtained a list of stocks in the VGT mutual funds from Zachs guide at the link below.

Vanguard Technology Fund VGT has a total of 356 firms.  This study examined the PE ratios of all firms where the equity investment was greater than or equal to 0.1 percent of the value of the VGT portfolio.     There were 109 such firms.

Results:   The frequency distribution of dollar share values invested and number of firms for five PE categories – less than zero, 0 to 15, 15 to 30, 30 to 40 and over 40 – are presented below.


   Shares of Firms in VGT by PE category

PE Category

Dollar Share Invested by PE Category

Percent of Companies

<0 6.31 17.43
0-15 5.74 6.42
15-30 36.19 34.86
30-40 31.16 12.84
40< 13.12 28.44
Total 92.52 100

Sample consists firms in VGT where the equity position was greater than or equal to 0.1 percent of the total value of the VGT portfolio.   There were 109 firms meeting this criterion.   These 109 firms represent 92.5 percent of the value of the VGT Portfolio.


Around 6.3 percent of dollars invested in the 109 positions of VGT are in firms with negative earnings.  Around 17.4 percent of the 109 firms had negative earnings.

Over 13 percent of dollars invested in the 109 VGT positions had PE ratios over 40.   Over 128 percent of the firms in this group had a PE ratio over 40.


 What can we conclude about the question of whether tech stocks are overvalued after examining the distribution of stocks in VGT?

The large number of tech stocks with high PE ratios or worse yet negative earnings is consistent with a bubble.   Perhaps the bubble is in the early stages and some people can buy, sell, and make money before the crash.   However, there are a lot of overtly optimistic analysts and a lot of inaccurate or misleading information out there.

This is not going to end well.





Comparing 15-year and 30-year Mortgages

25 Jan

Question One: A person is considering taking out a $180,000 mortgage and must choose between a 15-year FRM and a 30-year FRM.   The interest rate on the 15-year mortgage is 2.90 while the interest rate on the 30-year mortgage is 3.40.

What are the monthly payments on the two loans?

What are the total interest payments on the two loans over the life of the loan?

What is the after-tax cost of the interest payments on the two loans?

What is the tax savings from the tax deductibility of mortgage interest?

What is remaining loan balance after 15 years for the two loans?

Answer: The monthly mortgage payment calculation is directly calculated from the PMT function in Excel.  The variables inputted into the PMT function are the interest rate, the term and the loan balance.

The lifetime interest cost is calculated two ways.   The first way involves noting that the difference between total payments and the repaid loan balance is equal to interest payments. (180* $1234-$180,000) =$42,193.

The second way involves calculating cumulative interest payments directly from the CUMIPMT function in Excel. Put Rate=0.029/12, NPER=180, PV=$180,000 STARTPERIOD=1, ENDPERIOD=180, and Type=0 into CUMIPMT and get $42,193.)

The after tax cost of interest payments is (1-MTR) x INTEREST.

The tax savings from interest payments is MTR x INTEREST

The mortgage balance after 15 years is obtained directly from the FV function in Excel. Note FV (RATE=0.029/12,NPER=180, PMT=-1234,PV-180000) is equal to $0. This is a good way to check your work since the balance on a 15-year mortgage held for 15 years must be $0.

The complete answers are laid out in the table below.

A Comparison of 15-year and 30-year FRM
15-year FRM 30-year FRM Notes
Rate 0.029 0.034 Assumption
Period 180 360 Assumption
Loan $180,000 $180,000 Assumption
Payment -$1,234 -$798 Calculation From Payment Function
Interest Cost Calculation One $42,193 $107,376 Calculation: Total Payments – Loan Balance
Interest Cost Calculation Two $42,193 $107,376 Calculation From CUMIPT Function
Marginal Tax Rate 0.3 0.3 Assumption
After Tax Interest Cost $29,535 $75,163 Calculation: (1-mtr)*Interest Cost
Tax Savings from Mortgage Deductibility $12,658.05 $32,212.75 Tax Savings from Mortgage Deduction
Mortgage Balance After Fifteen Years $0 -$112,435 Calculation: From FV Function
Total Mortgage Payments Over 15 Years -$222,193 -$143,688 Calculation 180*MONTHLY MORTGAGE PAYMENT

