This blog is adapted material from the video “Who Owns This House” on WhereLifeMeetsWealth.com. In Part 1, we investigated the effects of inflation and down payments on three fictional couples who bought their house using various methods. To get up to speed, please read Part 1 before continuing.
Rather than paying cash for their home, the Owe-it-Alls invested all their entire $300,000 and took a loan out on the house. So, they now must make monthly mortgage payments. However, the interest portion of their payment is deductible. This deduction reduces their cost of borrowing significantly.
The Free-n-Clears, on the other hand, paid their entire $300,000 down, giving away the control of the money to the bank. They are now able to invest the after-tax monthly amount they would have otherwise given the mortgage company. However, since they have no mortgage interest deductions, they will have to assume a higher interest investment risk than the Owe-it-Alls.
So, with the understanding that money used for down payments earns no interest, is controlled by the bank, and reduces tax deductions, what is the ideal amount to put down when purchasing a home?
Remember, if you finance, you transfer interest to the lending institutions for the privilege of using their money. If you pay cash, you save interest expense, but you lose interest income as well, because that money is not earning anything for you. The money in your home earns zero.
Your Home as an Investment
Most people today consider their home as one of their largest investments. Let’s see if it’s a good place to put your money:
Assume that the Free-n-Clear’s home is $300,000 today, and that they bought it seven years ago for $229,000, and that they put about $25,000 into improving their property. Their rate of return would be in the neighborhood of 2.41%. Would you consider this a good return? When you add in property taxes and insurance, it looks even worse.
You may be thinking, we forgot that our house is appreciating. Let’s assume the Free-n-Clears, the Pay-Extras, and the Owe-it-Alls live next door to each other, in identical homes, at identical values. Whose house will appreciate the fastest? The fact is, they will all appreciate exactly the same. Making large down payments or extra monthly payments does not make your home worth any more.
Your home appreciates the same whether you have paid it off or financed it 100%.
Interest Rate Spread
Remember that the Owe-it-Alls chose to borrow the entire $300,000 for their home so they could invest the entire $300,000 they had into a safe account. Supposing the interest rate on their mortgage is 6%, what rate of return would they have to earn on their investment to break even?
On the surface, it looks like 6%, but it’s actually only 4.3%, assuming they are in a 31% income tax bracket. Why? Because of the mortgage interest deduction. Imagine, they would only need to net around 4.2% for them to control the money, rather than the bank.
Net cost to borrow equals your loan rate less your tax bracket. If you receive a mortgage interest deduction, it reduces the investment risk you have to earn on your money for you to be in control.
Extra Principal Payments
Unlike the Free-n-Clears, the Pay-Extras did not have enough money to pay off their home upfront. So, they chose a shorter loan period and make extra principal payments to pay it off early. Why did the Pay-Extras choose a 15-year mortgage? Because of the interest they think they will save. Key word: think.
The perception is, the shorter the loan, the lower the cost. If that was true, paying cash would make the most sense. We already looked at cash and found that the Free-n-Clears would have to sell their home in 30 years for $3,280,719. Will that be possible?
The Pay-Extras may be surprised to learn that once they get their 15-year note paid off, and start investing the 15 year payment amount, they will end up with the same amount they would have had if they invested the difference between the 15 and 30-year monthly mortgage payments for 30 years. This assumes the same interest rate and tax bracket.
There is more risk involved to earn a given rate of return over a 15 year period than a 30 year period.
That’s all for part 2! Make sure to come back for part 3 next month to learn all about tax deductions and the bottom line when it comes to buying a house.
Chris Jacob is a Registered Representative with Saxony Securities, Inc.. Securities offered through Saxony Securities Inc. (SSI). Member FINRA, SIPC. Non-security products and services or tax services are not offered through SSI. Cadeau is not affiliated with SSI.