Homeowners taking out 10-year mortgages

Wall Street Journal ^ | June 2, 2003 | RUTH SIMON

[speekinout]

You have to think about more than just the cost of the house. There are far too many seniors today who are "house poor". Most of their money is in equity in their homes, and reverse mortgages (the only way to get it out without moving) are far more expensive than the mortgage you can get while you're still working.
And if you intend to retire to a lower cost home or lower cost area, why would you ever want to pay off your current home? All you need is enough money for the next one.

I wish someone would tell me a good reason to pay off a house. I don't know one.
It seems to me that getting a mortgage with comfortable payments, and investing whatever you can in other things makes the most sense. If one part of the economy collapses (and housing can do it too) then you have some back-up.

[the bottle let me down]

I wonder what Rick's problem is? If a person pays only the required monthly payment on a 30 year mortgage, at the end of that 30 years, he will have paid at least double the selling price.

Primarily, it's a liquidity thing: yes, equity is an asset, but it can't be tapped quickly, and in some cases, it can't be tapped at all.

For example, you make extra payments and pay off your mortgage, so you own your house free and clear. Now you lose your job--try tapping into your equity to support yourself until you find a new job. You won't be able to. If you'd been investing the money in other, more liquid places rather than in paying off your mortgage early, you'd have a huge fund to live off of.

[Skywalk]

Yep and your house, one hopes, will at least maintain its value if not increase dramatically. This increase in value happens whether you have paid the mortgage or not. So why spend the extra money when you derive no further increase in the value of the house?

[Dog Gone]

If the real estate market goes down, you could get caught with negative equity.

Sure, but that could happen with my 30 year note, too. I'd only be refinancing my balance, so I'm not clear what difference that would make.

[E. Pluribus Unum]

Instead of refinancing my 30 year/6.125% loan with 29.5 years left on it, I am paying an extra $800 a month which will pay it off in 9 years.

If I refinanced at 4.5% and made the same monthly payment it would be paid off in 8 years, but I have to come up with $2500 closing costs right now and it would only save me about $4000 in interest.

If you already have a fairly decent rate and have the discipline to pay extra each month, refinancing is not really necessary to obtain huge savings in interest, plus if something happens and your income is drastically cut you have the safety net of being able to drop the extra monthly payment and not lose the house.

[Petronski]

Meanwhile down the street, other people are taking out seven year car loans...on cars from GM!!!!

[Skywalk]

Peep the link to Edelman's new rules of money, you'll be converted.

Of course, if the gubmint gets rid of the mortgage interest deduction altogether, it takes a bit of the wind out of the sails but it still stands on its own.

Oh, and NO STARTER HOMES! Stupid idea.

[Dog Gone]

I wish someone would tell me a good reason to pay off a house. I don't know one.

Well, I guess you could reach an arrangement with a mortgage company to keep paying them forever, but the concept of not sending them a monthly check seems appealing to me.

[E. Pluribus Unum]

I wish someone would tell me a good reason to pay off a house. I don't know one.

Because once it is paid off you can get by on a lot less monthly income. That means you could take a job that didn't pay as much, but that you really liked.

[Skywalk]

That is about the only thing appealing about it.

[Petronski]

Anyone considering doing this should keep in mind that if their current rate is good, and there's no prepayment penalty in the note, the borrower is free to send in the 10-year payment amount and get all these benefits without closing costs and without locking in to the higher payment.

[sysvr4]

Rick is right, folks. The thing you guys are forgetting is that interest paid on mortgages is tax deductible. This means that your effective interest rate is considerably lower than the stated rate once you consider the tax benefits.

For example, assume the following:

1) Loan amount of $150,000
2) Interest rate of 6%
3) Term of 30 years
4) 30% tax bracket for borrowing individual

Over the term of that 30 years, you'd pay $173,757 worth of interest. But at the same time, you'd save $52,127 over that same 30 years in taxes from the interest deductions. Thus, you'd have an effective cumulative interest of $121,630 ($173,757 - $52,127).

That being the case, your effective interest rate is closer to 4.5% than the stated rate of 6%. It may be even lower... the higher your tax bracket, the more your tax savings and the lower your effective rate. The prevailing thought is that you can invest your money over that 30 years at a higher rate than your (this example) AFTER TAX interest rate of 4.5%, meaning you'd be to the plus with any money you DON'T invest in your mortgage, but DO invest in an effective portfolio/401k/IRA/whatever.

So, the point is, borrow for as LONG as you can, as cheaply as you can, because you're borrowing cheaper than you can make money (you do believe your portfolio can do better than 4.5% over the long term, yes?) and invest whatever you have left in tax-deferred vehicles and you'll actually come out way ahead of where you would if you put the money in your house.

I know this will never convince a number of you, but this is standard practice amoung people "in the know" financially. You don't have to believe it, but you should ask someone you trust that knows what they're talking about before passing judgement. Hope this helps,

Jeff

[luckodeirish]

Do it! I just refinanced a rental townhouse in Irvine, Calif. 3 years ago no one wanted to re-fi it cause it was a rental prop. This time, I had 4 lenders wanting to do business with me. Did a 10 year, and the mortgage is now only $46 month more, take in to consideration that it was $1,284.04 per month, so the $46 is really not a lot. Happy as a clam about it, too.

