11 Reasons to Carry a Big Long Mortgage - Reason 10
This article has been around since I was originating loans and it was recently updated on Ric's site. I thought I'd take each one of his comments as a single post and share a few comments for those of you not familiar with this article or Ric's original claims about keeping the biggest and longest mortgage you can afford.
"His words in Blue", my words in white. I'll deconstruct his key points.
SHOULD I PAY OFF MY MORTGAGE?
11 great reasons to carry a big, long mortgage.
Ric Edelman – Edelman Financial Services
REASON #10: MORTGAGES GIVE YOU GREATER LIQUIDITY AND FLEXIBILITY.
To help explain this, let’s introduce you to Nervous Nick and Smart Sam. They have the same income and expenses, and are in the 24% tax bracket. Each has $100,000 in cash; each wants to buy a $300,000 house. Smart Sam gets a $240,000, 30-year mortgage at 3%. He makes no extra payments (and definitely isn’t wondering, “Should I pay off my mortgage?”). But Nervous Nick takes a different approach. Nick hates mortgages and fears that if he has a mortgage, he might one day lose his house. He doesn’t quite understand how that could happen, but someone told him that mortgages are bad and he believes them, so he goes with a small mortgage. That means he uses his entire $100,000 in cash to make a down payment. His mortgage is therefore smaller than Smart Sam’s – $200,000.
TOTALLY AGREE: This is a core typical conversation, in our 3-Sided Balance Sheet conversation, we help consumers and advisors realize the main question most consumers want to ask 'but don't know how' is around this key issue. Should I 'Prepay or Invest?'
Nervous Nick also gets a 15-year loan instead of a 30-year loan, because he wants to get rid of his mortgage as quickly as he can, and he figures the 15-year loan will let him get rid of his loan in half the time. Nick also knows that this garners him a lower interest rate, because lenders charge less for 15-year loans than they charge for 30-year loans. So while Sam is paying 3%, Nick is paying only 2%. Nick, in fact, is so obsessed with getting rid of his mortgage that every month he sends an extra $100 to his lender. He knows that the more he sends in, the faster his loan will be paid off. So, compared to Sam, Nick has a smaller mortgage, a shorter mortgage, a lower interest rate – and he’s adding money to each payment.
TOTALLY AGREE: As an aside, we did a lot of work on this, surveying consumers at large financial service companies about their prepayment behavior, and we found over 35% of consumers made one or more additional payments to their mortgage each year, and the average was $300 a month. (we'll do another post on this). Why? They don't know what to do so they invest and prepay.
Smart Sam’s monthly payment is $1,012. Thanks to amortization, 59% of Sam’s payment is comprised of interest. Thus, on an after-tax basis in the 24% federal income tax bracket, Smart Sam’s payment costs him $862 a month.
Meanwhile, Nervous Nick’s payment is $1,387 a month. But only 24% is interest, because Nick’s loan is for 15 years. The shorter the term, the more principal he must pay each month, and principal payments are not tax-deductible (only the interest is deductible). So even though Nervous Nick is paying more per month than Smart Sam, he’s deducting less. Nick’s after-tax cost, therefore, is $1,304.
Thus, Smart Sam is paying $442 less per month than Nervous Nick. But Nick doesn’t mind the extra monthly cost because he knows he’ll get rid of his mortgage quicker.
TOTALLY DISAGREE: This is no longer true, we have to remove the 'after tax' aspect of this case study - as both clients would be better off filing for the standard deduction and therefore there is no additional tax benefits. (This is not tax advice, simply current practice that renders this aspect of the example incorrect.)
So for the next five years, Smart Sam makes his monthly mortgage payments. And instead of sending an extra $100 every month to his lender like Nick does, Sam invests that $100 in the stock market. Then both men lose their jobs unexpectedly, causing their income to fall. Sam will be in a much better position than Nick. Why?
Nick’s been busy paying down his mortgage; the outstanding balance is only $134,000. He might have lost his job, but still must make his monthly mortgage payment. So it doesn’t matter that his mortgage balance is $134,000; what matters is that his mortgage payment of $1,387 is due at the end of the month. This is a real problem for Nick, because with no job, he has no income. He also has no money, because he’s given every available dollar to the bank in the form of extra loan payments. Nervous Nick’s nightmare is coming true – he’s about to lose his house! Although Sam’s mortgage balance is higher than Nick’s, Sam is in a much better financial condition. He’s not in the same predicament as Nick, because Sam has lots of savings. First, he gave the bank a smaller down payment, enabling him to invest $40,000. Based on an average annual return of 7%, that money grew to $56,102.
TOTALLY AGREE: This is the biggest opportunity and biggest misunderstanding of most consumers who believe mortgage acceleration is 'sticking it to the man' and the best way to do this is prepaying the mortgage. It depends. It depends on what the highest and best use of money is over time AND it depends on their future liquidity needs... to get money out of a house is hard, to put money in a house is easy. Sam also took advantage of the fact that his monthly payment was $442 less than Nick’s; he invested that money too, which is now worth $31,121. And instead of sending $100 a month to his lender like Nick, Sam added $100 to his investments; those investments are worth $7,041. All told, Smart Sam has $94,264. So even though he’s out of work, he’ll be able to make his mortgage payments for another six years! The irony is that Nick, who wanted to pay off his mortgage so he wouldn’t lose his house, is about to suffer the fate he was so desperately trying to avoid. This demonstrates why it is so important to minimize both your down payment and your monthly payment. By doing so, you retain more control over how you save or invest your money. By keeping control over access to your money, you maintain liquidity. After giving money to your lender, you lose control of it and the only way to get your money back is to sell the house.
PARTIALLY AGREE: This payment different is incorrect for the reason we mentioned above about taxation. That additional tax savings doesn't exist so it can't be invested, but the concept is correct, and the real point which and something I totally agree with is the fact that Nick is always at greater risk than Sam. The only person Nick made safer was the bank.
This reveals a fatal flaw in the logic that some people believe in about mortgages. Sure, owning a home mortgage-free is an appealing concept, but it is unrealistic. Paying off your mortgage is great – if that’s the only thing you need to do with your money. But what about paying for college? Saving for retirement? Caring for elderly parents? Paying for major repairs? Especially with the pandemic’s effect on the job market and people’s financial stability, the added flexibility and liquidity of having free cash and a big mortgage has its advantages. The fatal flaw of those who make you wonder, “Should I pay off my mortgage?” is that they may not be considering everything else going on in your life. If you succeed in paying off the mortgage quickly, you might fail in paying for college or covering costs in the event of a job loss, medical problem, marital issue or other family concern. We encourage you to rethink that the only important financial decision is paying off a mortgage. Life is more complicated than that, and by realizing this, you can see that trying to pay off the mortgage like Nervous Nick is actually a risky thing to do. Instead, the smarter and more efficient approach to wealth creation is to carry a big, long mortgage and don’t rush to pay it off!
TOTALLY AGREE: The most important part of this article is in the question "Should I pay off my mortgage?" and the answer is typically yes and you will over time, but the real answer should be: yes, but in the most efficient way possible. That's literally the $1M+ opportunity. There are so many way to as a liability manager to create an additional $1M for your client over 30-50 years they'll own a house.
TIP: When you realize that clients asking about a 15-vs-30 or an interest only, or a large down payment, or extra payments, or bi-weekly or ... (fill in the blank) is almost always 'what is the best way to repay my debt?' you start to think like a liability advisor - you focus on how to help the client Borrow Smart, and how to help them Repay Smart.