Discussion of Comparison of 15-year and 30-Year FRM:

  • Over a 15-year period the homeowner with the 30-year FRM has accumulated $112,435 less house equity than the homeowner with the 15-year FRM.
  • Over the 15-year period, the homeowner with the 15-year mortgage has paid over $78,000 more in mortgage payments than the homeowner with the 30-year mortgage. However, the owner with the 30-year mortgage is not done yet.
  • The additional tax savings from the use of the 30-year FRM is around $20,000.


Authors Note:   People interested in what will happen to the Affordable Care Act under Trump should go to my health care blog on the topic.

Here is a post on Senator Paul’s health care plan.

My own outline of potential modifications to the ACA will be presented shortly.



Increases in Undergraduate Debt 2003/2004 to 2011/2012

10 Jan

Increases in Undergraduate Debt 2003/2004 to 2011/2012


My holiday visit with in-laws included less discussion of politics this year for obvious reasons but I did have a brief discussion on student debt with one relative.   His view of the issue is that since his generation paid for their college no additional cost subsidies are needed. My concern is that the recent increases in costs are having substantial adverse impacts on the current cohort of students.


I am planning several more posts on college costs and their economic and impacts.   This post looks at the trend growth of student debt between the 2003/2004 and the 2011/2012 academic years.


The Data: The source of data for this study is the NSPAS database. I was able to access the data from the NCES Power Statistics Portal.


My variable of interest in this post is cumulative amount borrowed in the undergraduate years by people receiving a bachelor’s degree at four-year institutions.   I have presented separate tables for private and public four-year institutions.
Three statistics are presented – Average debt for borrowers, the percent of students who borrowed, and the percent of students who borrowed more than $25,000.


The data does not include information on borrowing by parents through the PLUS program.


Statistical Results:


The statistics describing change in cumulative student debt are presented in the table below.


Cumulative Under Graduate Student Debt at Four-Year Institutions

2004 to 2012

Bachelors Degree Four-Year Public
2003/2004 2011/2012 Diff. % Diff.
Average Debt for Borrowers $11,958 $18,845 $6,887 57.6%
% of Students who Borrowed 56.6 63.5 6.9 12.1%
% of Students with debt greater than $25,000 5.3 16.9 11.6 218.7%
Bachelors Degree Four-Year Private
2003/2004 2011/2012 Difference % Diff
Average Debt for Borrowers 14,536 22,962 $8,426 58.0%
% of Students who Borrowed 66.9 69.1 2.2 3.3%
% of Students with debt greater than $25,000 9.6 22.9 13.3 138.0%
Both Public and Private Four-Year Programs
Average Debt for Borrowers 12,876 20,163 $7,287 56.6%
% of Students who Borrowed 60.8 65.2 4.4 7.2%
% of Students with debt greater than $25,000 6.8 18.7 11.9 176.4%



Summary of Statistical Results:


The growth of cumulative student debt among people receiving a bachelor’s degree from a four-year institution was tremendous during this brief eight-year period.



Total debt incurred by student borrowers receiving a bachelor’s degree rose by around 57% over this eight year period.


The proportion of undergraduate bachelor degree students incurring debt rose by 6.9 percentage points at public institutions and 2.2 percentage points at private institutions.


The proportion of undergraduate bachelor degree students incurring more than $25,000 in debt went from 5.3% to 16.9 percent for students at public schools and from 9.6 percent to 22.9 percent for students at private institutions.


Other Student Debt Trends


These issues will be addressed in future posts.


The expansion of PLUS loans to parents:


Increases in the use of private debt:


Changes in debt incurred by graduate students:


Changes in the number of students with excessive levels of student debt:



Economic Financial and Social Implications:



Economic issues related to the increase in student debt include – (1) A decision by many young people to live with parents and delays in starting a family, (2) a decision to delay home purchases, (3) the choice between a 30-year and 15-year mortgage, and (4) a decision to delay placing funds in a 401(k) plan.


