Reason #10: Mortgages give you greater liquidity and flexibility.
To help you understand this, let me introduce you to Nervous Nick and Smart Sam.
Each earns $75,000 a year; each has $50,000 in savings; each wants to buy a $250,000 house.
Smart Sam gets a $237,500 30-year mortgage at 7%. 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.
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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 $50,000 in savings to makes 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 7%, Nick is paying only 6.75%.
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 (It’s hard to believe that Sam is the smart one, right? Wait and see.) monthly payment is $1,580. Thanks to amortization (which you learned about earlier in this chapter), almost all of Sam’s payment — 88% of it — is comprised of interest. Thus, on an after-tax basis (assuming he’s in the 25% federal income tax bracket), Smart Sam’s payment costs him $1,232 a month.
Meanwhile, Nervous Nick’s payment is $1,770 a month. But only 64% 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 $1,487.
Thus, Smart Sam is paying $255 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 $1,770 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 — $224,000 — but does that matter? Not at all. What matters is that he has to find some way to make his $1,580 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 $37,500. Based on an average annual return of 8%, that money grew to $55,100.
Smart Sam also took advantage of the fact that his monthly payment was $255 less than Nick’s; he invested that money too, which is now worth $17,951. And instead of sending $100 a month to his lender like Nick, Sam added $100 to his investments; those investments are worth $7,039. All told, Smart Sam has $80,090. So even though he’s out of work, he’ll be able to make his mortgage payments for another four 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.
Now That You’re Convinced
Go ahead, admit it. You’re convinced that carrying a big, long mortgage is the smart financial strategy. That means you might want to refinance.
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.
What the Academics Say About Mortgages
“Thus, a homeowner with a long time horizon and a willingness to assume some risk will likely have a much higher net worth than someone who selects the less risky option of the 15-year mortgage.”
“The Effects of Income Tax Rates and Interest Rates in Choosing Between 15- and 30-Year Mortgages.” The CPA Journal #65, 1995.
“…home owners…may not be adequately considering the opportunity costs of the investment in their home. Individuals should not attempt to analyze the mortgage decision in isolation from their overall personal financial plan. Instead they should consider the mortgage decision along with their plans for long-term investing, insurance needs, tax planning and so forth. If the only way home buyers can afford the higher 15-year mortgage payment is by delaying long-term investments or by limiting the funds they commit to a long-term investment plan, they may be better off in the long run by taking the 30-year mortgage with the lower payment and investing the difference….
“….the 30-year mortgage is clearly the best financial choice for many home buyers.”
“15-Year Versus 30-Year Mortgage: Which Is the Better Option?" Journal of Financial Planning, April 1998.
“Planners must consider many factors when analyzing the 15-year versus 30-year mortgage option, but certain issues deserve mention. First, even if the mortgage is held to maturity, the argument that the 15-year option is optimal because fewer total dollars are spent to purchase the home is seriously flawed. The fact that a smaller total dollar expenditure is required for the 15-year loan is irrelevant to the maturity decision.”
“Including a Decreased Loan Life in the Mortgage Decision” Journal of Financial Planning, December 2003.
“Advantages of the 30-year mortgage include lower monthly payments and accumulated wealth, in an investment account available to help alleviate hardships. Withdrawals from the investment account would be free of penalties for the non tax-deferred accounts, and free of penalties for the tax deferred….The data showed that a borrower…willing to invest with a risk level associated with the S&P 500 would benefit from a 30-year mortgage.”
“Effect on Net Worth of 15- and 30-Year Mortgage Term.”Journal, Association for Financial Counseling and Planning Education, 2004.
“When households have a substantial risk of unemployment -- or of a big fall in income -- a long-term fixed rate mortgage looks preferable.”
“The long-term fixed-rate contract becomes more attractive as people start to borrow a lot.”
“It is reasonable to expect that if consumers in the UK were helped to understand better the risk and cost profiles of different types of mortgages there would be more longer-term fixed-rate lending.”
“UK Mortgage Market: Taking a Longer-Term View. Final Report and Recommendations.” HM Treasury on behalf of the Controller of Her Majesty’s Stationery Office, March 2004.
"The popular press, following conventional wisdom, frequently advises that eliminating mortgage debt is a desirable goal. We show that this advice is often wrong…mortgage debt is valuable to many individuals."
“Mortgage Debt: The Good News.” Journal of Financial Planning, September 2004.
“Better financial results accrue to some borrowers when they select a 30-year mortgage coupled with a simultaneous investment plan rather than a 15-year mortgage term and a subsequent investment plan…for the vast majority of borrowers, there remains a significant probability that the 30-year mortgage is the better mortgage product even in higher mortgage rate scenarios. Further, the financial benefit associated with a 30-year mortgage increases as the borrower’s marginal tax rate and risk tolerance increase.”
“Is a 30-Year Mortgage Preferable to a 15-Year Mortgage?” Journal, Association of Financial Counseling and Planning Education, 2006, Volume 17 Issue 1.
“…U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice…in the aggregate, these mis-allocated savings are costing U.S. households as much as $1.5 billion dollars per year.”
“The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings.” Federal Reserve Bank of Chicago, August 2006.