11 Great Reasons to Carry a Big, Long Mortgage By Ric Edelman Part 2 of 2
The correct question is not about the amount of money you want to pay monthly, but the amount you want to invest. Again, it’s all about wealth creation, not debt elimination.
Here’s the question you should be answering:
Would you rather invest:
$240,000 right now, as a one-time-only deposit
$1,146 a month, every month, for the next 30 years?
Obviously, you’d prefer the strategy that results in a higher profit. And Figure 8-5 reveals the answer. Regardless of the time period, investing a large amount now produces better results than investing small amounts over long periods.
Thus, while a low mortgage payment lowers your overall expenses, it also lowers your overall wealth.
But you suspect there’s a flaw here. In order to invest that $240,000, you’d have to be willing to accept the higher monthly payment. Where will you get the money to do that each month?
You’ll find the money from two places. First, increase your paycheck! Remember that the new loan payments are almost entirely tax-deductible interest.
That means you don’t need to have as much money withheld from your paycheck. So file a new IRS Form W-4 at work to increase your exemptions; this will reduce the amount of taxes that are withheld from your paycheck, boosting your net pay. Yes — you’ve just given yourself a raise! And you can use this increased paycheck to help you pay for your new mortgage payment.
Second, if your paycheck isn’t enough, simply make periodic withdrawals from the investment account you’ve just created. Soon enough, as your income rises, you won’t need this crutch; your income will become enough to handle the cost, as shown in Reason #6.
In fact, getting a big mortgage and using investment proceeds to help you make the payment is superior to getting a small mortgage and having no proceeds to invest. This is especially true when you discover the most important reason of all to carry a big, long mortgage...
Reason #10: Mortgages give you greater liquidity and flexibility.
To help you understand this, let me introduce you to Nervous Nick and Smart Sam.
They have the same income and expenses, and are in the 25% tax bracket. Each has $100,000 in cash; each wants to buy a $300,000 house.
Smart Sam gets a $240,000 30-year mortgage at 4%. He makes no extra payments. But Nervous Nick takes a different approach. Nick hates mortgages and wants to get rid of his mortgage as quickly as he can.
He fears that if he has a mortgage, he might one day lose his house. He doesn’t quite understand how that could actually happen, but his granddaddy told him that mortgages are bad, and Nick believes his granddaddy, so he goes with a small mortgage — as small as possible.
That means he uses his entire $100,000 in cash to make a down payment. His mortgage is therefore smaller than Smart Sam’s — $200,000.
Nervous Nick also gets a 15-year loan instead of a 30-year loan, because he hates mortgages and he figures the 15-year loan will let him get rid of his loan in half the time. Nick also knows that this clever ploy garners him a lower interest rate, because lenders charge less for 15-year loans than they charge for 30-year loans. So while Sam is paying 4%, Nick is paying only 3.5%.
Nick, in fact, is so obsessed with getting rid of his mortgage that every month he sends an extra $100 to his lender. He knows that the more he sends in, the faster his loan will be paid off. So, compared to Sam, Nick has a smaller mortgage, a shorter mortgage, a lower interest rate — and he’s adding money to each payment.
Figure 8-6 shows where the two men stand. Smart Sam’s monthly payment is $1,146. Thanks to amortization, almost all of Sam’s payment — 70% of it — is comprised of interest. Thus, on an after-tax basis in the 25% federal income tax bracket Smart Sam’s payment costs him $946 a month.
Meanwhile, Nervous Nick’s payment is $1,530 a month. But only 38% is interest. That’s because Nick’s loan is for 15 years: The shorter the term, the more principal you must pay each month, and principal payments are not tax-deductible (only the interest is deductible).
So even though Nervous Nick is paying more per month than Smart Sam, he’s deducting less. Nick’s after-tax cost, therefore, is $1,384.
Thus, Smart Sam is paying $438 less per month than Nervous Nick. But Nick doesn’t mind. He doesn’t mind the extra monthly cost because he knows he’ll get rid of his mortgage quicker.
So for the next five years, Smart Sam makes his monthly mortgage payments. And instead of sending an extra $100 every month to his lender like Nick does, Sam puts that $100 into exchange-traded funds.
Then both men lose their jobs. Or perhaps one develops a medical condition, or his wife has a baby and quits work. Whatever the cause, something happens in five years that causes their income to fall or expenses to rise — or both. Figure 8-7 shows Sam's status.