Many older financial experts do not agree with the decision by many in the current generation to delay home purchases and delay saving for retirement.


My view is that the older generation is not in fully touch with the economic realities facing many in the millennial generation from the explosion in student debt occurring over a mere eight years.


I am planning a lot more empirical work on this issue.




Some of my previous work examines proposal to provide financial relief to some debtors who get over their head in debt. Here are some examples:



Seven Ways to Provide Debt Relief:


Is IBR the best way to provide student loan debt relief:



In addition, I have a short book on Kindle on managing debt and the impact of debt on lifetime savings.


The Nine Essays on Debt and Your Retirement:


Essay Nine: Retire Mortgage Debt or Accumulate in Your 401(k) Plan?

9 Oct

Essay Nine: Mortgage Debt and 401(k)

Assets in Retirement

Increasingly, many Americans nearing the end of their work life find they have a large mortgage and must choose between paying off the mortgage or contributing more funds to their 401(k) plan. A large number of financial advisors advise their clients to increase 401(k) contributions rather than pay off their mortgage.

My view is that it is essential for people nearing retirement to eliminate their mortgage debt even if this goal requires some reduction in 401(k) contributions.   I have two reasons for this view.   First, as noted and explained in the previous section 401(k) plans are not capable of mitigating the impact of market down turns at the end of a career or during retirement.   Intuitively, a person with no debt is much better able to withstand market downturns than a person with a mortgage.   The Wall Street analysts always say don’t sell on a panic the market will come back.   Well retirees with a large mortgage often have no choice but to sell.

Second, the financial risk considerations interact with another factor, the tax treatment of 401(k) plans. During working years mortgage interest and 401(k) contributions reduce income tax burdens.   During retirement a person with a large mortgage payment and most financial assets inside a 401(k) plan will pay more in tax than a person without a mortgage.

All disbursements from a 401(k) plan are fully taxed at the ordinary income tax rate.   A person with no mortgage disburses enough to cover discretionary expenses and taxes   A person with a mortgage must disburse enough to cover discretionary expenses, the mortgage and taxes.

The disbursement to cover the mortgage leads to additional taxes because all disbursement from the 401(k) plan is taxed. MOREOVER, THE DISBURSEMENT ON FUNDS USED TO COVER THE TAX ON THE 401(K) DISBURSEMENT IS ALSO TAXED.

Part of Social Security is taxed for people with income over a certain threshold. A quick way to find out if part of Social Security benefit is taxable is to compare your income to the threshold for your filing status — $25,000 for filing status single and $32,000 for filing status married.

Higher disbursements from the 401(k) plan can increase your adjusted gross income beyond the threshold and increase the amount of the Social Security benefit subject to tax.   Of course any 401(k) disbursement used to pay the income tax is also taxed.

So let’s take a household with all financial assets in their 401(k) plan with a $30,000 annual mortgage.   This monthly mortgage is $2,500, not huge.   Let’s assume that the person has to pay around $1,000 more in tax on Social Security benefits because of the additional disbursement to pay down the mortgage. A first order approximation of the amount of additional tax needed because of the additional $31,000 disbursement is $31,000 x the marginal tax rate for the taxpayer.   For most filers the marginal tax rate would be around 25 percent in 2014.

So the taxpayer with the mortgage and the additional tax burden because of the additional 401(k) disbursement will probably disburse $39,000 more per year from their 401(k) plan.

This analysis puts a whole new wrinkle on the question how much money does one have to save in their 401(k) to have a secure retirement.   The answer is much more if you have not paid off your mortgage.

Note that the disbursement to cover the unpaid mortgage must occur whether the market falls or rises.

Many people who choose to add to their 401(k) plan rather than pay off their mortgage prior to retirement are going to have sell their home and downsize. Downsizing may make sense but most people don’t want to downsize until they are fairly old.

Some people who end up selling their home may choose to rent rather than buy a new home.   The main risk of choosing to rent throughout retirement is that home prices and rents may rise.   This exacerbates longevity risk.

