Mortgages for the Holistic Investor

Key Terms

Amortization: is the crossover from paying a higher percentage of monthly payments for interest to a higher percentage of monthly payments going to the principal*.

Mortgage: debt backed by real estate as collateral

Mortgages = bad debt?

Traditional wisdom dictates debt is bad, and we should get rid of it as quickly as possible. However when understood and structured correctly certain forms of debt can become asset-like. The following will rationalize why a long, expensive mortgage can be a sound financial decision. Although it is not justification to purchase a home out of your price range.

First let’s clarify if you would like to avoid bank loans and interest payments altogether, paying the entire value of a home in cash is the ideal option. In reality not many individuals can afford such a luxury and a bank loan is the natural alternative.

The interest rates of mortgages are determined by banks and dependent on your income. Higher annual income means lower interest rates. Shorter loans (15 year mortgages) have lower interest rates than longer loans (30 year mortgages). This is because shorter loans are generally less risky and less expensive for banks. Fannie Mae and Freddie Mac (Federal backed mortgage entities) may also assess additional fees to a 30 year mortgage. Overall a 15 year mortgage may have a quarter of a percent to a full percent less interest than 30 year mortgage.

The higher the interest rate, the more potential profit a bank will reap out of your pocket. Consider a 300k loan, available at 4% for 30 years or at 3.25% for 15 years. The combined effect of the faster amortization and the lower interest rate means that borrowing the money for 15 years would cost $79,441. Compared to a total of $215,609 over 30 years, or about 2/3 less.

It is true 30 year mortgages have a higher price tag than shorter loans. One might jump to conclude a shorter loan is the best financial decision. I would argue that this individual is failing to look at their finances from a holistic perspective.

Imagine you decide to take the 15 year loan for 300k at 3.25%. Your monthly payments are now going to be about $2,108.00. If you had opted for the 30 year loan at 4% you would be paying about $1,432.24 a month. In this example the difference in payments is about $675 a month. This is without calculating the additional tax deductions of paying more interest than principal. The difference should be either saved or invested elsewhere.

Let’s compare the two options at the 15 year benchmark and assume the 25% tax bracket.

15-Year 30-Year
Total Payments $379,441 $257,804
Interest Paid $79,441 $151,433
Interest Portions 21% 59%
Tax Savings -$21,293 -$37,858
Net Payments $358,148 $219,946

The 15 year mortgage would now allows you full ownership of your home with no debt. But you have paid an extra $138,202 or $768 a month than if you had elected the 30 year mortgage.

Now lets say you had decided to invest the $768 a month at a healthy 7% return a year. Although a 7% annualized return is hypothetical and not guaranteed with any investment.

At the end of the 15 years this account would hold a value of $243,110.08

At the end of the 15 years the mortgage balance would be $193,628.00

If you wanted to liquidate the account, pay the 25% income tax AND pay off the mortgage you would pocket the difference of $33,462. A 15 year mortgage means higher payments, less saving, and can be riskier if job security is an issue. The 30 year alternative allows time for equity to build, results in better tax deductions and allows increased savings or reinvestment.

More Reasons a 30 Year Mortgage is a Sound Financial Decision

1) The size or length of your mortgage will have no impact on the value of your home.
  • as you chip away at the mortgage you home will be gaining value
  • building home equity is nearly automatic
  • 2) A mortgage is a relatively cheap loan
  • consider most student loans live within the range of 4-7%, personal loans 7-12% and credit cards 14-18%
  • this is because the house is an asset and serves as collateral. If you don’t pay mortgage installments, banks have a right your home
  • 3) Mortgage interest is tax-deductible
  • as long as you are still paying the mortgage interest you will receive tax deductions
  • the same is not true for the mortgage principal
    4) Mortgage payments get easier over time
  • with age comes the likelihood of increased wages
  • smaller payments means higher monthly savings
  • 5) Mortgages allow you to create wealth (if you’re savvy)
  • more savings can mean more investing
  • mortgages are considered liquid assets
  • 5) You will never completely rid yourself of monthly payments
  • Homeowners insurance, property taxes etc. are recurring monthly expenses that cannot be eliminated
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    This theory emphasizes saving over spending and greater detail can be found in The Truth About Retirement Plans and IRAs by Ric Edelman.