Mortgages originally posted from MoneyTrax and Don Blanton
Home Mortgages – Choosing the Right Loan and Avoiding Losses
We are of the opinion that everyone should have their home paid off and paid off as fast as possible—but choosing the right loan to accomplish that can be confusing. That’s because people ultimately make decisions based on what they believe to be true, not necessarily what is true.
This video will help you separate fact from fiction—so that you can learn how to pay off your home in the fastest, safest manner possible. By the end of the video, you will learn a few things about mortgages that could change how you look at your money for the rest of your life.
Mortgage Quiz. True or False?
- A large down payment will save you more money on your mortgage over time than a small down payment.
- A 15-year mortgage will save more money over time than a 30-year mortgage.
- Making extra principal payments saves you money.
- The interest rate is the main factor in determining the cost of a mortgage.
- You are more secure having your home paid off than financed one hundred percent.
If you answered “true” to any of these questions—you will want to watch the rest of this video.
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What’s Really Important About Mortgages?
Many mortgage decisions are commonly made by looking at “payment amount” and “interest rate”. While these factors are important, there are several other factors that also must be considered. To help understand how these factors might ultimately impact you, we will introduce you to three fictitious couples.
Each couple has the same goal: having their home paid off. They each believe their method is best.
The first couple is the Free-n-Clears. They have paid off their mortgage. So, they do not have to make any monthly mortgage payments.
The second couple is the Owe-it-Alls. They could have paid cash for their home like the Free-n-clears—but decided to keep their money and invest it in a “safe account” so they could access it in case they ever needed to. Although they “owe it all” on their mortgage—they have no other debt.
The third couple is the Pay-Extras. They make extra principal payments every month in hopes of paying their mortgage off as soon as possible.
So which of these couples do you think is in the best position? Let’s explore several mortgage aspects to find out how they impact our couples:
Inflation
One area people often forget to consider when financing is inflation. If you have a fixed payment today of $2,000 a month, what will that same $2,000 buy in 10, 20 or 30 years?
Assuming an inflation rate of 3%, $2,000 will only buy $823.97 of goods in 30 years.
Let’s apply what this means to you and your mortgage. Making a fixed mortgage payment of $2,000 today feels like $2,000—but in 30 years, it will only feel like you are paying $823. So, the mortgage payments you make in the early years of your mortgage feel more painful—because they are your most valuable dollars.
So let’s check-in on the couples.
The Free-N-Clears gave their most valuable dollars to the bank up front.
The Pay-Extras voluntarily give the bank their “best dollars” on top of their required mortgage payment every chance they get.
The Owe-it-Alls have a monthly mortgage payment that allows them to give the bank payments that are worth less and less each month—while keeping their money invested to potentially offset the impact of inflation.
Key Concept: Your home actually costs you more the faster you pay it off because you are doing so with your most valuable dollars.
Down Payments
Most people make a large down payment to reduce their monthly payments. But does their down payment earn them any interest? No. This loss is called “Opportunity Cost”.
Key Concept: Opportunity Cost: If you lose a dollar that you did not have to lose, you not only lose that dollar but you also lose what that dollar could have earned for you had you been able to keep it.
What would the Free-n-Clears down payment be worth had they been able to keep it and invest it?
Let’s put some math behind this concept and take a deeper look.
Assume each of the couples bought a $300,000 home.
The Free-n-Clears made the biggest down payment possible—which was the entire $300,000.
The Pay-Extras did not have enough up front so they accelerate the principal payments by paying extra each month.
The Owe-it-Alls put the least amount down—and financed as long as possible.
Assuming an investment rate of 8%—the $300,000 that the Owe-it-Alls invested would grow to be worth $3,280,719 in 30 years. If they could borrow the $300,000 at a lower rate—they will keep the difference.
The $300,000 down payment that the Free-n-Clears made, however, earns NO interest. So, if the Free-n-Clears can not sell their home in 30 years for $3,280,719—they made a minor financial error.
Investment Opportunities
Rather than paying cash for their home, the Owe-it-Alls invested their entire $300,000. So, they now must make monthly mortgage payments. However, the interest portion of their payment is deductible. This deduction reduces their cost of borrowing significantly.