Downsizing should be a choice not an outcome from a failed financial plan or worse the result of financial advisors putting their interests over your interests

Concluding thoughts on mortgage debt in retirement: An increasing number of households are retiring prior to their mortgage being entirely paid off. Surprisingly, the existence of a mortgage in retirement is often consistent with a financial plan developed by a financial planner.   Many financial analysts and planners advise their clients to increase savings in their 401(k) plan rather than retire their mortgage.

These financial planners are not being upfront with their clients.   Retirees with mortgage debt and all or most financial assets in a 401(k) plan are at the whim of the market and have a substantial tax obligation.   The advice that put people in this position is in my view a form of malpractice.

Appendix to Essay on Mortgage Debt and 401(k) Assets in Retirement

The issue of whether to pay off a mortgage or contribute to a 401(k) plan for an older worker is related to the issue of mortgage choice, especially for older homebuyers.   The following question addresses the interaction between mortgage choice and 401(k) investment strategy for an older worker.

Question:   A 50 year-old person is buying a house and must choose between a 15-year mortgage and a 30-year mortgage.   The mortgage choice will impact how much money the person can contribute to his or her 401(k) plan.

The person makes $80,000 per year. The initial mortgage balance is $400,000.   The person’s 401(k) balance at age 50 is $200,000. The 30-year FRM rate is 3.9 percent and the 15-year FRM rate is 3.1 percent.

Discuss the advantages and disadvantages of two strategies (1) taking the 30-year FRM and investing 15% of salary in the 401(k) plan and (2) taking the 15-year FRM and investing 5% of salary in the 401(k) plan.


Let’s start with a reiteration of mortgage choice issues a subject previously broached in essay four.

Observations and Thoughts on Mortgage Choice Issues:

  • The monthly payment on the 30-year FRM is nearly $900 less than the monthly payment on the 15-year FRM. The higher mortgage payment on the 15-year FRM will all else equal require the person who chooses the 15-year FRM to make a smaller 401(k) contribution than the person who chooses the 30-year FRM.
  • After 15 years the 15-year FRM is completely paid off.   The remaining loan balance on the 15-year FRM is around $257,000.
  • Note that gains from the quicker pay down on the 15-year mortgage are not dependent on market fluctuations.   The gain from debt reduction occurs regardless of whether the market is up or down and regardless of when bear or bull makers occur.
Analysis of 15-Year Versus 30-Year FRM
  30-Year 15-Year
Mortgage 0.039 0.031
Term 360 180
Loan Balance 400000 400000
Payment -$1,886 -$2,781
Future Value $256,799 $0.00


Observations and Thoughts on Two 401(k) Contribution Strategies:

As noted in essay eight, the final 401(k) balance after 15 years depends on both the rate of return of the market and the sequence of the returns in the market.   Outcomes are presented for two market scenarios.   The first involves 7% returns for the entire 15-year period.   The second involves 7% returns for 10 years followed by -4% returns for 5 years.

  • The difference in the final 401(k) balances (high contribution minus low contribution) under the 15-year bull market scenario is around $211,000.
  • The difference in the final 401(k) balance (high contribution minus low contribution) under the 10-year bull and 5-year bear scenario is around $131,000
Analysis of Different 401(K) Contribution Strategies
5% Contribution Rate 15% Contribution Rate Difference
7.0% Return for 15 Years $675,442 $886,752 $211,309
7.0% Return for 10 years followed by -4.0% return for 5 years $394,339 $525,090 $130,751

The initial balance in the 401(k) plan for both scenarios is $200,000.


Additional insights on the tradeoff between 401(k) contributions and mortgage retirement:


  • The 30-year mortgage/high 401(k) contribution strategy results in major tax savings during working years compare to the 15-year mortgage/low 401(k) strategy.   All mortgage interest is tax deductible and the 401(k) contribution is not taxed.
  • The 15-year mortgage/low 401(k) contribution strategy results in major tax savings during retirement compared to the 30-year mortgage/high 401(k) strategy.   The previous example in this section demonstrated exposures for the person with mortgage debt in retirement when the person is dependent on 401(k) disbursements.   Remember all disbursements from a conventional 401(k) plan including disbursement used to pay the mortgage and disbursements used to pay taxes are fully taxed at ordinary income rates.   By contrast, the money gained from paying off the mortgage and most capital gains on owner-occupied real estate is not taxed.
  • Financial risks associated with a bull market persist through retirement as long as the saver allocates 401(k) assets into equity.


