The premise of this book is that you have a lot of equity tied up in your home, not earning any return, that could be invested profitably elsewhere. The author, Douglas Andrew, lives in Salt Lake City and has six children so one would expect his advice to be saintly.
Recommend this product?
Many people pay off their mortgages early, either by taking out 15 year, instead of 30 year, loans or by making accelerated payments. I count myself amongst the former camp as I have a 15 year 6% fixed rate mortgage. The argument in this book is that one would be better served by taking out a 30 year (or even interest only) mortgage and investing the difference in payments. The author goes several steps further out on a very shaky limb, and suggests pulling equity out of your home, or out of your qualified retirement accounts, to invest in life insurance.
The author has a very patronizing way of expressing his arguments, e.g., "Let me teach you how ...", that I found really irritating. The book is also very confusing, taking hundreds of pages to express what is really a very simple concept. In addition, it intermingles both good and bad advice, which I will try to deconstruct. Be forewarned, however, that whereas the concept is simple in theory, exploiting the nuances of tax code makes this complex in practice. A thorough explanation merits an entire book, but I'll do my best to distill the essence of the argument.
Missed Fortune 101 (CliffNotes version)
Utilize the tax-deductibility of mortgage interest to borrow money at a favourable rate, subsidized by the government. Invest the borrowed money in life insurance and make tax-free withdrawals, until you die, by exploiting a loophole in the tax code. Just hope that you earn a satisfactory rate of return and that the scheme doesn't come unglued before you die.
Why have a mortgage?
I view a home mortgage as a necessary evil. Being a thrifty Scot, I'm debt-averse, but I do like a place to live for monthly payments that get more affordable over time as the real value of the payments is eroded by inflation. When my wife and I bought our own home we couldn't afford to pay for it in cash so we had to take out a mortgage. We also like a home that we can call our own. It gives my wife and me a warm, fuzzy feeling.
The tax advantage of mortgage interest
In "Missed Fortune 101", Douglas Andrew says that we should take on mortgage debt willingly because it is tax-favored. It is certainly true that mortgage debt is tax-favoured. Borrowing money on a 6% mortgage is effectively borrowing at only a 4% rate of interest if the tax advantage can be fully exploited. However, this is only true if you are lucky enough to be in the combined (federal and state) 33% income tax bracket and are able to fully utilize the mortgage interest in your itemized deductions. The 2007 standard deduction for a married couple, filing jointly, is $10,700. If you can't itemize deductions that reach at least this figure before adding the mortgage interest then you're out of luck because your mortgage interest will not be fully deductible. For the majority of people, the mortgage interest is likely to push the total amount of deductions above $10,700 so the mortgage interest will be at least partially deductible. In addition, Mr. Andrew bases his tax savings estimates on the assumption that you, dear reader, are in the 33% combined federal and state income tax bracket. However, a married couple, filing jointly, can make $81,200 gross income in 2007 before being pushed above the 15% marginal federal tax bracket. On $81,200 the average federal tax is only 10.8%. In California, where I live, state income tax increases my total income tax burden to approximately 14% on $81,200 income. This is less than half the amount of income tax that Mr. Andrew uses in his examples. Thus, it is going to be impossible for the average American to achieve the financial results that Mr. Andrew claims is possible if you follow his advice.
What Mr. Andrew fails to mention is:
(1) You have to be able to deduct all the interest on this loan from your adjusted gross income.
(2) The standard deduction is $10,700 (married filing jointly) on the 2007 federal 1040 tax form
(3) The deduction is more effective the higher the tax bracket you're in.
(4) The deduction favours those who are already wealthy.
Should you prepay your mortgage?
15 year mortgages, making bi-weekly instead of monthly payments, and making extra payments (to pay down the principal) are all considered to be prepaying your mortgage. As a general rule, as Mr. Andrew correctly points out, prepaying your mortgage may not be a good idea, but it depends on your circumstances.