The Free-n-Clears, on the other hand, paid their entire $300,000 down—giving away the control of the money to the bank. They are now able to invest the after tax monthly amount they would have otherwise given the mortgage company. However, since they have no mortgage interest deductions—they will have to assume a higher investment risk than the Owe-it-Alls.
So with the understanding that money used for down payments earns NO interest, and is controlled by the bank, and reduces tax deductions—what is the ideal amount to put down when purchasing a home? Nothing! That’s right. Zero! Zilch! Nada!
Key Concept: Remember if you finance you transfer interest to the lending institution for the privilege of using their money. If you pay cash—you save interest expense, but you lose interest income as well—because that money is not earning anything for you.
The money in your home earns zero.
Your Home as an Investment
Most people today consider their home one of their largest investments. Let’s see if it is a good place to put your money.
Assume that the Free-n-Clears home is worth $300,000 today and that they bought it 7 years ago for $229,000 and have put about $25,000 into improving their property. Their rate of return would be in the neighborhood of 2.41%. Would you consider this a good return? When you add in property taxes and insurance—it looks even worse!
Appreciation
You may be thinking we forgot that your house is appreciating?
Let’s assume The Free-n-Clears, the Pay-Extras and the Owe-it-Alls live next door to one another in identical homes with identical values.
Whose house will appreciate the fastest?
The fact is they will all appreciate exactly the same. Making larger down payments or extra monthly payments does not make your home worth any more.
Key Concept: Your home appreciates the same whether you have it paid off or financed 100%.
Interest Rate Spread
Remember that the Owe-it-Alls chose to borrow the entire $300,000 for their home—so they could invest the $300,000 they had into a “safe account”. Supposing the interest rate on their mortgage is 6%–what rate of return would they have to earn on their investments to break even?
On the surface, it looks like 6%–but it’s actually only 4.2%–assuming they are in a 31% income tax bracket. Why? Because of the mortgage interest deduction. Imagine, they would only need to net around 4.2% for them to control the money rather than the bank.
Key Concept: Net cost to borrow equals your loan rate less your tax bracket. If you receive a mortgage interest deduction—it reduces the investment risk you have to earn on your money for you to be in control.
Extra Principal Payments
Unlike the Free-n-Clears, the Pay-Extras did not have enough money to pay off their home up front—so they chose a shorter loan period and make extra principal payments to pay it off early.
Why did the Pay-Extras choose a 15 year mortgage? Survey says: The interest they think they will save. Key word, think. The perception is the shorter the loan—the lower the cost. But if that was true then paying cash would make the most sense.
We already looked at paying cash and found the Free-n-Clears would have to sell their home in 30 years for $3,280,719. Will that be possible?
The Pay-Extras may be surprised to learn that once they get their 15 year note paid off and start investing the 15 year payment amount—they will end up with the same amount they would have had had they invested the difference between the 15 and 30 year monthly mortgage payments for 30 years. This assumes the same interest rate and tax bracket.
Key Concept: There is more risk involved to earn a given rate of return over a 15 year period than a 30 year period.
Tax Deductions
Perhaps one of the most overlooked aspects affecting mortgage decisions is the mortgage interest deduction.
Let’s see how that impacts our couples.
Since the Free-n-Clears have no mortgage—they receive no deductions. However, with no mortgage payment, they had plenty of money to maximize their contribution to a qualified retirement account at work—like a 401(k). When asked what was the main reason for their contribution to this account they said “tax deductions”. By contributing to their retirement plan, they deferred a tax to potentially pay it at a higher bracket later—but, they also gave up their known mortgage interest deduction today.
The Pay-Extras received some deductions but unknowingly reduced their tax advantage with every extra principal payment they made.
The Owe-it-Alls kept their money in a safe investment. Although their mortgage rate was 6% they only had to earn 4.2% after their tax deductions to cover their mortgage payments to the bank—giving them control of their money. They maximized both their qualified plan deductions as well as their mortgage interest deductions. They chose to make a mortgage payment knowing that if things ever got tight they could always count on access to their money.
