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How the Affluent Manage Home
Equity to Safely and Conservatively Build Wealth
If you had enough money
to pay off your mortgage, would you? Many people wold. If the
“American Dream” of owning your own home outright with no
mortgage is so wonderful, why do thousands of financially
successful people-who have more than enough money to pay off
their mortgage-refuse to do so?
Most of what we learned
from our parents and grandparents about mortgages is no longer
valid. They taught us to make a big down payment, get a
fixed-rate mortgage, and make extra principal payments to pay
off your loan as early as possible. Mortgages, they said, are
necessary evil at best.
The problem with this
rationale is it has become outdated. The rules of money have
changed. Unlike our grandparents, we will no longer have the
same job for 30 years or depend on our company’s pension plan
for a secure retirement. Also unlike our grandparents, we will
no longer live in the same home or keep the same mortgage for 30
years.
Statistics show that
they average homeowner lives in their home for only seven
years. According to the Federal National Mortgage Association,
or Fannie Mae, the average America mortgage lasts 4.2 years.
People are refinancing their homes to improve their interest
rate, restructure their debt, remodel their home, or to pull out
money for investing, education or other expenses.
Give these statistics,
it’s difficult to understand why so many Americans continue to
pay a high interest rate, restructure their debt, remodel their
home, or to pull out money for investing, education or other
expenses.
Given these statistics,
it’s difficult to understand why so many Americans continue to
pay a high interest rate premium for a 30 year fixed rate
mortgage, when they are likely to just use the first 4.2 years
of it. We can only conclude they are operating on outdated
knowledge from previous generations when there were limited
options.
Wealthy Americans-those
with the ability to pay off their mortgage but who refuse to do
so-understand how to make their mortgage work for them. They
put very little money down, keep their mortgage balance as high
as possible, choose adjustable-rate interest-only mortgages and,
most importantly, integrate their mortgage into their overall
financial plan. This is how the rich get richer.
The good news is that
any homeowner can implement the strategies of the wealthy to
increase their net worth.
Why You Shouldn’t Fear Your
Mortgage
Back in the 1920’s, a
common clause in loan agreements gave banks the right to demand
full repayment of the loan at anytime. When the stock market
crashed on October 29, 1929, millions of investors lost huge
sums of money, much of it on margin. Since the value of the
stocks dropped, few investors wanted to sell, so they had to go
to the bank and take out cash to cover their margin call. It
didn’t take long for the banks to run out of cash and start
calling loans due from good Americans who were faithfully making
their mortgage payments every month. However, there wasn’t any
demand to buy these homes, so prices continued to drop. To
cover the margin calls, brokers were forced to sell stocks and
once again there wasn’t a market for stocks so the prices kept
dropping. Ultimately, the Great Depression saw the stock market
fall more than 75% from its 1929 highs. More than half the
nation’s banks failed and millions of homeowners lost their
homes.
Out of this the American
Mantra was born: Always own their home outright. Never carry a
mortgage. The reasoning was simple: If the economy fell to
pieces, at least you sill had your home and the bank couldn’t
take it away from you. Since the Great Depression, laws have
been introduced that make it illegal for banks to call your loan
due. Additionally, the fed is now quick to infuse money into
the system if there is a run on the banks, as we saw in 1987 and
Y2K. Also, the FDIC was created to insure banks. Still, its
not wonder the dread of losing their home became instilled in
the hearts and minds of the American people, and they quickly
grew of fear their mortgage. And because of this, for nearly 75
years most people have overlooked the opportunities their
mortgage provides to build financial security.
Why You Shouldn’t Hate Your
Mortgage
Many people hate their
mortgage because they know over the life of a 30-year loan, they
will spend more in interest than the house cost them in the
first place. To save money, it becomes very tempting to make a
bigger down payment or extra principal payments. Unfortunately,
saving money is not the same as making money. Or put another
way, paying off debt is not the same as accumulating assets. By
tackling the mortgage payoff first and the savings goal second,
many fail to consider the important role a mortgage plays in our
savings effort. Every dollar we give the bank is a dollar we do
not invest. While paying off the mortgage saves us interest, it
denies us the opportunity to earn interest with that money.
A Tale of Two Brothers
Ric Edelman, one of the
top financial planners in the country and a New York Times
bestselling author, has educated his clients for years on the
benefits of integrating their mortgage into their overall
financial plan. In his book, The New Rules of Money, he tells
the story of two brothers, each of whom secures a mortgage to
buy a $200,000 home. Each brother earns $70,000 a ear and has
$40,000 in savings.
Brother A believes in
the traditional way of paying off a mortgage as soon as
possible. He bites the bullet and secures a 15
year mortgage
at 6.38% APR and shells out a $40, 000 of his savings as a 20%
down payment, leaving him zero dollars to invest. This leaves
him with a payment of $1,383. Since he has a combined federal
state income tax rate of 32% he is left with an average monthly
net after tax cost of $1,227. Also, in an effort to eliminate
his mortgage sooner. Brother A sends an extra $100 to his
lender every month.
Brother B in contrast,
subscribes to the new way of mortgage planning, choosing instead
to carry a big, long-term mortgage. He secures a 30 year,
interest-only loan at 7.42%APR. He outlays a small 5% down
payment of $10,000 and invests the remaining $30,000 in a safe,
moneymaking side account that earns an 8% rate of return. His
monthly payment is $1,175, 100% of which is tax deductible over
the first 15 years, and 64% over the life of the loan, saving
him a monthly net after-tax cost of $799. Every month he adds
$100 to his investments (the same $100 Brother A sent to his
lender), plus the $428 he has saved from his lower mortgage
payment.
Which brother made the right decision? After only five years,
Brother A has received $14,216 in tax savings; however, he made
zero dollars in savings and investments. Brother B, on the
other hand, has received $22,557 in tax savings, and his savings
and investments account has grown to $83,513.
Now, what if both
brothers suddenly lost their jobs? Even though Brother A has
$74,320 of equity in his home, he can’t get a loan because he
doesn’t have a job. He can't make his monthly payments as has to
sell his home to avoid foreclosure. Unfortunately, at this
point it’s a fire sale so he must sell at a discount, and then
pay real estate commissions. Brother B, however, has $83,513 in
savings to tide him over. He doesn’t need a loan and can easily
make his monthly payments, even if he remains unemployed for
years.
Let’s suppose neither
brother lost his job and evaluate the results of their financing
strategies 15 years after they purchased their homes. Brother A
has now received $25,080 in tax savings, has $30421 in savings
and investments (once his home was paid off he started saving
the equivalent of his mortgage payment each month), and owns his
home outright. Not to bad, right?
Brother B has received
$67,670 in tax savings and has $282,019 in savings and
investments. If he chooses to, he can pay off the mortgage
balance of $190,000 and still have $92,019 left over in savings,
free and clear.
Finally, let’s assume
that Brother B decides to ride out the whole 30 years of the
loan’s life. While Brother A has still received only $25,080 in
tax savings, his savings and investments have grown to $613,858,
and he owns his home outright. Brother B, on the other hand,
has received a whooping $107,826 in tax savings, has accumulated
an incredible $1,115,425 in savings and investments, and also
owns his home outright. He can start over fresh and enjoy the
same benefits once again.
Unfortunately, the
majority of Americans follow the same path as Brother A as it’s
the only path they know. However, once the path of Brother B is
revealed, they realize it enables them to pay their homes off
sooner (if they choose to), while significantly increasing net
worth and maintaining the added benefits of liquidity and safely
the entire way. And that is just one way strategy used by the
wealthy that will work for the rest of Americans as well.
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