My wife and I originally took out a 30 year 10% fixed rate loan on our house. Subsequently we refinanced to a 15 year 8% fixed rate loan and then again to a 15 year 6% fixed rate loan. We opted for the 15 year loans, as soon as we qualified for the payments, because the interest rates were lower than for the corresponding 30 year loans and the loan will, of course, be paid off faster. For us, the 15 year mortgage was also a means of enforced saving. Not making the payments was not an option or we'd lose the house. We are earning a 6% rate of return, that is as safe as a house (literally, as it is our house), compounding tax-free, on the difference between our 15 year payments and the notional 30 year payments.
Mr. Andrew argues that making these additional payments reduces your liquidity and increases the risk that you will lose your home should you be unable to meet the payments. Had you invested the difference you could have built up a substantial cash reserve, increased your liquidity and reduced the risk of losing your home due to a temporary inability to make the mortgage payments.
What Mr. Andrew fails to mention is:
(1) Enforced saving is better than not saving at all.
How could you invest extra payments?
Mr. Andrew "teaches" that you should do what the rich do and what the banks do, which is to borrow other people's money to invest. What he fails to point out is that the banks are able to borrow money at a much lower cost than you and I are able to borrow for. Indeed, there is a group of investors out there who figure that the return on our 6% mortgage is a good, safe investment for them.
In a manuscript entitled, "The tradeoff between mortgage prepayment and tax-deferred retirement savings" sponsored by the Federal Reserve Bank of Chicago, the authors point out that tax arbitrage could be undertaken to increase one's net wealth by offsetting the tax-deductibility of mortgage interest against an investment with equivalent risk, e.g., a mortgage-backed security, in a tax-deferred retirement account (e.g., a traditional IRA, Roth IRA, 401k or 403b). For example, a 6% interest rate on a mortgage might only cost 4% under ideal conditions (see above). In this case, any extra payments that you make to pay off this loan will only earn 4% interest whereas you could invest in something of equivalent risk that earns 6%. The authors note that US households, in aggregate, forego $1.5 million annual savings by not buying mortgage-backed securities in tax-deferred accounts rather than prepaying their mortgages. This sounds as though it's a lot of money but, as there are 120 million households in the USA, this works out to only $12.50 annually per household.
My own inclination would be to maximize use of the Roth IRA, or the new Roth 401k, on which all the tax is paid up-front, by funneling discretionary payments into it. Alternately, I would maximize contributions to a traditional IRA, a 403b or a 401k (especially if the latter is employer-matched). The advantage of the Roth IRA/401k is that it is forever free of tax, but there are contribution limits and withdrawal rules that have to be considered. For those aged over 50, a couple is allowed to contribute up to $10,000 in 2007 provided their modified gross income is less than $100,000. The Roth IRA/401k, therefore, is a savings vehicle that favours the rest of us, not just the wealthy. The traditional IRA, 403b and 401k are all tax-advantaged, in that interest is permitted to compound free of tax, but all withdrawals are taxed at the ordinary income rate. An exchange-traded S&P 500 index fund, such as Barclays' iShares S&P 500 ETF (ticker: IVV), would be a potential candidate for investment within such an account. However, this would also be an excellent candidate for receipt of discretionary savings outside of a qualified retirement plan. Although the dividends could be taxed, the bulk of the money would accrue as long term capital gains which would be taxed, upon withdrawal, at the much more favourable capital gains tax rate.
Thanks to the Economic Growth and Tax Relief Reconciliation act of 2001 (EGTRR), the Job Creation and Worker Assistance Act of 2002 (JCWAA), the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 and the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), taxes have rarely been lower in the past century than they are at present. In particular, long term capital gains and dividends are tax-free (yes, tax-free!) in the years 2007-2010, providing your adjusted gross income (married couples filing jointly) is less than $81,200 (in 2007). Furthermore, the $100,000 cap on adjusted gross income for contribution (and conversion) to the Roth IRA is scheduled to be removed in 2010. This means that non-deductible traditional IRAs can be converted to Roth IRAs in 2010 even for those whose high incomes currently preclude them from making this conversion. If you can't contribute to a Roth IRA at present, because your income is too high, it would nevertheless behove you to start contributing to a traditional IRA in anticipation of being able to convert in 2010.