You have heard several things that perhaps have challenged your thinking on this subject of a mortgage and as you can see there is a lot to know.
As we said earlier, we believe you should have your home paid for. That said, this does not mean that one should not have a mortgage. What it means is that you need to have and an account with more money than you owe. If you have a mortgage of $300,000 and you have $300,000 in a safe account—your house is “free and clear”. The big question is not should you have your house paid for, we agree you should.
The question is really who is going to control your money, you or the bank?
Having your home paid for is a safe financial position—but it may not be as safe as you once thought or it could be.
There is a form you need to become familiar with called a 1003b form which is the Uniform Residential mortgage application. It is 5 pages long and is designed for the lending institutions to determine if you qualify for a mortgage loan.
Once you put your money in your home through “down payments” or “extra payments”—you now must qualify to get it back. How does the thought of having to qualify to access your money sound?
Disability
So what would happen in the event of a disability to our couples?
The Free-n-clears must complete these 5 pages if they would like to access any of their money. In the event of a disability what will the bank say? We are sorry but we will not be able to honor your request. In fact, disability is the number one reason people lose their homes in America. Tragic!
The Pay-Extras would also be required to complete the 1003b form for the bank. Once again, the bank will say “We are sorry but we will not be able to honor your request.”. And although they have been making extra payments in previous months, they will still be required to make their payment next month to avoid foreclosure. Does that sound like a safe position to you?
The Owe-it-Alls, on the other hand, have complete control and access to their money—so they will not have to qualify to get it back.
Unemployment
What would happen if our couples lost their jobs?
It would seem that if there was ever a time when one would need access to their money would be when they lose a job.
The Free-n-Clears must again fill out the form and the bank will most likely say “no”. Their response will be “When you get another job call us”.
The Pay-Extras want to get some of the extra money they have put in the house while they look for a new job. But, once again, the bank will most likely say “no”. What’s worse, if they move to a new line of work it may take two years before the bank will give them a decent look.
The Owe-it-Alls are still earning interest on their money and they have access to the account to withdraw what they need until they can get back on their feet with no questions asked.
Interest Rate Increase
What happens if mortgage interest rates increase and the couples need their money for a new car, medical emergency, or college education?
The Free-n-Clears may be forced to refinance at a higher rate today than the rate they could have secured earlier.
The Pay-Extras are in the same boat as the Free-n-Clears.
The Owe-it-Alls have complete access to their money and are not affected by rate increases.
Interest Rate Decrease
What would happen to the couples if mortgage interest rates go down?
The Free-n-Clears will not even notice.
The Pay-Extras may refinance—ending up paying more closing costs just to pay off their existing loan quicker—giving the bank even more control of their money.
The Owe-it-Alls may want to refinance to reduce their present payments—giving them more control and greater opportunities with even less risk.
Let’s review our quiz one more time. True or False?
- A large down payment will save you more money on your mortgage over time than a small down payment.
- A 15-year mortgage will save more money over time than a 30-year mortgage.
- Making extra principal payments saves you money.
- The interest rate is the main factor in determining the cost of a mortgage.
- You are more secure having your home paid off than financed one hundred percent.
The answers are all false. Why?
Because during this video we’ve learned that, compared to the other couples, the Owe-it-Alls:
- Are least affected by the impact of inflation
- Lose the least amount of money from Down Payments that earn zero interest
- Have more Investment Opportunities than the other couples
- Achieve the greatest return on the money they pay for their home
- Obtain the same Appreciation on their home as the other couples
- Are able to maximize Interest Rate Spread
- Experience the least amount of loss from Extra Principal Payments
- Receive the most Tax Deductions of any of the couples
- Maintain control of their money in the event of a Disability
- Can still access their money in the event of Unemployment
- May be able to benefit from Interest Rate Increases, and
- Have the most opportunity to benefit from Interest Rate Decreases
Granted, there is a lot to know about your mortgage and this post and video are certainly not an exhaustive overview. What you don’t know may be more important that what you do know.
It is possible that more money will go through your mortgage than any other area in your financial life including your retirement plan. Isn’t it time you gain control of this important area of your financial life?
If we can help you gain control of your finances, let us know, request a personal consultation.