Saving money from what we make is arguably the most reliable way to build wealth. Your savings form the base. Any investment gains are built on top of those savings. If you don’t have a base, you won’t have much investment gains.
There’s an age-old rule of thumb: save 10% of your income. Then there’s a 50-30-20 budget from Senator Elizabeth Warren and her daughter in their book All Your Worth. It calls for saving 20% of your after-tax income. There are also some neat tables on the Internet that link your savings rate to how soon you can retire. The higher your savings rate, the sooner you can retire.
Whether you calculate your savings rate against your gross income or against your net income, first you have to know how much you are saving. At a first glance, your savings are simply what you don’t spend.
Savings = Gross Income – Taxes – Expenses
However, confusion starts as soon as you have mortgage or other loan payments. There was a long thread on the Bogleheads investment forum Do you consider mortgage payments as savings? After over 400 posts I don’t see a clear answer. Whether mortgage payments are savings or an expense shouldn’t be wishy-washy whatever you consider them to be.
Why does it matter whether it’s savings or an expense? It’s not for bragging on the Internet how high your savings rate is. It matters because savings are better than expenses in building wealth. If it’s savings you should do more of it. If it’s expenses you should do less of it (unless it brings income elsewhere).
If mortgage payments are savings, are you saving more when you have a larger mortgage? If mortgage payments are just an expense, do you increase your expense when you pay extra toward your mortgage or when you have a 15-year loan versus a 30-year? Are only the “extra” payments savings but the “regular” payments are expenses?
It’s not just mortgage. The same questions also apply to student loans, car loans, and credit card debt. If credit card payments are an expense, are you saving more when you make only the minimum payment on your credit card and you send the difference to your bank account? Let’s get to the bottom of this confusion. I will start with simpler parts and build up from there.
Escrow Payments Are Expenses
If your mortgage payments include escrow for insurance and property tax, that portion is clearly an expense. At best you get to hang on to the money temporarily. When the insurance and property tax bills come due, that money is gone. If we ignore the small escrow reserve and the slight difference in the timing of the expenses, month in and month out, the escrow portion of your payments is simply an expense. The money goes to the insurance company and the state and local governments.
Interest Is An Expense
Likewise, the interest portion of your payments goes to the bank. Just paying interest doesn’t increase your net worth. It’s an expense for borrowing money.
So far so good. Now we are left with only the principal part of the loan payments.
Your Expenses Don’t Go Up Simply Because You Pay More Toward Your Debt
If you receive a bonus at work and you use it as an extra principal payment on your loan instead of putting it into a savings account, your expenses for that month don’t shoot up simply because you use the money to pay down your debt. Because the interest rate on your loan is usually higher than the interest rate on a savings account, you are better off paying down a loan. You wouldn’t think using the money to pay down the loan is an expense but putting it into a savings account is savings.
If you refinance a 30-year mortgage to a 15-year term, your monthly payments go up, but you are not suddenly having a big jump in your housing expenses. You actually lower your expenses because the interest rate on a 15-year loan is usually lower than the rate on a 30-year loan. Again, month in and month out, the higher amount paid toward the 15-year loan isn’t an expense versus putting it into a savings account when you had the 30-year loan.
Your Savings Don’t Go Up Simply Because You Have No Payments
If you pay cash to buy a car outright as opposed to taking advantage of the manufacturer’s 0% financing, you are not saving more money every month simply because now your money goes toward replenishing your savings versus making the monthly payments on your car loan.
Suppose person A and person B both have $100k in the bank. Person A buys a car with $30k in cash. Person A now has $70k left. When person A puts $500 every month into their bank account, we say person A is saving $500 a month.
Person B decides to take the loan with zero down and 0% APR financing. Person B now has $100k in the bank, $30k in debt, net $70k. When person B has a $500/month car payment, it looks like an expense.
However, to an outsider, both person A and person B have the same net $70k plus a car, and they are both paying $500 out of their monthly income. If we ignore the small amount of interest person B earns from the extra cash in the bank, they will have the same net worth at any point along the way. Person A’s saving $500/month isn’t any better than person B’s $500/month car payment.
This is important. Let me repeat it. Buying a car with cash and saving $500/month afterwards isn’t any better than a $500/month car payment.
