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.
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.
This graph clearly shows that home prices up until the year 2000 were essentially flat.
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.
Get Rich Slowly provides an excellent comparison between the costs to rent versus the costs to own a home in the Seattle area.
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.
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.
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.
Partners4Prosperity, a premier consulting firm specializing in the economics of prosperity provides a full list of principles:
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 them 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 detailed explanations with illustrations 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: How to Own Your Home Years Sooner - without making extra interest payments
Understanding mortgage principles number 2 and 4 is critical to understanding why mortgage reduction plans work, so let’s synthesize them again:
Key principle: The proportion of each payment that goes to interest depends on the unpaid principal balance at the end of each month.
Key principle: Mortgage payments are made one month in arrears.
Mortgage Prepayment plans
In general mortgage prepayment plans fall under two types; automated (the bank has control) and manual (the home-owner has control). If you choose to prepay your mortgage, and there are sound financial principles for not doing so, please do it on your own terms! Pay Plan 26 offered by Countrywide Financial now Band of America is a simple plan. In a nutshell, a homeowner makes a principal and interest payment every two weeks. The homeowner will make a half payment every 2 weeks or 26 times per year. That means that a homeowner who signs up for this program will make 13 principal and interest payments per year, but the 13th payment will go to principal. These payments are automated payments that the bank withdraws from a homeowner’s account every two weeks. Depending on the bank, the payments will be applied in one of two ways, either in one extra principal and interest payment per year or one and a half payments twice a year. There is a small difference in interest savings depending on the way the payments are applied.
Let’s look at what a bi-saver program like Pay Plan 26 really does:
1) A bi-saver program started immediately will turn a 30-year mortgage into a 24-25 year mortgage saving the homeowner thousands of dollars in interest payments.
2) A bi-saver program allows the bank to collect fees for a service the homeowner can provide for himself at no charge. Simply dividing the monthly payment by 12 and applying that amount monthly to each principal and interest payment will save a homeowner additional interest payments in addition to the fees assessed by the bank for its program.
Two Illustrations follow. In both the loan amount is $125,000 at 6.75% interest. The first total interest figure indicates what you would pay in interest if you did not pre-pay the loan. The second total interest figure indicates what you would pay in interest with a pre-payment plan.
Bank-sponsored pre-payment plan:
Home-owner do-it-yourself payment plan. $67.56 ($810.75/12) is added to each principal and interest payment. The monthly payment is $810.75. The final summary takes into account the additional $67.56 paid each month.
3) A bi-saver program allows the bank ready access to a homeowner’s bank account
4) A bi-saver program saves the homeowner very little in the first five years of the loan. As an illustration a homeowner who purchases a $125000 home at 6.75% interest will pay $40989.50 in interest. Enrolled in Pay Plan 26 that homeowner will make $4053.75 in extra payments to the bank will pay $40384.30 in interest and another $240 in fees. His total interest savings then will be $365.20. That is $4053.75 in additional payments to save $365.20. The interest savings become much more pronounced the longer you stay in your home with the savings totaling $3373.09 by year 10.
It is very important when you buy a home to determine how long you truly plan to be in the home. There is so little equity build up in the first 5 years of home ownership that it makes very little sense to buy a home if you know that you won’t be in the home longer than 5 years. Data from the Census Bureau and the National Association of Realtors indicates that the average length of home ownership is 6-8 years. Banks understand this. When the average homeowner enrolls in a bi-saver program, he guarantees the bank cash flow, while carving out little benefit for himself.
Be very cautious if you choose to participate in a bi-weekly program in which the bank uses a third party to collect and deliver payments. The third party processor may charge fees for set up and monthly transaction fees. Additionally the homeowner can end up in a bind if the loan is sold to another bank and the third party processor fails to deliver the payment to the new lender.
The Down-payment Secret Weapon
What is a down payment?
A down payment is typically a lump sum of money that a homeowner applies against the purchase price of a property. The loan amount is typically equal to the purchase price less the down payment. Homeowners make down payments because they feel they ought to and to lessen the “payment shock” of the mortgage. Banks want homeowners to have a down payment because it lessens their overall risk. If you could maintain foreclosure rights on a property by loaning a fraction of its appraised value, wouldn’t you want to do that? That is what a bank wants to do.