It is also worth noting that, thanks to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), all IRA assets are fully protected from creditors in the event of bankruptcy.
What Mr. Andrew "teaches" you to do instead is to invest in equity-indexed universal life insurance policies. Thanks to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the Deficit Reduction Act of 1984 (DEFRA) and The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) and IRS codes 72(e) and 7702 it is evidently possible to utilize an equity-linked life insurance policy as a tax-favoured investment vehicle. You are permitted to withdraw money from the policy on a first in, first out (FIFO) basis and this money, the money with which you funded the policy, is exempt from taxation. Once the tax-exempt, contributed money has been exhausted, you can subsequently borrow against the policy and you will still not have to pay any tax. You will, however, have to pay this borrowed money, with interest, back into the policy. Apparently, and this is an interesting twist, the money doesn't have to be repaid until you die so long as you don't withdraw more than a certain percentage from the account. However, there's always the danger that you'll withdraw money faster than the account's value increases, especially since the fees go up as the account's value decreases. As with the Roth IRA, a 10% penalty is applied to withdrawals made earlier than age 59 1/2. The life insurance component of the policy can be paid out to your heirs tax-free.
You have to be careful how you set up, fund and withdraw from the life policies to ensure that you conform to the IRS rules that allow tax-favoured status, lest you fall afoul of IRS rule 7201. This is an interesting scheme, but it's expensive to fund and maintain. Aside form the annual insurance fees, the annual cost, viz-a-viz direct participation in an equity-lined index, includes the stripping out of the dividend. Index-linked market participation never credits the participant with the associated dividend. Thus, I would expect the rate of return to be impacted adversely to the tune of approximately 6% annually. The up-front tax benefit will never be able to offset this downstream cost. Furthermore, the scheme could become unglued if either Congress votes to repeal any of the involved tax laws and if the return from the secondary policy failed to exceed the interest rate on the primary policy.
What Mr. Andrew fails to mention is:
(1) The compelling advantage of the Roth IRA/401k.
(2) The advantages conferred by new tax laws, especially TIPRA (*).
(3) IRA assets are fully protected from creditors in the event of bankruptcy.
(4) The fees and commissions will cause serious damage to the investment returns
(5) The dividend isn't credited to the insured in equity-linked insurance policies
(6) The insurance loophole could be closed by Congress.
(7) You may not be able to meet the loan payments on the primary life policy.
(8) Keep it simple, stupid.
(*) To be fair, "Missed Fortune 101" is copyright 2005, so Mr. Andrew may not have been aware of the provisions of TIPRA at the time the book went to press.
Should you cash out home equity to invest?
Mr. Andrew "teaches" that, in order to build up your savings, you should take equity out of your home and invest it in life insurance. Ouch, this is very poor advice. If you do this, you risk losing your home. The National Association of Securities Dealers (NASD) specifically warns against liquefying home equity in a November 2004 notice to its members.
If you liquefy home equity you are going to have to make payments. The smarter choice is to invest those same payments instead. Don't run the risk of losing your home! Consider the following two scenarios.
(A) Liquefy $100,000 home equity with a 15 year 6% loan and invest this lump sum at 8% interest. The monthly payments will be $843.86. After 15 years, if it's permitted to compound tax-free, the lump sum will have grown to be worth $331,000 and the loan will have been paid off in full. Unless you can invest this money in a tax-advantaged way, you could end up having to pay a lot of tax on the $231,000 gain.
(B) Instead of taking out a loan, invest the same amount, $843.86, monthly in a Roth IRA (this is $126 over the annual contribution limit of $10,00 for an over 50's couple, but let's not split hairs). After 15 years, if it's permitted to compound at the rate of 8%, tax-free, it would have grown to be worth $292,000 that's completely free of tax. This is less than you could theoretically earn investing the lump sum, but the difference only amounts to $2,600 per year over the course of 15 years. Why be that little bit more greedy and risk losing your home? $292,000 is still a lot of money. If you can't contribute to a Roth IRA because you don't meet the eligibility requirements then you should invest in something like Barclays' iShares S&P 500 ETF and pay long term capital gains tax rates when you cash out. Warren Buffett's Berkshire Hathaway (ticker: BRK-A or BRK-B) is even better suited as a long term investment on which you will only pay tax at the favourable capital gains rate because it pays no dividends.