[E. Pluribus Unum]

If the real estate market goes down, you could get caught with negative equity.

Which is worse?

1) Having the market value of a house that you own free-and-clear go down?

2) Having a house that is worth less than the outstanding balance of the loan?

[Fred Mertz]

I need to go for a 10 year vs a 15 year loan. I have 20 years left on my 30 year mortgage and I don't know what I'm waiting for.

Thanks for posting this article.

[Skywalk]

This is from that link:

That translates to a mortgage. Why carry 18% credit card debts - which are not tax-deductible - when you could instead carry an 6% mortgage that is tax-deductible? Ditto for auto loans, school loans and personal loans. Your mortgage is the cheapest money you'll ever buy, so it makes sense to use it as much as you can. The next time you buy a car, finance it with a home mortgage instead of a car loan.

There I go again, talking about carrying debt. That's what scares you. You know that if you owe $5,000 to credit cards and then lose your job, VISA can't reclaim that sweater you bought. But if you have a home equity line of credit which you fail to repay because you're out of work, the bank can take your house. That's why you don't want to borrow against your house - in case you're out of work and money gets tight; it sure would be a relief knowing that you don't have a big mortgage payment to make.

That's wrong again, I'm afraid. First, it's unlikely that you're going to find yourself in such dire straights. But then, that's what financial planning is all about, so let me do some effective planning for you. Let's look at Pat and Ed. They both earn $50,000 a year. Both have $20,000 in savings. Both buy a $120,000 house.

Pat wants to minimize his mortgage, so he uses his $20,000 in savings as a down payment, and he opts for a 15-year loan at 5.5%. His monthly payment is $817, but only 55% of that payment is tax-deductible interest; the rest is principal. Therefore, Pat's net after-tax cost for his mortgage is $669. And to pay off his mortgage even quicker, Pat sends in an extra $100 with every payment. Of course, these payments are devoted entirely to principal, and therefore provide no tax deduction.

Ed listens to me, and therefore obtains a 30-year mortgage at 6%, putting down just 5% and financing the rest. Even though his mortgage balance is bigger than Pat's ($114,000 compared to $100,000), his monthly payment is just $683. That's not all: A full 83% of the payment is interest, meaning that Ed's after-tax cost is just $496 a month - $173 less than what Pat has to pay! Ed invests this savings of $173 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 Pat does, Ed adds it to his savings. Result: Over five years, Ed accumulates nearly $19,000. Because he kept $14,000 from his original $20,000, he's able to keep that money invested, too. Now, that money has grown to $21,000. All told, Ed has accumulated $40,000 in savings and investments.

Suddenly, both men find themselves out of work. Because Pat used all of his money as a down payment, he has no savings to tide him over. True, he's got $48,000 worth of equity in his house, but he can't access it. He tried, but the bank turned him down for the loan. "But I've got all this equity in my house!" Pat exclaimed. It didn't matter, the loan officer said, because banks only lend money to people who can repay the loans. With no job, Pat has no income and therefore he cannot qualify for a loan.

Indeed, Pat has fallen victim to the biggest misconception in real estate: That a mortgage is a loan against the house. It isn't. A mortgage is a loan against your income. Without an income, you cannot obtain a loan. If Pat doesn't fix his income problem in a hurry, he'll lose his house. How ironic: Pat, who never wanted a mortgage in the first place, is now in financial jeopardy because he was trying to get rid of one too quickly, and now can't get another!

Ed, though, is in much better shape. With $40,000 in savings, he's easily able to make his payments each month. In fact, even if he doesn't find work for a long time, his home is not in jeopardy. At the rate of $586 a month, Ed won't run out of money for nearly eight years!

[Fred Mertz]

Rick is right, folks. The thing you guys are forgetting is that interest paid on mortgages is tax deductible.

Screw the IRS and their complicated formulae. Screw the financial institutions while you're at it.

"Get out of debt" is the best advice I gave to one of my Army friends before he retired with a fat paycheck as a Colonel.

[Joe Hadenuf]

I agree. It's best to have the low monthly payment of a 30 year and just prepay it if you have the extra dough. At least then, if you hit a rough spot, you're not stuck with a killer high monthly payment.

Excellent point.

[Skywalk]

If you have substantial loot that you can invest ON TOP of paying extra to get rid of the mortgage quickly, then perhaps.

But financial planners would disagree.

Even if the IRS is gone and the deduction goes the way of the dodo there are STILL advantages to the 30 year note. A perfunctory knowledge of economics assists in understanding the situation. Does it guarantee success? No, but hey this is life not Paradise.

I look at it like this: It's better to have bigger cash stocks or liquid assets than to simply not have debt. But house notes are COMPLETELY different type of debt than credit cards.

But even with credit cards, sometimes it's better to carry a low balance and make the minimum so that you have a greater cash supply on hand for a given "tough" month.

[Dog Gone]

It seems to me that Rick's argument is based on a presumption that you can substantially gain more by investing your money elsewhere than in reducing the debt. That is often true, but it really hasn't been true in the last couple of years. If you had invested that money in the stock market, you might well have negative returns.

And, unless you're investing in some tax-sheltered investment, you have to consider what your after-tax return really is. Look at my calculations in post 22. I don't think I can guarantee a 20% return on my money for the next 10 years anywhere else. Where am I wrong?