All nine essays on debt and your retirement can be purchased at Kindle, Ibooks or Nook.

The description of nine essays is at the post below.


Nine Essays on Debt and Your Retirement

5 Oct

My book nine essay on debt and retirement is now available on Kindle, Ibooks, and Nook.   The introduction to this book is presented below. 


Most financial advisors, bankers and realtors that you will interact with during your life time stress the importance of asset purchases and are generally oblivious to issues pertaining to controlling the amount you borrow and will ultimately repay to your creditors. Financial firms want you to contribute to your 401(k) plan as soon as you get out of school, even if you have extensive credit card or student debt and lack a basic fund for emergencies.   Realtors and bankers want you to buy a house with a 30-year mortgage, (assuming you qualify for the mortgage) even if you have credit card debt and student loans and even if it is highly likely that you will have to relocate within a decade.

Realtors and bankers will never advise you to delay purchasing a home until the student loan is paid down or to delay a home purchase until you can qualify with a 15-year rather than a 30-year mortgage. Realtors and bankers will never tell you to stay in your current home for a few more years in order to build up equity for the second home.

Financial advisors and brokers will seldom if ever recommend that you reduce your contributions to a 401(k) plan in order to more quickly pay off credit card debt, obtain a 15-year mortgage instead of a 30-year mortgage, more quickly eliminate student loans or use funds to reduce debt and improve your credit score. Realtors, bankers, financial advisors and brokers are united in their view that the best ways to reduce taxes is to leverage yourself up with a big mortgage and plow a lot of money into your 401(k) plan and if you have extra left over buy stocks. However, delaying loan repayments in order to fund a 401(k) can lead to higher interest rates and hundreds of thousands in additional debt payments over the course of a lifetime.

In past generations, it has not been unusual for a person or a household to buy 3 or more houses during their lifetime.   Typically, each house was purchased with a 30-year mortgage.   Often the house would be sold or the mortgage refinanced in 5 to10 years.    As a result, many workers nearing retirement have a substantial mortgage. Interestingly, many financial advisors advocate 401(k) accumulation over mortgage reduction for older workers.

A financial formula that leads to match of a risky 401(k) asset filled with equities and a mortgage debt at retirement is not a viable strategy.  The value of the 401(k) plan fluctuates with the market.   The retiree with a mortgage and a 401(k) plan must make additional disbursements to cover both the mortgage and the tax on the additional disbursement.  Most individuals with substantial mortgage debt in retirement will have to sell their home and downsize if most of their financial assets are in 401(k) plans, even if returns on assets in the 401(k) plan are reasonably high.

Estimates of the proportion of workers who will likely have inadequate retirement income will range from 50 percent to 70 percent. Some articles on the adequacy of retirement income:

The financial plan used by the baby boom generation has failed. Moreover, financial challenges are even more daunting for the new generation of workers.

  • First, the current generation starts their career with substantially more debt than previous generations.  The average student loan for all age groups has gone from around $15,000 in 2005 to around $29,000 in 2015.

  • Second, the current generation is having a slow start to their career.   Labor force participation has been down and unemployment up for the younger cohort of workers, especially during and after the last recession. It is possible that older workers remaining in the workforce have displaced younger workers.   Also, it appears likely that the new cohort of workers are more likely to switch jobs more frequently during their career.
  • Third, the current generation lacks secure defined benefit plans and is even more heavily dependent on 401(k) plans and IRAs, which fluctuate in value with the market. The percent of workers who have a defined benefit plan that provides annuity income at retirement has fallen from around 38 percent in 1980 to around 20 percent in 2008.

