Lies you’re being told about your mortgage

When shopping for a mortgage, we heard a lot of things that sounded a little fishy. In this post, we’ll share some of the things that we learned as first time home buyers shopping for a mortgage.

Pay off your mortgage as fast as possible, you’ll save tons of interest!

houseThere are many reasons you might want to pay off your mortgage, but saving interest shouldn’t be one of them. If you’ve recently gotten a mortgage or refinanced, you are probably paying a phenomenal 3 or 4% on your balance, depending on your mortgage term. The amount you owe doesn’t go up with inflation, so you can think of the balance as “deflating” over time by about 2-3% per year. Unless you think the economy is really going to tank over the entire remaining life of your loan, you are better off investing your money and taking your sweet time paying off the loan. Let’s run some numbers. The actual interest rates offered to the Paradise Family were 4% for a 30 year mortgage and 3.25% for a 15 year mortgage. Let’s say our house sale price was $300,000 and we put 20% down for a mortgage of $240,000. For simplicity, let’s assume we are able to make 7% in the stock market each year (we’ll get more general in a bit). What do we choose so we are in the best place in 30 years?

The interest argument

Over the life of the loan, our 30 year mortgage costs a whopping $109,000 more in interest than the 15 year. On the 30 year loan we have to pay almost DOUBLE the amount of the initial balance. Did I sell you on the 15 year? Hold on just one sec…

The opportunity cost of owning a home

Think of “opportunity cost” as “what could have been” if you didn’t do this other thing with your money. The first opportunity cost you have is your down payment. On our fictional $300k house, we paid $60k down. Over 30 years compounded at 7%, the opportunity cost of this payment is $457k. Next, let’s do the mortgage payments. What if instead of paying your mortgage, you paid yourself an annuity equal to your monthly payment and compounded it at 7%? For the 15 year example, you’d have your annuity for 15 years followed by another 15 years of compounding, for a total value of $1,475k. For the 30 year, you have an annuity the whole 30 years for a total value of $1,398k. So…with these very specific numbers, you’d save almost $80,000 in the 30 year scenario, and this is not even including any mortgage interest deductions you might achieve (see below for a discussion on that).

Now, what if you are a real high-roller and you don’t even want a mortgage, you just pay for your house in ca$h? Now you’ve got the entire $300k as an opportunity cost over 30 years. At 7%, this amounts to about 2.3 million dollars. Yowza.

Of course, this depends strongly on the interest rate you are able to get on your investments. The lower the interest rate, the more the 15 year mortgage will swing in your favor. Here’s a graph showing how this will change with the rates:

mortgage2

Stuff I left out:

Ok, I admit this is a very simplified discussion. I didn’t include deductions on mortgage interest, fluctuating rates of returns, inflation, or housing appreciation (although this is constant for all scenarios, it just makes your bottom line opp cost less in all cases). This also assumes you stay in your house for 30 years. If you move to a new house and start a new mortgage…well, that’s going to take a little bit more math.

Your mortgage interest and real estate taxes are tax deductible. You can basically subtract about half of it because you’ll get that much back. Yes!

This is one of the worst ones because so many people believe it. The mortgage expert you are working with probably even believes it. For many people, buying a house is the first event that triggers them to itemize deductions on their taxes instead of taking the standard deduction. The standard deduction for a couple married filing jointly for 2016 is $12,600. That means that you get to subtract $12,600 from your income before you calculate your taxes. This saves you $12,600 times whatever your marginal (highest) tax rate is. Let’s say you are in the 25% tax bracket, so therefore your savings are $3,150. Woohoo!

What you don’t normally hear is that in order to deduct mortgage interest (and/or anything else like property tax, sales tax, charitable giving…) you have to give up the standard deduction. You are automatically $3,150 in the hole when you do this, more if you are in a higher tax bracket. If you can’t save at least $3,150 by itemizing, you save ZERO dollars off your mortgage interest. It is actually the people with the highest incomes that are able to save the most by itemizing and deducting mortgage interest and property tax. These people have high state income tax (and typically bigger mortgages) which allows them to come up with more than the standard $12,600 worth of deductions before they even get to the real estate-related ones1.

More math!

Let’s say as a couple your taxable income is $100,000 per year and your state income tax is 5%, or $5000. You also give $2000 a year to charity. You’ve got $7,000 worth of deductions banked. You are still missing $5,600 to get you up to the standard deduction. Maybe you live in a swanky area and your real estate taxes are about that much per year. Now you are achieving real savings on your mortgage interest (although none on your real estate taxes). In the first year you’ll pay about $7,600 in interest on your mortgage (using our numbers above), so you get to save about $2,000 by itemizing your deductions. Keep in mind though, we were pretty conservative in the numbers here and this is the highest the deduction would ever be in this scenario. It will only decrease as the loan is paid off. You saved 15% off your mortgage interest + real estate taxes. Nothing to sneeze at but not the windfall it is made out to be.

We can help you pay off your mortgage faster and save you money!

I cannot tell you how many letters we have received the mail from mortgage payment companies offering to help us “save thousands” in interest on our mortgage. The sheer volume we receive convinces me these people must be making money off of unsuspecting homeowners. These companies work by setting up a payment plan for you to increase your monthly payment to an amount that lets you pay off your mortgage in whatever time period you want. Often it is by making bi-monthly payments so you pay 26 times a year which amounts to one extra monthly mortgage payment. Magically your loan term decreases by ~8 years. This isn’t magic, it is just paying more money earlier! They will do this simple thing that you can very easily do yourself for a low enrollment fee of $200-$400 and a small percentage of each payment you make. If you want to pay off your mortgage faster, tell your bank you want to increase your monthly automatic withdrawal. This is the exact same thing and ALL the extra you pay goes toward principal, which especially helps at the beginning of your loan.

Just get a 30 year mortgage and pay if off fast. You’ll save on interest, and you’ll have the freedom to pay more when you want but won’t be locked into the higher payments on the 15 year term.

If this even enters into your mind as a factor when buying a house, you are buying a house that is too expensive. We already debunked the interest part. If you want to pay your mortgage off fast for whatever reason, get the shorter loan with the cheaper interest rate!

So, there you have it, a few things we learned when buying our house. We hope this has been helpful, and sorry about all the numbers!

  1. By the way, if you get sold the same line when you are buying a car, please correct your financing person. You can deduct sales tax OR state income tax, not both. Deducting sales tax almost never works out in your favor. If it does, geez, what are you buying?

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