Purchasing a home can be one of the biggest financial decisions you can make in your lifetime. That decision can raise a myriad of questions regarding the logistics behind it.
Do you pay for the home in cash (assuming that’s an option)? Or take out a mortgage?
If you take out a mortgage, what should the terms be? Should you buy points or not? 15 or 30 year term? Bi weekly or monthly payments? These can be intimidating questions to tackle without the proper knowledge or know how.
Conventional wisdom would have you believe any debt at all has a negative affect on your financial future. For most debt that may be the case, but not necessarily with a mortgage.
Mortgage Parts
If you’ve ever taken the time to familiarize yourself with your mortgage statement, you’ve noticed it consists of 4 parts. The principal, interest, taxes, and insurance – or PITI for short.
- Principal – the amount paid towards reducing your debt
- Interest – the amount paid to the bank for their risk in lending you the money
- Taxes – self explanatory
- Insurance – the amount paid to protect your financial future (and the banks) if something adverse happens to your home
What most people forget is that the latter two letters in that acronym will never go away. Even after you’ve exhausted your last payment to your lender, you’re taxes and insurance are still due each and every year.
Now that we’ve quickly refreshed on the components of a mortgage, why should you have one (or not)? Here are 6 things to consider.
#1 Mortgage Interest Costs Are Low
Why would anyone WANT to have mortgage if it’s not absolutely necessary. For starters, it’s very cheap money – especially in today’s environment.
Mortgage rates are at historic lows. If you’re in the market for a home (or even looking to refinance your current one), you can expect to pay something along the lines of 3.5% – 5.0%.
With mortgage rates at historic lows, it’s entirely possible – even highly likely – they’ll be higher in the future.
Why not lock in a low rate today? You may never have an opportunity to get low rates like this again in your lifetime!
The 3.5% to 5% is an enormous difference compared to the rate you’ll find on say, your credit card. On average those can range anywhere from 15% to 25% and up.
Why the big difference? The answer is collateral. If you charge up a $10,000 credit card bill and decide not to pay it back, the best the credit card company can do is send you a couple nasty letters and try to tie you up in court, hoping you’ll to pay them back.
It’s also far more likely you’ll default on simple “things” you may buy than the house you may live in.
Collecting can be very costly and time consuming for creditors, so they compensate for this by charging a much higher rate.
Your mortgage on the other hand, is secured by real property. If you fail to pay your mortgage on time, your lender can foreclose on the property. They’ll then sell it to recoup their losses.
#2 Mortgage Interest Expenses Are Tax Deductible
Another reason to hold a mortgage, is the interest is tax deductible at your top tax bracket. This can create a favorable tax situation when considering investment alternatives.
Let’s say you’re in the 25% tax bracket and have the ability to buy your home outright. Conversely, you could take out a mortgage and invest the proceeds you would’ve put down on your house.
If you can reasonably expect to get a 7% long term return on your investment account, and the mortgage rate is only 4%, it’s a no brainer! Invest the money and earn 7% over time while paying 4% to the bank. That 3% spread is call “arbitrage”.
But lets say the environment is equal – or at least seems equal on the surface. Suppose you can reasonably expect to get a 7% long term return on your investment account, but your mortgage will cost you 7%.
Since your interest is tax deductible at your highest tax rate, the net cost of your loan is 5.25% (7% * (1 – 25%)).
In your investment account, you’ll generally be taxed at capital gains rates of 15%. The net profit on your return will be 5.95% (7% * (1 – 15%)).
That’s a .70% increase AND you retain the liquidity of your own money rather than tying it all up in an illiquid asset.
These are ultra simplistic calculations however, and there are many other tax factors which may come into play with your specific situation.
#3 A Mortgage Maintains Your Liquidity
Why is liquidity important? We don’t live in a perfect world. Things go wrong. Emergencies happen. Life changes.
There’s always the “what if” around the corner. Things can be much easier to deal with if you retain the control of your money. If you pay off your house, that money is highly illiquid.
For exactly this reason, it’s advisable not to make extra payments on your mortgage. You’re cheating yourself out of liquidity today, and for what? Maybe a few years clipped off of your 30 year mortgage down the road?
The reward is simply not worth the risk. If anything, mortgage payments get easier over time. You’re going to get promotions and raises, your kids are going to be out of the house and tuitions paid for, your investments should increase in value over time.
While all this is happening, your 360th mortgage payment is exactly the same as your 1st mortgage payment you made 29 years and 11 months prior. Financially things got easier throughout the life of the mortgage.
#4 Buy Points Or Not?
The combination of the tax savings and liquidity alone is evidence enough to never buy points. Buying points involves an extra capital cost up front to you, in order to lower your mortgage rate for the life of the loan.
Why spend the extra cash up front when you get a deduction on the interest anyways? The extra cost up front also lowers your liquidity and investment capital, and there’s an opportunity cost to doing this.
#5 A 15 Or 30 Year Loan?
The same can be said for a 15 year vs a 30 year loan. Why have a higher monthly payment when you could be socking away the difference in an investment account? And you’re still getting a deduction on the interest.
In reality, all you’re doing by shortening the term of your loan is locking yourself into making higher payments. Alternatively, with a 30 year loan you could easily make the 15 year payment if you wanted to do so.
#6 Should You Make Bi-Weekly Or Monthly Payments?
We’ve already established that keeping your loan on the books for as long as possible can be beneficial. Why would you want to make an extra monthly payment every year?
Most would think that bi-weekly payments really just means that they’re paying 2 payments per month. Maybe in February, but what about the other 11 months out of the year that have 30 or 31 days.
There are 52 weeks in a year. Bi-weekly payments are due every other week. That’s 26 payments you’re responsible for every year.
Divide that by 2 and you’ve essentially got 13 “monthly” payments you’re now making when you could be making 12 with a traditional loan. Don’t do it!
The Caveat
These are reasons to carry a mortgage. There is really one reason not to – and it’s 100% emotional.
Some people just can’t handle any debt at all. While I completely understand this fact, financially it’s likely not the best way to approach your money management.
As you’ve seen, there are several reasons to get a mortgage and pay it off per the original terms. If having this debt really bothers you, by all means pay cash for your home or pay it off as quick as possible!
Mortgages In Summary
Now this is all great in theory, but I’ll leave you with this. These strategies only work if you’re smart about your finances.
If you take the couple hundred bucks per month you saved on getting a 30 year mortgage over a 15 and blow it on a corvette instead of staying within your means and buying that Hyundai, you’re on your own! You’d have been better off getting the 15 year loan!
But if you can stay diligent and be smart with your liquidity, you can turn your mortgage into an asset that works for you, rather than a liability that works against.