Most people know that over the life of a 30-year loan, they will pay more in interest than the house cost in the first place. So when my clients say that they plan to pay their mortgage at an accelerated rate, I ask one question: Why do financially secure people who have more than enough money to pay cash for a house get a mortgage?
To save money, it is tempting to make a bigger down payment or extra principal payments. But saving money is not the same as making money and many people fail to consider the important role that a mortgage plays in that equation. Every dollar that we give the bank is a dollar we do not invest and denies us the opportunity to earn money with that money. To illustrate, I quote a story from Ric Edelman’s bestseller, The New Rules of Money. The story describes two brothers who both secure a mortgage to buy $250,000 homes in the same neighborhood appreciating in value at an average of 4%. Each brother earns $85,000 a year and has $50,000 in savings.
Brother A believes in paying off a mortgage as soon as possible. He secures a 15-year mortgage at 4.5% and shells out all $50,000 of his savings as a 20% down payment. His monthly payment (principal & interest) is $1,530. Since he has a federal income tax rate of 28%, he is left with an average monthly net after-tax cost of $1,320. Also, in an effort to eliminate his mortgage sooner, Brother A sends an extra $100 to his lender every month.
Brother B, in contrast, secures a 30-year loan at 5%. He outlays a small 5% down payment of $12,500 and invests the remaining $37,500 in a safe, moneymaking account that earns an 8% rate of return (yes, they do exist). His monthly payment is $1,429 ($1,275 principal & interest +$154 mortgage insurance, which is also tax deductible as of 2011) leaving him a monthly net after-tax cost of $1,109. Every month he adds $100 to his investments (the same $100 Brother A sends to his lender), along with the $211 he has saved from his lower mortgage payment. Once the mortgage insurance is dropped at about year 4, he invests the additional savings for a total of $422 a month (allowing for the lost tax deduction on the mortgage insurance that was dropped).
Which brother made the right decision? After only six years, Brother A has received $12,538 in tax savings; however, he has zero dollars in savings and investments. Brother B, on the other hand, has received $22,122 in tax savings, and his savings and investment account has grown to $92,135. Now what if both brothers suddenly lost their jobs? Even though Brother A has $188,912 of equity in his home, he can’t get a loan because he doesn’t have a job. If he can’t make his monthly payments, he may have to sell his home to avoid foreclosure. Brother B, however, has $92,135 in savings and can easily make his monthly payments, while seeking new employment. Now fast forward to twelve years after the brothers bought their homes. Even after paying $100 extra each month, Brother A still owes $32,386 on his mortgage. If Brother B wanted to, he could write a check from his investment account, pay off his mortgage and still have $6,145 left. That’s a difference of $38,531! That’s the magic of compound interest at work.
Unfortunately, most Americans are taught the path of Brother A. However, once the path of Brother B is revealed, they realize it enables them to pay off their homes sooner (if they choose to) while significantly increasing their net worth. And that is just one strategy used by the wealthy that will work for the rest of America as well.
If you are interested in reviewing the benefits of refinancing or looking to purchase a new property and would like to see how a mortgage can help build your wealth email Gary Solka at Sente Mortgage (gary.solka@sentemortgage.com) or call him at (512) 637-9900 to get the process started.
-----------------------------------------------------------
Gary L. Solka, Mortgage Banker
Sente Mortgage
Gary.Solka@SenteMortgage.com
512-637-9900
www.SolkaTeam.com