Nick’s been busy paying down his mortgage; the outstanding balance is only $149,000. But does that matter? The guy just lost his job, but he still has to make his monthly mortgage payment.
So it doesn’t matter that his mortgage balance is $149,000; what matters is that his mortgage payment of $1,5301 is due at the end of the month.
This is a real problem for Nick, because with no job, he has no income. He also has no money, because he’s given every available dollar to the bank in the form of extra payments. Nervous Nick’s nightmare is coming true! He’s about to lose his house!
Sam, though, is in much better financial condition. Oh, sure, his mortgage balance is higher than Nick’s but does that matter? Not at all. What matters is that he has to find some way to make his $1,146 payment.
But Sam is not in the same predicament as Nick. That’s because Sam has lots of savings, as shown in Figure 8-7. First, he gave the bank a smaller down payment, enabling him to invest $40,000. Based on an average annual return of 7%, that money grew to $56,102.
Smart Sam also took advantage of the fact that his monthly payment was $438 less than Nick’s; he invested that money too, which is now worth $31,367. And instead of sending $100 a month to his lender like Nick, Sam added $100 to his investments; those investments are worth $7,159.
All told, Smart Sam has $94,628. So even though he’s out of work, he’ll be able to make his mortgage payments for another six years!
How ironic that Nick, who wanted to get rid of his mortgage so he wouldn’t lose his house, is about to suffer the fate he was so desperately trying to avoid. This fable shows you why it is so important that you minimize both your down payment and your monthly payment. By doing so, you retain more of your money.
By keeping control over access to your money, you maintain liquidity. But when you give your money to your lender, you lose control of it. After giving money to your lender, the only way to get your money back is to sell the house — and that’s the one thing Nervous Nicks does not want to do.
This reveals the fatal flaw in the logic of those who lie to you about mortgages. Sure, owning a home mortgage-free is an appealing concept. But it is completely unrealistic! I mean, sure, paying off your mortgage is great — if that’s the only thing you need to do with your money. But what about paying for college? Saving for retirement? Caring for elderly parents? Or even just paying for car repairs!?!?
Indeed, the fatal flaw of those who tell you to do everything you can to pay off your loan as quickly as you can is that they are completely ignoring everything else that’s happening in your life! If you succeed in paying off the loan, you might fail in paying for college, or covering costs in the event of a job loss, medical problem, marital issue, or other family concern.
That’s why you must stop listening to those who pretend that the only thing that matters is paying off a mortgage.
Your life is more complicated than that, and by realizing this, you see that trying to pay off the mortgage like Nervous Nick is actually a risky thing to do. Instead, the smarter and safer approach is to carry a big, long mortgage and don’t bother trying to pay it off!
Reason #11: You’ll never get rid of your monthly payment, no matter how hard you try.
You want to eliminate your mortgage so that you don’t have to make any payments in retirement. That’s too bad, because even if you somehow eliminate your mortgage, you won’t eliminate your payments.
Sure, paying off your mortgage means you no longer make any principal or interest payments. But mortgages are known as PITI, and we’ve only addressed the P and the I. Let’s not forget about the T and the other I — or the M and the R.
I’m talking about taxes and insurance. Even if you manage to pay off the loan, you’ll still have to pay property taxes and homeowner’s insurance. Thus, your goal of “getting rid of the mortgage payment” is impossible! Even if you eliminate the mortgage, you’ll still have tax and insurance payments.
And as long as you own your house, you’ll have Maintenance and Repairs to contend with as well. So don’t bother trying to make your mortgage go away. Instead, create wealth so that you can comfortably afford the cost of living in and owning your home.
The above examples are for illustrative purposes only and do not fully take into account expenses such as property taxes or homeowner’s insurance. The examples used here assume that the rate of return on investments will be greater than the interest rate paid on a home mortgage.
As there are risks with virtually any investment, there can be no assurance that you will achieve returns greater than the interest rate on your home mortgage. Changes in federal income tax laws could have adverse consequences for the mortgage interest deduction.
Taking equity out of your home involves risk, particularly in slow or declining markets. This could result in some homeowners owing more money than their home is worth.
Even if your home sells for its appraised value, the net proceeds could be much lower than anticipated due to legal fees, realtor fees, and other closing costs. There is also the potential for a reduced tax deduction. Any amount that you borrow over 100% of equity is not tax deductible.