Expenses Come From the Purchase, Not From the Payments
What makes a difference, is person C, who keeps the old car and doesn’t spend $30k on a new car. Person C keeps $100k and puts $500 a month into the bank. If the old car continues to run without problems, in a few years person C will have a higher net worth than both person A and person B.
People familiar with depreciation would know the value of the $30k new car should be written down over a number of years. Both person A and person B have this non-cash depreciation expense. That’s why person A and person B are in the same situation even though one is saving and the other has payments. Person C’s depreciation and maintenance expenses are lower.
Our savings formula should be revised to:
Savings = Gross Income – Taxes – Cash Expenses – Non-Cash Expenses
Now it’s clear why person C is saving more than person A and person B. Principal payments are indeed savings, but whatever was purchased by the loan brings non-cash expenses, which reduce one’s savings.
We finally have a logically consistent answer. Loan principal payments are savings. Feel free to make additional principal payments toward your loans. Feel free to refinance your mortgage to a shorter-term. Feel free to finance when terms are favorable. The principal payments are just as valid as savings as sending money to your own bank account. However, having high loan balances as a result of larger purchases (expensive house, education, cars, …) means you have high non-cash expenses from writing down those purchases, which reduces your savings. So do less of those unless the expensive house appreciates more or the expensive education brings higher incomes.
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Great article explaining the simplest of the concepts that even the so-called experts cannot lucidly explain. Love it! Thanks!
I cannot for the love of me make my friends understand this.
Why is it that some of us get this and use it in real life, some say they understand it but do not use it in real life, and some still do not get it at all?
This is a good way to look at the entire purchase decision and not just the financing aspect. I think I read the same bogleheads thread. In thinking about how people react when I tell them I paid off my mortgage in 3 yrs, I usually get congratulations, surprise, etc. I don’t think it was a big deal because I had been saving for 10+ years prior to purchase. When I finally did purchase, it was just a matter of how to structure financing. I actually took out a larger loan than I actually needed because of better rates, and then I paid the balance down quickly as to not incur much interest charge. The point being that the decision to buy an asset (purchase a house in this case) mattered to me much more than how I structured the financing (focus on rates/pmts).
>>Why is it that some of us get this and use it in real life, some say they understand it but do not use it in real life, and some still do not get it at all?>>
In my experience as an accountant, the vast majority of people can’t grasp the concept of “accrual accounting” versus “cash accounting”. Simply put, most people operate on a cash basis, where every cash payment is an expense and every cash receipt is income. So whenever you talk about contracts, mortgages, car loans, etc. that extend longer term and where the expense does not match the cash outlays, it goes over their head. All they really focus on is the monthly payment and whether they feel they can afford it today.
Unfortunately, our governments largely operate under the same theory when it comes to issues like Medicare, SS, the VA, etc. where the current cost of new promises is never accrued, and therefore the future payments are charged as expense when incurred rather than to the people who initially made them into law.
There is another confusing issue, or perhaps more precisely a confounding issue, where income taxes are currently offset by the mortgage interest payments. This is often used as an argument to continue a mortgage. Using the last equation in the text may suggest a way to calculate this, similar to a business calculation of EBITDA (earnings before interest, taxes, depreciation, and amortization), although there may be interactions between depreciation/amortization as well as interest and taxes.
I may be a few months late to comment but this article was a great find for me. My wife and I will be needing a new car soonish (I’m hoping we can ride it out for at least 3 more years) but I’m also being realistic. We own a few rental properties and I was thinking with car loan rates so low if it would just make more sense to take whatever we were going to spend on buying the car cash and instead paying off the principal towards one of our properties.
I know I haven’t provided a complete snapshot of our financials but overall does this seem like a good strategy? Thanks!
Harry Sit says
It depends on the rates on your rental loans after taxes are taken into account.
The interest rate on the rental properties is 4.25% and not sure how to answer the “after taxes” part. Could you clarify? Thanks for the help.
Harry Sit says
The mortgage interest you pay on the rental is an expense that offsets the income you earn from the rental. Every $4.25 you pay reduces your income by $4.25, which lowers your taxes by however much that $4.25 extra income would otherwise cost you in taxes (both federal and state). Say the combined rate is 30%. Then the after-tax cost is really 4.25% * 70% = 2.975%. If you can get a car loan lower than 2.975% then it costs less to get a car loan and use the cash you already have to pay off the rental loan.
Thank you so much for the reply. I swear just when I think I have a grasp on things I learn something new. Great stuff.