There is a great debate within the inner-mortgage circles these days. Should we, as loan professionals, encourage clients to borrow as much money as possible? Or would consumers benefit more if we helped them to understand the advantages of 15-year amortization schedules and pre-paying principal? Let’s examine the pros and cons of both strategies.
Leveraging Your Property. In order to understand why you’d want to borrow as much as possible for your home purchase, you must first grasp the concept that equity has a zero rate of return. Here’s an example:
If Consumer “A” buys a home for $300,000, and puts 20% down, then they have $60,000 in equity. Over the next 5 years, the property appreciates $100,000 in value. Consumer “A” now has $160,000 in equity.
Consumer “B” buys a home for $300,000, and puts no money down. At the end of 5 years, that same home is now worth $400,000. Consumer “B” has $100,000 in equity, which is the same appreciation as Consumer “A”, a net $100,000.
As you can see, your down payment has nothing to do with your rate of return. What becomes important is how you choose to manage the $60,000 you didn’t use as a down payment. If you use it for frivolous activities, such as buying toys or going to Las Vegas, it would be more prudent for you to use that money as a down payment. Especially since this will enable you to obtain a lower interest rate.
However, if you were to invest the $60,000 in a vehicle that can out-earn the cost of that debt, then this could be a formula for success. This is why some lending professionals suggest putting as little down as you possibly can, maximizing your tax write-off, and investing the rest. This principle has been applied for many years in the life insurance game. The old saying goes, “Buy term and invest the rest.” The key component is taking the money you would have used as a down payment and creating an asset accumulation account. This account should earn a significant enough rate of return to enable you to pay your mortgage off entirely and achieve the ultimate goal of being debt-free.
Paying Your Home Down Rapidly. There are very few times over the course of my career that I have seen a client with zero debt and no financial difficulties. Choosing to pay off all of your debt can reduce stress and help you to gain freedom of cash flow for investment opportunities. A 15-year mortgage or a bi-weekly payment strategy provides structure. It can also put you on track to have your mortgage paid off within a set timeframe. Simply put, it contains built-in discipline.
It’s important, however, to understand that regardless of how rapidly you pay your home off, you’re not getting any greater rate of return on your investment than if you paid it off slowly.
Conclusion. So how does one determine which scenario is best? The choice depends entirely upon the individual. Savvy consumers who are disciplined, and are comfortable taking chances from an investment perspective, would do well with the first scenario. Over the course of time, it’s been proven that your rate of return over the long-haul will be far greater than the rate you’d pay for a mortgage in today’s rate environment. It’s important to seek the advice of a skilled investment advisor to ensure success with this strategy.
The second scenario is best for those who have a difficult time managing their money or who’ll sleep easier at night knowing they have a plan in place to pay their loan off more rapidly. Be sure that your budget can handle accelerated payments. When consumers “bite off more than they can chew” with a 15-year mortgage, they frequently end up having to refinance back into a 30-year schedule.
If you find this subject intriguing and would like to know more, I recommend that you read a book titled, Missed Fortune 101
I think everybody needs to run their own numbers to get an idea of what getting a lower interest rate and less or no mortgage insurance would mean.
Our allied real estate professionals at Golf Savings make several good points as well as the last post. It is individually up to the borrower what risk they take in the guise of tax savings on the mortgage itself. Thing is, human behavior tells another story. The refinances we closed in 2005 tell us that many people are not taking any downpayment savings and investing it. They are doing just what you reported, going to Las Vegas, 2 SUV’s in driveway at 4-500/mo. a pop, credit cards, you name it. In fact, many borrowers at the closing comment : oh, we’ll just refinance again at our next adjustment in 2 years (with a pre-payment penalty of course).
Our 2005 statistics were just compiled recently and it is quite telling.
Of all purchase transactions we closed during 2005, 71% were 100% financed. Not one dime down. For some, eh, no big deal. For others it is a sobering statistic. Since our firm is such a tiny microcosm of the market, you have to ask yourself what the title companies and others are closing. I would venture that their numbers would mimic ours.
Live under your means.
T.Kane
Legacy Escrow Service. Inc.
Good post, Randy and D.R. I think the pay down your home as a savings account model is a pretty good way to go for lots of people who otherwise aren’t savers. I’ll be sure to check out Missed Fortune 101.
Some questions: What does the scenario look like if home prices flatline or drop slightly over the course of 5 years. Lets say there is a 15% chance of this happening over the next 5 years (I made that up) – what would you recommend for someone who doesn’t have a lot of savings?
Also, what is the incentive for mortgage lenders? Do most get a flat commission on the size of the loan, or are loans with 20% down payments more profitable. I ask not to accuse you of anything, but because I assume that incentives would cause the industry in general to favor certain types of loans even if they are not in the interest of consumers. Or am I wrong – are industry incentives and consumer incentives perfectly aligned?
This is still one of my favorite topics! My clients are sometimes surprised at my response to “We’re conservative. We want to make a large downpayment.”
My answer is that larger downpayments only INCREASE your risk. Large downpayments favor the BANK, not the BORROWER.
One of my favorite posts ever (from my blog): http://21stcmb.typepad.com/the_mortgage_reports/2005/03/want_to_be_cons.html.
Great post! You’ve made a difficult subject for some to grasp (and hold tightly to, since it goes against what so many assume to be the way you should do things) in a way that makes perfect sense. Great points, and I’ll be checking out your book suggestion!
I have been telling people in Hawaii this concept for a while. People look at a $100k gain on a $500k house and say they gaine 20%. I tell them they actually gained 100% if they put 10% down. I say leverage real estate hard and try to gain 7% with the money you would have put down.
As Mortgage Planners it is our job to open the eyes of the clients to all the possible options and to show them that times have changed from what their parents and grandparents have taught them.
Money sitting in your house’s equity is not working for you.