Most people don’t think this way but when you are buying a home, you are actually buying two things.
- the actual property (i.e. — the land and the improvements that rest upon it)
- the money to buy the home
Wait, what do you mean ‘buying the money to buy the house’?
The Cost of Money
Yes, you are buying money, too. And that sounds odd.
Money isn’t free. It has a cost associated with it, just like any other asset. The cost you incur is reflected in the interest you pay over the life of the loan.
The price you pay for the money you borrow is based on a combination of privilege (someone has the money you need and you don’t) and certain risks (the chance that you might not pay them back and the chance that the money will be worth far less when you actually do pay them back).
The combination of these factors is what sets the interest rates in our market.
The Impact of Interest
So why are we talking about interest rates? That’s boring — and besides they are really low so it doesn’t matter much, does it?
Yes, we are in a very unique interest rate environment right now where rates are extremely low, like ‘in our lifetime’ low. And that makes the decision a bit easier. Take a look at this chart to get a sense of how low interest rates truly are.
For those who have been homeowners for 30 years, they will remember rates in the middle teens. For those who have been homeowners for 20 years, they will remember rates around 10%. And for those who owned a home before the bubble, they will remember paying 7.5% for their mortgage and thinking nothing of it.
But just because they are low, does not mean that the 30 year fixed rate is the right choice for everyone.
When Ben Franklin used to say that ‘Time is money,’ he easily could have been talking about mortgage finance.
Take a look at the comparison between two mortgage situations below — a 30 year fixed rate at 4.5% and a 15 year fixed rate at 3.75%, both originated in January of 2005 on a $400,000 loan amount.
|30 Year Fixed||15 Year Fixed|
|Total in payments over life of the loan||$729,627||$523,600|
|Total interest paid over life of the loan||$329,627||$123,600|
|Last Payment Due:||December 2034||December 2019|
|Balance after 5 years||Approx. $277,000||Approx. $204,000|
|Balance after 10 years||Approx. $240,000||Approx, $100,000|
|Balance after 15 years||Approx. $200,000||$0|
The difference in payments over 15 years is $159,000 but:
- You saved $206,000 in interest
- Your balance is $0 at the end of the 15th year (versus $200,000)
The $159,000 you invested in your mortgage swings $406,000 in your favor in 15 years.
Put another way, the ‘extra’ $882 per month you make in payments is really the same as being invested in an investment product whose approaches 11.5% (before appreciation!).. Additionally, the favorable tax treatment that real estate receives will increase the return by several points (depending on your tax rate) and probably yield closer to 15%.
And a 15% extremely low risk rate of return would even get Warren Buffet’s attention.
We are a monthly payment based society and often times we ignore the multiple ways we can deploy our cash.
Are we saying that we should all rush out and buy using a 15 year mortgage? No, each situation is unique. But we are saying that the allure of the lower payment and the maximum loan are not always the best financial play. Sometimes buying a little less home and financing it over a shorter time period can really set the stage for increased wealth sooner, rather than later. Just know that home buying, like any other financial decision, is as much of a strategic decision as it is an emotional one.
Yes, looking at amortization calculators and analyzing the various debt structures available to you is about as exciting as watching the paint dry in your new home, but it is one of the most important exercises you could go through.
Looking at houses is a lot of fun, but so is several hundred thousand dollars. Make sure to spend as much time with securing the correct mortgage as you do the correct home.