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Mortgage Reduction Secret Weapon: Your Down Payment Part 1 of 3

By Ouida Vincent

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Published: 30Jul2009
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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 available 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 key principles as regards home ownership, wealth creation and money management.

Principle 1:

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 means that $100 dollars invested in a home in 1950 was worth $104 in inflation-adjusted dollars in 1997. Housing prices have yet 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 benefit of home ownership accrue to the homeowner. How much of an economic benefit is that? A quick trip over to Hugh’s Calculators 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 roughly $111000 that will go to the banks as profit for them. This homeowner will have paid roughly $236000 for a $125000 home that appreciates at maybe 1% per year in inflation-adjusted dollars. The $236000 figure does not include 30 years worth of property taxes, insurance, maintenance and repairs. A home is not an asset, it is a roof over ones head. The blog, Get Rich Slowly, provides an excellent comparison between the costs to rent versus the costs to own a home in the Seattle area.

Principle 2:

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. Even during boom 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.

Principle 3:

To minimize opportunity costs people who seek to create wealth, must maintain a level of liquidity. This means 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 through principle and interest payments is trapped and not readily available and the costs of taxes, insurance, maintenance and repairs are true costs and are monies not available 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 benefit 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.

Principle 4:

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 nature 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 remain 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 benefit the lien holder. Therefore 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 benefit 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 means 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.

Principle 5:

Understand what a mortgage is and what it does. According to Wikipedia: “ “A mortgage comes from the old French “dead pledge” apparently meaning that the pledge ends (dies) either when the obligation is fulfilled or the property is taken through 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 enable to purchase a property 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 means 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 primarily go to benefit the bank and its investors, the latter payments in the loan term primarily go to benefit the homeowner and build equity.
2) With a fixed-rate loan, the principle and interest payments are fixed. The proportion of each payment that goes to interest depends on the unpaid principle balance at the end of each month. This last statement is true whether the interest rate is fixed or adjustable.
3) Extra principle payments have the greatest power 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. Even though you will make 12 payments in the second year, you will always be one payment in arrears.

One of the best explanations I have found about how mortgages work and the advantages and disadvantages of the different payment options can be found in Harj Gill’s book: Own Your Home Years Sooner! Understanding mortgage principles number 2 and 4 is critical to understanding why mortgage reduction plans work, so let’s synthesize them again:
1) Key principle: The proportion of each payment that goes to interest depends on the unpaid principal balance at the end of each month.
2) Key principle: Mortgage payments are made one month in arrears.

Part 2 of this series covers Wealth Principles and the truth about bank-sponsored prepayment plans.

Ouida Vincent is an active real estate investor and entrepreneur. Unfortunately people often pay more to live in their largest asset, a home, than they have to. This article is being published in 3 parts. Because it uses illustrations and graphs and active links that don't appear in the individual articles, it has been published in its entirety on my weblog at http://www.ouidavincent.com/blog

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