2 Great Mortgage Myths.
Mortgages are a great tool for wealth building - as long as you understand what you are really getting!
Myth #1: Early payoff saves you interest cost.
Here we must introduce a vital concept - "opportunity cost." Simply put, opportunity cost is what I give up to acquire something else. If I invest in "A" that means I lose the opportunity to invest in "B." In this case, "A" is my home equity and "B" are other investments that earn a rate of return.
Because home equity and home value are different, home equity itself does not earn a rate of return. This means that each extra dollar you pay against your mortgage represents an additional deposit into a non-interest bearing investment. This also means that you LOST the opportunity to invest that same dollar - thus costing you money. The result is that paying down your mortgage only eliminates an interest payment, not an interest cost. The difference is that you don't receive a bill for this cost - so you never see it! Assuming your time frame is at least 5 years, even a simple balanced 60/40 mix of stock and bond should return 6%-8% net after expenses. This lost earnings potential on your extra mortgage payments often adds up to more than the savings gained from paying down your mortgage at today's low rates - especially considering that mortgage interest is deductible.
Myth #2: Early payoff always makes you safer.
(This myth can be dangerous....read on...)
Purchase price: $300,000
Mortgage: 30 year, $240,000 @ 4%
Over the next 5 years, you aggressively pay it down to $100,000 while the house goes up in value to $400,000. This results in $300,000 of home equity accumulation - but does it make you more secure? Let's examine...
Your original investment was $300k. The bank "invested" $240k via their willingness to extend you a mortgage. By accelerating your mortgage, you have returned $140k back to the bank which lowers the bank's "at risk" amount to only $100k. The $140k of extra payments represents 65% of the profits (interest) the bank would have earned on this loan if it was paid over 30 years.
Now assume you suffer a life setback. Perhaps you get hurt, sick, or become partially disabled - or you simply lose your job and can't get re-hired in your industry or re-hired at the same rate of pay (very common) - what happens to you as the homeowner??
Banks prioritize foreclosures on properties with more equity. This is because they can recapture more of their original "at risk" amount at a faster rate when they sell your property under foreclosure. Unfortunately for you, your large equity balance may now be lost to foreclosure if you can't come up with payments or sell. If you have reduced or no income it will be almost impossible to refinance the mortgage. (Would you give a new loan to someone without a job?) In addition, you have also lost years of investment opportunity cost because you failed to invest the money utilized for extra mortgage payments. This investment balance could have been used to save your home had it been sitting in an accessible account - but it was trapped inside the home.
The lesson of this article is to understand that having a mortgage is one of the smartest things you can do with your money. Assuming you can afford your payment and plan to stay in your home, the last thing you should do is trap extra dollars inside the property. This only results in lost earnings and putting yourself in a riskier financial position. The best thing to do is buy a bit less house than you need, and simply pay the contracted mortgage as planned.