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February 7, 2005
�The equity from sale of our old
house will cover the first 6 months of payments on the new one. To avoid
spending this money, we plan to make 6 payments immediately, then we have 6
months to save enough from our current income to repeat the process. Is this a
wise strategy?"
You are attempting to impose a savings discipline on yourself,
which is admirable. The cost is the interest that you would otherwise earn on
the money that you send to the lender early.
In itself, the lost interest is not
a compelling argument against your plan. Savings discipline is a value that many
people the world over are willing to pay well for, as I�ll illustrate shortly.
The argument against your plan is that it won�t be very effective.
A Forced Saving Plan That
Won't Work
Putting a sum equal to 6 months of
payments beyond the reach of temptation will work, but your plan breaks down in
phase 2. Having made the first 6 months of payments in month 1, you now have to
save another 6 months of payments during months 1-6, with no payments due until
month 7. Without the prod of an imminent required payment, you are subjecting
yourself to less discipline rather than more.
I suggest you invest your existing
nest egg in a form that discourages early redemption, such as a larger down
payment or a deferred
annuity. Then subject yourself to the discipline imposed by having to make a
monthly payment, on-time, each and every month.
Fully Amortizing Mortgage
Promote Savings Discipline
The fact is that the
fully-amortizing mortgage is the best instrument ever invented for promoting
savings discipline. The payment you are contractually obliged to make every
month has a savings component � it is the portion of the payment that is
allocated to principal. This piece of the payment gets larger every month as the
interest portion gets smaller, until the loan is finally paid off.
People without access to fully
amortizing mortgages come up with numerous techniques for imposing savings
discipline on themselves. Some of them are quite costly.
Costly Forced Savings
Devices
When I was in Liberia, for example,
I noted that many people saved for a house by purchasing cinder blocks, which
they piled up on their land until they had enough to start building. Not only
did they lose the interest that would have been earned had their savings been
deposited in a bank, but their cinder blocks also deteriorated in bad weather.
Nonetheless, there was no secondary market in cinder blocks, so they were
protected against any sudden impulse to spend their savings.
In another costly forced saving
practice that is widespread in developing countries, a group of like-minded
persons commit themselves to contribute a certain amount every month to their
informal association. In Africa, these are called ekub or susu. One of the
group, usually chosen by lottery, gets the full amount every month. If there are
12 members contributing $100, for example, each member receives $1200 at some
point during the year. The risk, of course, is that those who get theirs early
will decide to get lost.
Costly forced savings practices are
not limited to developing countries. In the US, millions of taxpayers � mostly
lower tax-bracket non-homeowners � deliberately over-withhold on their income
taxes so they can get a refund at the end of the year. They usually realize they
are giving an interest-free loan to the Government, but they don�t care. The
practice is so widespread in the military that the legal assistance department
of the adjutant general�s office sends out warnings not to do it, but to no
avail.
Savings Discipline
Continually Weakens in the US
This provides a useful perspective
on recent trends in the US toward weakening the savings discipline provided by
the amortized mortgage. For a small increase in the price, a borrower today can
switch from an amortized mortgage into an interest-only mortgage that doesn�t
amortize for 5 or 10 years. The borrower who takes an interest-only mortgage
pays to avoid savings discipline, which so many others throughout the
world pay to receive.
Savings discipline is also
undermined by the ready availability of home equity lines and credit cards.
Don�t get me wrong, these are useful options, but useful options that appeal to
the weaker part of our nature are often misused. Many of the people who write me
after they get into trouble -- who unfortunately outnumber those who write me on
how to avoid trouble -- are in trouble because they could not resist temptation.
Our system is rich in financial gadgets for avoiding savings discipline, and
poor in gadgets for promoting it.
Copyright Jack Guttentag
2005
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