The view espoused and outlined in the essays published here is that debt management will have a more important impact on your financial security and your retirement than asset acquisition.   The advice obtained from the interdependent essays in this book differs from the advice that you will get from your realtor, broker or mortgage lender.

The first essay describes and critiques a rent versus buy calculator displayed at the web site   The calculator uses input on house and renting costs and taxes to calculate the number of years it would take for a house purchase to be less expensive than renting.   The model is useful but has several limitations. First, the model assumes constant house appreciation and does not measure the risk or variability associated with this forecast. Second, the user of the model needs to consider the likelihood that he or she will have to move prior to recouping their investment. Third, the model does not allow the user to consider advantages associated with delaying a house purchase in order to repay student loans and credit card debt.

The second and third essays examine the impact of student debt and credit card debt on the ability of a person to qualify for a mortgage and estimated costs incurred when borrowers restructure student debt in order to qualify for a mortgage. The example in the second essay involves a person with a very large student loan. The example in the third essay involves a person with a substantial student loan and additional credit card debt. The essays consider the costs and benefits associated with increasing the maturity of the student loan from 10 years to 20 years in order to purchase a home.  We also consider the potential advantages of more rapid debt reduction even if this goal requires a delay in the home purchase or a reduction in 401(k) contributions.

An appendix to the second essay provides a description and assessment of the Income Based Replacement (IBR).   The IBR program allows eligible borrowers to link student loan payments to household income and provides for the eventual forgiveness of student loans.

The fourth essay provides background information on the choice between the 15-year FRM and a 30-year FRM.   There are advantages and disadvantages associated with both 15-year and 30-year mortgages.   The 30-year mortgage has a lower payment, which allows the borrower to take out a larger mortgage or make additional payment to her 401(k) plan.   The tax deductibility of mortgage income combined with the fact that interest on 30-year mortgages early in the life of the mortgage makes up the lion share of mortgage payments further reduces the cost of 30-year FRM mortgage payments relative to the cost of 15-year FRM payments.

However, housing equity growth is excruciatingly slow for 30-year mortgage. There are several risks and costs associated with the slower growth rate for house equity.   First, the borrower with a 15-year mortgage will have less equity and may not be able to refinance their mortgage should interest rates fall.   Second, the increase likelihood of negative equity may make it difficult to sell the home.   (The homeowner with negative equity would have to pay the difference between the mortgage and the house price at the time the house is sold.)   Most importantly, the lack of housing equity becomes a major problem in retirement especially for retirees who use fully taxed 401(k) disbursements to fund consumption and mortgage payments.

The fifth essay examines how mortgage choice and housing or mortgage holding period impact lifetime house equity growth when people buy multiple houses in their lifetime and the down payment for the second home come from proceeds obtained from the sale of the first home.   The results presented in this essay indicate that people who use 15-year mortgages and who have a long holding period for their home and mortgage will retire with substantial house equity and with no mortgage obligation. By contrast, people who use 30-year FRMs and have short holding periods will retire with little housing equity and substantial mortgage debt.

The sixth essay considers issues related to the use of adjustable rate mortgages (ARMs).   The lower interest rate on ARMS can reduce initial payments. However, in virtually all instances payments will increase substantially once interest rates reset even if the general interest rate environment remains stable.   The numbers presented in this essay strongly indicate that consumers should shun ARMs with interest rate reset periods less than 5 years.

Essay seven examines issues pertaining to subprime mortgages, especially mortgages with penalties against prepayment.   The essay critiques the claim that prepayment penalties can be good for risky borrowers. My analysis suggests that risks associated with subprime mortgages far exceed the lower possible interest rate.   The endorsement of these products by prominent academic economists strikes me as evidence of a perspectival bias in favor of the needs of the financial services industry and against the interests of the consumer.

Essay eight examines the role played by 401(k) plans and Individual Retirement Accounts.   Most financial advisors emphasize a key to a secure retirement is the early and continued investment of equity inside 401(k) plans. However, many economists and financial analysts now recognize that the adoption of 401(k) plans has increased the number of workers who will have inadequate resources in retirement.   There is wide disagreement over whether the failure of 401(k) plans stems from inadequate participations and bad decisions by workers or the shortcomings of plans.