Here's the real problem. Americans like to spend all their income, and then some. This is true at every level from the federal government down to individual households. The real secret to having a fortune in retirement is to live below your means in your income-generating years, which means saving some of your income and investing the savings in such a way that it will compound tax-free. Mr. Andrew and his cohorts capitalize on your greed to cheat you out of your money.
What Mr. Andrew fails to mention is:
(1) Don't risk losing your home when you can achieve similar results with much less risk.
Should you cash out your IRA, 401k or 403b to invest?
This is truly incredible, but Mr. Andrew "teaches" that you should transfer money out of your qualified retirement plans, paying the 10% early withdrawal penalty if necessary, and transfer it into a life insurance policy. To paraphrase Margaret Thatcher, "No, no no, no, no".
What you ought to do is convert as much money as you can from your traditional IRA into your Roth IRA between now and 2010 while income taxes are still so extraordinarily low. Remember, with a Roth IRA you pay all the tax up-front.
What Mr. Andrew fails to mention is:
(1) You should maximize the size of your Roth IRA/401k now, while income tax is low.
What does Mr. Andrew get out of this?
First of all Mr. Andrew makes money on sales of his books. Less obvious, but potentially much more lucrative, however, is that he appears to be at the top of a three layer pyramid scheme of suckers. Mr. Andrew trains salesmen, no doubt in exchange for lucrative fees, on how to con their marks (clients) into liquefying home equity and "investing" the proceeds in life insurance. You can enroll, if you like, through his Web site at http://www.missedfortune.com/team/index.aspx. This is potentially a very lucrative business for everyone involved, everyone except the clients that is. The salesmen earn fees for originating the mortgage, commissions on selling the life insurance policies and legal advisory fees for setting up and maintaining the life insurance scheme in a manner that complies with the applicable laws. They will promise to show you the path to golden riches, but it will most likely prove illusory.
What did I get out of this?
The "Missed Fortune 101" concept is sold at seminars throughout the country, to which people are enticed by the offer of a free dinner. One of my friends was conned into exchanging his IRA for a variable annuity at a dinner/seminar like this, so I view these salesmen as deer in my headlights. My goal is to reduce the profitability of their running these dinner/seminars and dissuade others from being lulled by the siren call of the easy road to riches.
Okay, I admit that I was also attracted by the offer of a free dinner for two. "Hey sweetie", I asked my wife, "How about a romantic dinner for two at Olive Garden next Tuesday?". I expected the evening to be both entertaining and we would get a free dinner. As it turned out though, the speaker was dreadful. He must have been a rookie. I don't think he could have sold ice cream cones to a tribe of Bedouins. Not to my surprise, an attorney and a mortgage broker accompanied the speaker. The dinner was quite good though.
I learned (almost) everything I know about investing from Mary Poppins when I was eight years old.
If you invest your twopence wisely in the bank, safe, and sound
Soon that twopence, safely invested in the bank, will compound
And you'll achieve that sense of conquest as your affluence expands
In the hands of the directors who invest as propriety demands
When you deposit twopence in a bank account
Soon you'll see that it blooms into credit of a generous amount
Semiannually, and you'll achieve that sense of stature as your influence expands
To the high financial strata that established credit now commands
What Mr. Andrew fails to mention is that the fees, including mortgage origination fee, sales commissions and legal fees, together with the loss of the dividend associated with the equity index, are going to take such a bite out of your investment that you'll end up earning a derisory return. Play it safe, play it smart, and invest regularly in a Roth IRA/401k so as to be a direct participant in the equity market . Don't be played for a fool. I borrowed "Missed Fortune 101" from the public library, by the way. Did I mention that my wife and I both retired at the age of 50? We didn't do this by following Douglas Andrew's advice and neither will you.