Our most recent post discussed cost benefit analysis (CBA), debt service obligations (DSO) and Income/Investment Opportunities (IIO).
Today we'll expand the conversation and look at some of the myths and truths surrounding homeownership and its broader connotations.
First, homes are not good long term investments compared to stocks. The simple fact is that homes have not appreciated at a rate greater than the rate of inflation over the past century. And the recent house price fiasco still has millions of 'happy' homeowners financially 'under water.'
On the other hand, stocks have outperformed inflation by ~5% annually on average. Over thirty or forty years, the estimated ~5% annual advantage for stocks over home price appreciation will grow to become a huuuuuge chuck of money --- like a 5 to 1 beat or so over time, using the compounding rule of 72 as our guide.
So the idea of homeownership, albeit a good one, is not to be confused with a 'no brainer' investment opportunity, despite what the realtor, mortgage lender, home seller or home builder may say.
When the real estate commission and the lack of instant liquidity are included in the homeownership equation, the only sensible approach is to buy and stay for many years or not buy and rent in the interim until such time as we are ready to buy and stay.
Why a 30-year home mortgage may leave you house poor is subtitled 'Your first instinct to finance a house purchase isn't always right' and offers solid advice for the responsible would be home buyer and saver.
Don’t take any aspect of home finance lightly, especially if you are a first-time buyer.
Many people in the U.S. assume when buying a home that a 30-year mortgage loan is their only real choice, but you can save a lot of money by going with a 15-year loan if you can afford it.
Spreading the payments over 30 years of course makes loan payments more affordable, but you will pay so much more if you go this route. And if you think you can’t swing a 15-year loan, you should still learn about all available options. The potential savings might be so large that it’s worth considering “buying less house” or reducing your expenses another way to get it done....
Comparing loan terms
Let’s start by comparing a 30-year fixed-rate mortgage loan with a 15-year fixed-rate loan. We’re only looking at fixed-rate loans here, because interest rates are so low that it doesn’t really make sense to consider a variable-rate loan at this time....
Most borrowers will have to come up with a 20% down payment to qualify for a loan. But your mortgage lender can help you to learn whether you qualify for a lower down payment through the Federal Housing Administration (FHA) or another government program.
Fannie Mae and Freddie Mac, the government-sponsored mortgage giants that buy the great majority of newly originated residential loans in the U.S., have guidelines that also allow down payments of less than 20% for “conventional mortgage loans,” which have balances up to $417,000. But in return for the lower down payment, the borrower pays a monthly private mortgage insurance premium. The insurance protects the lender or investor, which won’t have the customary 20% cushion to protect its interest.
To keep things simple, we’ll use the 20% down payment for this example. Your down payment is $52,000, so you will borrow $208,000. You will also have to cover the costs associated with purchasing the home and taking out the loan. These closing costs typically range from 2% to 5% of the purchase price, according to Zillow. If you are a first-time home buyer, this can be a brutal surprise.
According to Bankrate.com, the average interest rate for a 30-year fixed mortgage loan is currently 3.66%, while the average rate for a 15-year fixed mortgage loan is 2.72%. These are extraordinarily low rates — possibly the lowest you will see in your lifetime. . . .
For simplicity, we’ll round the interest rates for our example to 3.65% for the 30-year loan and 2.70% for the 15-year loan.
30-year vs. 15-year loan
Based on our purchase price of $260,000, the 20% down payment of $52,000, loan amount of $208,000 and interest rate of 3.70%, the monthly principal and interest (P&I) payment for the 30-year loan is $957.39.
You might be ready to celebrate, but keep in mind this does not include any monthly escrow payment for insurance and taxes that will be required by the lender. Of course, you will also have the escrow payments with the 15-year loan, so we’re just comparing P&I here.
With an interest rate of 2.70%, the monthly P&I payment for the 15-year loan is $1,406.59.
Many people have a terrible habit when deciding on home or car purchases of only considering the affordability of monthly payments, rather than the entire cost for the life of a loan.
The total interest paid over the life of the 30-year loan will be $136,659. Total interest paid over the life of the 15-year loan will be just $45,186. So if you can afford the 15-year loan, you will save $91,473.
Common arguments in favor of the 30-year loan include the likelihood that you won’t stay in the home even for 15 years, and that its best to “buy the best house you can afford,” because then you will see a greater benefit from home-price appreciation over time. The mortgage credit crisis of 2008 and 2009 should be enough to prove that these are both weak arguments. You might not be able to sell your home if you are ready to move in just a few years, since its market value may have dropped significantly. You might even be “upside down,” with the market value being lower than the remaining loan balance.
Building equity faster
Fixed-rate mortgage loans have amortizing loan payments, which means the balance of the payment applied to principal and interest changes each month. Sounds boring? It’s critical to your understanding of why the 15-year loan has such huge advantages.
The first monthly payment of $957.39 for the 30-year loan is made up of $641.33 for interest and $316.06 for principal. After five years, the weighting of the payment is $578.38 for interest and $379.01 for principal. After 60 payments, you’re still building up equity very slowly. Your loan balance is $187,204.
You have built just $20,796 in equity over the five years, so including the down payment of $52,000, your total equity is $72,796, or 28% of the $260,000 purchase price.
Because the 15-year loan payment is so much more heavily weighted toward principal, in five years your situation will be a lot more favorable. The first monthly payment of $1,406.59 is made up of $468.00 in interest and $938.59 in principal. After five years, the weighting of the payment is $334.91 interest and $1,071.68 principal and your remaining loan balance is $147,778.
So after five years with the 15-year loan, you have built $60,222 in equity. Including the down payment of $52,000, your total equity is $112,222, or 43% of the purchase price of $260,000....
And if the 15-year loan doesn’t look right for you, other payment terms are available. . . . you can easily get fixed-rate mortgage loans with 20-year or 25-year terms (or even 10-year terms) that Fannie and Freddie are willing to buy from lenders. A shorter term means a lower interest rate, faster equity build-up, and plenty of savings on interest as you get the debt monkey off your back much sooner.
When making your mortgage finance decision, be sure to think about your entire financial situation. Are you saving for retirement? Will you be able to do so if you buy your dream house? Maybe it would be better to look for balance in all aspects of your financial life, so you can afford a home, minimize interest payments, and save for retirement and college tuition for your children. Such careful purchasing and borrowing decisions can save you a lot of money — and pain."
Utilizing the CBA method of financial analysis, and thereby avoiding unnecessary DSO, will facilitate IIO.
Following the KISS and MOM common sense approach will make a huuuuge difference to knowledgeable home buyers.
Buying a home and paying off student loans, car loans or credit card balances, or setting aside money to save for retirement, should not be mutually exclusive or time phased sequential goals.
Doing the right things financially for ourselves and our families should not be mere fantasies or 'impossible dreams.'
As the above example illustrates, the home buyer is well advised to take out a 15 year mortgage and avoid paying an additional ~$100,000 in interest expenses over the duration of the loan.
And when the 15 years are up, our smart buyer will own that house free and clear.
Or, perhaps even smarter, the smart buyer can elect to use that growing equity and interest savings all along the way to take out a low interest rate HELOC (home equity line of credit) and use the growing 'equity' to pay off student loans, car loans, credit cards or even put some additional money in the individual IRA account.
So why don't we all do ourselves a favor and adopt the CBA way for all big ticket financed purchases, including college, cars, credit cards and homes?
Simple KISS and MOM rules apply.
That's my take.