In my view, these explanations are not mutually exclusive. My analysis found that even households who aggressively contribute to 401(k) plans and make astute investments often come up short if there is a market downturn near the end of a career. Moreover, it is often the case that highly leveraged household will be better off paying off debt than contributing funds to a 401(k) plan.

Essay nine was prompted by the view held by several financial advisors that people nearing the end of their career should emphasize accumulation of assets in their 401(k) plan even if this approach requires them to hold a mortgage during retirement. The analysis presented here documents two important reasons why the elimination of a mortgage prior to retirement should be the top objective.   First, people in retirement with mortgage debt who are reliant on 401(k) disbursement for cash will pay much more in taxes during retirement than retirees who have paid off their mortgage.   Second, the household who keep debt and builds up their 401(k) balance is exposed to substantially more financial risk than households who pay off their mortgage. The discussion of the tradeoff between paying off the mortgage and building up 401(k) assets for workers nearing retirement is intertwined with the issue of choosing between a 15-year and 30-year FRM, the issue discussed in essay five.

The paper concludes with a brief summary of my concerns discussed in the essays. My worldview is pessimistic.   I am concerned that self-interested financial professionals are giving their clients inappropriate advice. Moreover, tax incentives too often encourage asset accumulation over debt reduction.   People who fail to aggressively pay off their loans and remain in the market may eventually find the same fate as the player in the gambler’s ruin game.

Concluding Thoughts:

The interdependent essays in this book attempt to motivate an alternative path towards financial security for the current generation of workers.   The advice presented here differs sharply from the advice that you will receive from your realtor and your financial advisors or lenders.

The realtor’s job is to persuade you to buy or sell your home.   My advise for the person starting her career is to rent rather than buy a home if you have substantial student or consumer debt or will likely have to sell a house in order to relocate for career reasons. Do not extend the term of your student loan to 20 years in order to purchase a house. Do not take out an ARM that resets in less than 5 years or a subprime mortgage in order to obtain a lower interest rates.   The risk of these products is too great. Remember that mortgage debt is detrimental in retirement so in order to pay off your mortgage you will have to stay in your home, use a 15-year mortgage and refrain from borrowing with second mortgages or home equity lines.

Your financial advisor’s job is to persuade you to invest in a 401(k) plan under all circumstances.   401(k) plans have many good features and should be part of your retirement plan.   However, your earnings are fungible and limited.   People starting their careers with large amounts of student debt or consumer loans and a shaky credit rating must consider the tradeoff between debt reduction and 401(k) contributions. Your financial advisor will tell you that you should never refuse the employer match to a 401(k) plan or take out a 401(k) loan. It is not difficult to come up with examples where this is bad advice.

Your financial advisor and your mortgage lender are both likely to argue that adding money to your 401(k) near the end of your career is more important than paying off your mortgage. The analysis presented here indicates this strategy will make you worse off than one emphasizing the elimination of all mortgage debt prior to retirement.

The traditional approach to financial planning – buy houses with 30-year mortgages and throw money into the market through 401(k) plans does not work. Instead the new generation of savers needs to focus on debt reduction and growth in housing equity even if this approach delays the purchase of your dream house and decreases investments in 401(k) plans.

Link to Nine Essays on Debt and Your Retirement in Kindle


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Hello world!

3 Dec

Finance Memos discusses issues related to your money.  We are interested in housing, mortgages, retirement planning, Social Security, student debt, credit cards, taxes, employment — bascially anything that affects your financial security.  We accept submissions for posts on your view of financial problems.

David Bernstein is the editor of Finance Memos.  He retired as an economist from the U.S. Treasury after 25 years of service.

The primary focus of is on personal fnancial decisions that households make.  We are also intersted in how public policy proposals impact personal financial choices.  However, we are trying to make Finance memos relatively non political.   David also publishes a blog, which also accepts submissions for posts.

I hope you enjoy and benefit from these blogs.  Again, submissions are welcome!