Mortgage Reduction Secret Weapon – Your Down Payment (Part 1 of 3)
Part 1: A Primer on Wealth Creation and How Mortgages Work.
The personal finance literature is replete with tips to assist you with paying off your mortgage sooner than the standard 30-year amortization period. Most of these tips rely on bank-sponsored bi-saver programs or snowflake and snow ball debt reduction plans geared to help a home owner own his or her home years sooner and save thousands of dollars in interest payments. Each of the mortgage reduction strategies pales in comparison to the method obtainable to every homeowner with a down payment. What is this method? Strategic use of the down payment.
Before I outline this strategy, it is important to review some meaningful principles as regards home ownership, wealth creation and money management.
As iconoclastic as it may seem, a home is not an investment. According to Wikipedia, investing is the active redirection of resources from being consumed today to creating benefits in the future; the use of assets to earn income or profit. At present millions of homeowners have learned that they will earn neither income nor profit upon the sale of their home. However, what has happening today as regards home prices is not far out of the ordinary, what happened over the past decade in terms of housing appreciation is. Robert Schiller, professor of economics at Yale, has charted housing prices since 1890. Indeed, the average annual investment return from 1950-2000 was less than one half of 1% per year after adjusting for inflation. This method that $100 dollars invested in a home in 1950 was worth $104 in inflation-modificated dollars in 1997.
Housing prices have however to fall further to reach historic norms. At best, a home is a form of forced savings plan in which the home interest deduction and the intangible assistance of home ownership accrue to the homeowner. How much of an economic assistance is that? Any mortgage calculator commonly obtainable on the internet provides the following illustration on a $125,000 mortgage with no down payment. Over the life of the loan, the homeowner will pay $166869.14 in interest payments. At best he will enjoy a reduced tax burden equal to $55623 over the life of the loan due to the mortgage interest deduction. Leaving approximately $111000 that will go to the edges as profit for them. This homeowner will have paid approximately $236000 for a $125000 home that appreciates at maybe 1% per year in inflation-modificated dollars. The $236000 figure does not include 30 years worth of character taxes, insurance, maintenance and repairs. A home is not an asset, it is a roof over ones head.
To create wealth, each unit of money must do more than one job. On the surface a home would appear to do that. A home provides a roof over the head and equity that can be tapped for future use. But does it really? Who determines whether and when a homeowner can tap equity? The bank does. When is a person most likely to need the equity? When the bank doesn’t want him to have it: during tough economic times, during periods of job loss or downsizing, when incomes have been cut. already during expansion times a home owner’s income-to-debt ratio will determine whether or not he can tap the equity in his home, how much he can tap and at what rate of interest. The recent meltdown in NJNA (no job, no asset), Alt-A and no doc loans will insure that home equity will be difficult to tap for everyone. A home, then, does one thing: it provides a roof over one’s head.
To minimize opportunity costs people who seek to create wealth, must continue a level of liquidity. This method access to ready cash for emergencies or to take advantage of long and short-term investment opportunities. Home ownership inherently presents an opportunity cost in that equity that accrues by rule and interest payments is retained and not freely obtainable and the costs of taxes, insurance, maintenance and repairs are true costs and are monies not obtainable for investment. For a simple $145000 dollar home in my area, taxes, insurance maintenance and repairs are approximately $3500 dollars per year. That is money that is not saved, not invested to provide future assistance to the homeowner. Does insurance protect the home? Yes it does. Do repairs and maintenance protect the home? Yes they do, but these are sunk costs and are costs that will not, in all likelihood, be realized when the home is sold. These costs are expenses aimed at preserving something that is appreciating at a glacially slow rate.
Wealth is not automatic. Despite the numbers of books sold with the words “automatic” and “wealth” and “automatic” and “millionaire” in their titles, wealth does not come automatically. Now savings plans can and should be automated but individual decisions that create wealth by their very character cannot be. You can automate your stock market investing, but you cannot automate the stock market so that you become wealthy. You can automate your savings, so that you have something to invest, but you cannot automate the economy so that yields keep fixed and your savings earn a meaningful rate of interest. You can automate debt payments, but those payments will come at a hefty cost to the debtor in the form of service fees and those debts will be collected in terms that assistance the lien holder.
consequently allowing a financial institution, especially a bank, access to your accounts for the purposes of debt reduction is a dicey proposition at best and will most likely assistance the bank by allowing them to collect fees that a person truly seeking to create wealth for themselves would do better to avoid. Finally, wealth creation requires more than preparing bulk casseroles, reusing tin foil, denying yourself Starbucks or a coke. Wealth creation requires contemplation of what it truly method to have wealth in all its many incarnations. It requires vision, choices and active participation. While Ron Popiel may encourage you to set it and forget it, doing so with your personal finances will cause you to stagnate in your quest for wealth.
Understand what a mortgage is and what it does. According to Wikipedia: ” “A mortgage comes from the old French “dead potential” seemingly meaning that the potential ends (dies) either when the obligation is fulfilled or the character is taken by foreclosure. In many countries it is normal for home purchases to be funded by a mortgage. Few individuals have enough savings or liquid funds to permit to buy a character outright.” A mortgage, then, is an instrument of debt, serious debt.
There are four principles to understand about a mortgage:
1) Mortgages are front-loaded. That method that most of the payments made during the first half of the loan term are used to satisfy interest while most of the payments made later in the loan term are used to satisfy principal. Put another way, the first payments in the loan term chiefly go to assistance the bank and its investors, the latter payments in the loan term chiefly go to assistance the homeowner and build equity.
2) With a fixed-rate loan, the rule and interest payments are fixed. The proportion of each payment that goes to interest depends on the unpaid rule balance at the end of each month. This last statement is true whether the interest rate is fixed or adjustable.
3) additional rule payments have the greatest strength the earlier they are made in the loan term.
4) Mortgages payments are made one month in arrears. If you close on a loan in January, your first payment will not be due until March 1st. In the first year of your loan you will make 11 payments. already though you will make 12 payments in the second year, you will always be one payment in arrears.
Understanding mortgage principles number 2 and 4 is basic to understanding why mortgage reduction plans work, so let’s synthesize them again:
1) meaningful rule: The proportion of each payment that goes to interest depends on the unpaid principal balance at the end of each month.
2) meaningful rule: Mortgage payments are made one month in arrears.