Los Angeles based Mortgage Broker, Bill Rayman of Mortgage Capital Partners, addresses a number of myths and misunderstandings about the mortgage business and in particular how it can affect you in refinancing and even whether or not you should consider refinancing.
Myth number three is that it makes sense to pay off the home as quickly as possible. A corollary of that myth is that interest-only loans are bad. The fact is, it is not necessarily bad to pay off your home, and often it is simply not a good choice what so ever. There are several components to this answer.
The first is, not all debt is bad debt. Considering that you might be borrowing potentially hundreds of thousands of dollars for ten, twenty or thirty years, and you can lock that interest rate in today at under 5%. Plus, the interest on that money is very likely tax deductible, so if you’re in a 25% tax bracket which is close to the national average, a 5% interest rate means your effectively borrowing 3.75%. Where else can you get debt like that, certainly not from your credit cards?
The second reason to consider not paying off your mortgage is this; think about the use of the funds. Paying down the principle, which is to say increasing your equity in the house, feels like a good thing and I respect that’s a really good reason to do it if it feels good. From a strict financial point of view, your house is an asset and if you put money into any asset you want to see that the asset appreciates in value; that it grows. It sounds somewhat counter intuitive until you realize no matter how much you put in to your house in terms of the equity, whether you put down 100%, or you borrow 100%, the price of your home is established by the market. Therefore, paying money into your mortgage is technically a zero rate of return. With that in mind, the issue that comes up is if you didn’t put it into your home, what else could you do with it? Right now, the investments in the market are very poor. CDs are paying on average 1.6% in the country, but that’s today. Looking further down the road, we’ve been accustomed to five, six, seven, eight percent returns on investments. So if you can borrow from the bank at three, four, or five percent and put it in stocks or even just very secure treasury bonds; treasury bonds so much as there are secure bonds that you can probably be getting five, or six percent on, and ideally you probably will down the road. You are doing what a bank does, you’re borrowing low, and you’re investing high at a secure rate.
Another reason that makes sense and is something that I’ve experience greatly for these last two years, with a number of people around the country that I’ve been helping, is people have been dutifully paying down their mortgage and then all of a sudden for a variety of reasons they can no longer refinance. Then they are in a situation where they don’t have cash in the bank, which they might need for anything from school, or typically a big medical debt, and other expenses that came along. Whereas, if they had had the money and kept it in a separate account, yes they would owe more on their home but they’d have that extra cash in a bank. Again, arguably that cash is going to be earning interest so it’s worth more, and the key words that you should be thinking about are net worth. When you add up your home and all your other liquid assets, less your liabilities, that’s what your worth is. So whether you own a $100,000 home of which you owe $90,000 and therefore you have a net worth of $10,000; or you have a $100,000 home of which you owe $100,000 but you have $10,000 in the bank, you still have a net worth of $10,000. They are the same, except from these last 2 years I couldn’t count the number of people that would have been better off having the cash outside the house.
A third reason to consider not paying off your mortgage is to recognize that the more you own of your home, the greater your equity share, and arguably the more viable that asset is to a potential creditor who is going to be looking to claim it. There is a wonderful story from the 1930s, where Walt Disney owed Bank of America $7million dollars that he had borrowed to finance Snow White. And they started laughing he and his brother because they realized that the last thing Bank of America was going to do was foreclose on them; and in fact the bank wound up giving them more money because they couldn’t afford to take the studio from them. And then luckily Snow White was a hit and they were able to resuscitate. The same thing, just imagine if you own a home that is completely paid off versus your neighbor who has the exact same home but owes the bank 90% of the money and you both have some kind of financial problem. I can’t promise you, but hypothetically I’ll promise you, if the bank has to choose who to go after, they’re coming after you because your house they could put on the market and sell and get their money back. The person who owes the bank a lot of money, that house isn’t worth anything and they are more likely to keep the house.
The fourth reason to give some consideration about not paying down your mortgage is to not be fooled by how the amortization schedule works with the bank. Most people never look at the amortization schedule, that is, the payments that are made every month for lets say a 30-year fixed 360 months. The payment amount itself might be static. It will never change. However, the proportion of principle to interest each month will change. In the first five to ten years almost all you are paying to the bank is principle and interest but its about 80% interest and the first five years in fact it averages about 86% interest. The banks are front-loading the loans so that they make a ton of interest because they know on average, people refinance every four to five years; and they move every eight to ten years so you are paying a lot interest anyway. So it doesn’t necessarily make sense to be taking that approach where your committing yourself to making these extra payments if you are not really getting the value and the equity you might otherwise. One reason interest only loans have always been attractive to some people is it obligates you simply to make a low payment. Any time you want you can voluntarily make extra payments that will go directly to the principle. If you made the exact same payment of principle and interest voluntarily that the 30-year fixed commands, you’d be exactly on that schedule but now you have control of your funds. If something comes up one month that you need the money, you don’t make that payment and you make the interest only payment that’s fine. There are 30-year fixed loans that include an interest only component for ten years, so having an interest only loan doesn’t mean your going to have an adjustable rate mortgage, or something happening five years down the road that’s going to put you in trouble with the bank. It’s a fixed rate; it simply gives you the option to pay interest for those couple of years.
Lastly here is the solution if the goal is that you want to pay off the house as quickly as possible; there are several ways of doing it. One is to make extra payments. That’s one way. Two, there are home accelerator loans that give you a lot of flexibility on how to do that. Another is to get a loan that has a shorter term to it. Now the shorter the term means your going to make a larger payment, but that payment is going to be largely equity. The shorter-term loans and here I’m talking about a fifteen, or twenty-year loan as apposed to a thirty-year or forty year; not only will you pay it off quicker because the timing is shorter, but the interest rates on the shorter-term loans are generally anywhere from a quarter to three-quarters of a point less than a thirty year fixed. So I’m using a $500,000 mortgage at a 30-year fixed rate; over 30 years you will pay $466,000 in interest. If instead you did a 15-year loan, the interest rate is a little bit lower. At the end of 15 years you will have paid $176,000 in interest. The difference is roughly a little short of $300,000 in interest. Well if you figure the interest you don’t pay over 15 years you’re really saving legitimately, out of pocket, roughly $20,000 a year. So if you can afford the higher payment and the goal is to pay down the house quickly, save yourself a lot of interest and do a shorter term loan.
A huge part of my business is advising folks for free about the decision process related to getting a mortgage on their home, business property, or investment properties. Please feel free to call me anytime to discuss your needs or just walk through options regarding refinancing, a new mortgage, fha mortgages, down payments, or any other aspect of the process. There is no cost or obligation associated with my providing you consulting. 
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