Let’s look at Sam and Nick.
They both earn $75,000 a year. Both have $50,000 in cash. Both buy a $250,000 house. Nick wants to minimize his mortgage, so he uses his $50,000 in savings as a down payment, and he opts for a 15-year loan at 6.75%. His monthly payment is $1,770 — but only 64% of that payment is tax-deductible interest; the rest is principal. Therefore, Nick’s net after-tax cost for his mortgage is $1,489. And to pay off his mortgage even quicker, Nick sends in an extra $100 with every payment. Of course, these payments are devoted entirely to principal, and therefore provide no tax deduction.
Nick’s decision to send extra payments to his lender is a critical point. You see, every time you send extra money to your mortgage company, you deny yourself the opportunity to invest that money elsewhere. In business school, professors call this “opportunity cost.” It means, essentially, that every time you turn left, you deny yourself the opportunity to turn right. So, although paying off the mortgage saves you interest, you deny yourself the chance to earn interest with the money you used to pay off the mortgage.
Sam understands this, and therefore, he obtains a 30-year mortgage at 7% (a bit higher than Nick’s rate). He puts down just $12,500 and finances the rest. Even though Sam’s mortgage balance is bigger than Nick’s ($237,500 compared to $200,000), his monthly payment is lower (because it’s a longer term). That’s not all. A full 88% of Sam’s payment is interest, meaning that Sam’s after-tax cost is just $1,234 a month — $255 less than what Nick has to pay! Sam invests this savings of $255 each month for five years, earning 8% after taxes per year. And, instead of sending an extra $100 a month to his mortgage company, as Nick does, Sam adds it to his savings.
Smart Sam versus Nervous Nick
Monthly payment: $1,580 Interest portion: 88% After-tax cost: $1,234 Sam’s payment is $255 less per month than Nick’s $1,770 64% $1,489. Over five years, Sam has about $79,000 in savings and investments.
Nick, however, has no cash whatsoever, because he’s placed every available dollar into mortgage payments.
So, when both men suddenly find themselves out of work, Sam is in excellent financial condition, but Nick is in real trouble. He has no savings to tide him over, and he can’t gain access to the $100,000 worth of equity that’s in his house because, being out of work, the bank turned down his loan application. (It’s true: Lenders don’t care about how much equity you have in the house. They lend money only to people who can repay the loan).
With no job, Nick has no income, and therefore, he cannot qualify for a loan. Indeed, Nick has fallen victim to the biggest misconception in real estate: A mortgage is not a loan against the house; it’s a loan against your income. Without an income, you cannot obtain a loan.
If Nick doesn’t get a job real soon, he’ll lose his house. How ironic! Nick, who never wanted a mortgage in the first place and who did everything he could to eliminate his mortgage as quickly as possible, is now in serious financial jeopardy!
Sam, though, is in much better shape. With $79,000 in savings, he’s easily able to make his payments each month. In fact, he can make mortgage payments for four years, giving himself plenty of time to find a new job! And that’s really my point. When you have a mortgage, you are required to make only that month’s payment. You are never required to pay off your loan immediately. You might want to do so, but that doesn’t mean you must do so. You must not send extra payments to your mortgage lender. Invest that money instead, just as Sam did.
Never prepay your mortgage payments like Nick did, because once you give money to a lender, the only way you’ll ever get it back is to re-borrow the money or sell the house. Selling your home is the last thing you want to do, and if unemployed, you probably will be unable to get a loan when you need it most. Besides, if you’re simply going to borrow it back later, why bother giving the money to the lender in the first place? Tip your hat to your spinning-in-his-grave grandfather, and go get a big, long-term mortgage today!
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