Home owners ought to have a down payment because a home purchase is an expensive transaction and once the excitement of the home purchase has passed, homeowners typically find that they are very cash poor forced to put unforeseen expenses on credit cards.
The amount available for down payment should be at least 20%. Given the expenses of owning a home, having a down payment of 10% means just barely getting into a home. Scraping together a down payment, barely qualifying for the monthly payment, then living in the home can create a level of stress that will make a homeowner regret ever purchasing the home. Although principal and interest payments may remain fixed home ownership costs are guaranteed to go up due to rising tax, maintenance and insurance costs.
Now even though I believe you should have at least 20% down, I don’t believe you should apply the down payment the way the bank wants you to.
For homeowners seeking to prepay their home loan and save massive amounts of money in interest payments. Their down payment is their secret weapon. Simply making the down payment the first payment on the loan will turn a 30 year mortgage into a 22 year mortgage saving thousands more than the bi-saver programs banks offer. The down payment, then will serve at least two purposes: 1) save massive money in interest payments 2) build equity in the home. Strategically using your down payment employs the wealth principles outlined previously by reducing the opportunity cost incurred when using a down payment as traditionally dictated by the banks.
Why does this work?
Strategically applying your down payment works because of mortgage principles number 1 and 2. Mortgages are front loaded meaning that the bank collects half of the total interest due in the first 10 years of the loan. 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. Applying the down payment to the first mortgage payment literally disrupts the mortgage shaving time and interest payments off of the front end of the loan. The best way to illustrate this is to use the mortgage calculator at http://www.bankrate.com
On a loan balance of $197000 a first principal payment of $19700 will drop the principal balance to $177300. The interest that would have been paid is $94000. By strategically applying your down payment, that is $94000 that you don’t have to pay.
As the illustrations below prove, strategically applying your down payment is a far superior equity and savings strategy than putting 10% down and taking out a loan for $177000. It is also a far superior strategy than putting 10% down and enrolling in a bi-saver program. In fact there is no need to ever enroll in a bi-saver program when you strategically apply your down payment. Applying 20% with the first payment does not deliver the “bank for the buck” that 10% does. Applying 20% however will deliver another $57000 dollars in savings and shave an additional 5 years off the loan converting a 30-year loan into a 17-18 year loan. Strategic application of 10% down provides the biggest return per dollar applied. It makes sense to hang onto the other 10% as a cushion or for future investment. Although this strategy will work for any loan amount and any interest rate, a home price of $197,000 is used for illustrative purposes.
Loan amount $197,000. No down payment, no prepayment plan:
Loan amount $177,000. Home valued at $197,000 less 10% down payment:
Loan amount $157,000. Home valued at $197,000 less 20% down payment:
Loan amount $177,000. Home valued at $197,000 less 10% down payment and bi-saver program:
Loan amount $197,000 with 10% applied to the first payment:
Loan amount $197,000 with 20% applied to the first payment:
One of the main reasons that people make a down payment is to lower the monthly payment. $127.78 is the difference in mortgage payments between a $197000 loan at 6.75 percent and $197000 less 10 percent down ($197000-$19700=$177300). There are an incredible number of things that can happen when you own your own home, which is why you should hold on to your capital. If $127.78 will make a payment unaffordable, then it is probably best to pass on the house until your financial situation improves.
We used this strategy in 2006 when we purchased the home we intend to retire in. The loan was an 80/20 loan with a blended rate of 6.77%. The 80/20 loan avoided PMI. By strategically applying the down payment, the 80% portion will be paid in 19 years and the 20% portion in 16 years.
About Private Mortgage Insurance;
The loan is collateralized by the underlying real estate. Private Mortgage Insurance (PMI) is a premium you pay to make sure the bank is reimbursed in the event of a default. The banks are double dipping here and it is unfair. The premium is typically $55 per month per $100,000 financed. There is specific law about private mortgage insurance and how you can petition to remove it. Through 2010 PMI is tax deductible. I had PMI for the first 3 years I was in my home it was relatively easy to get rid of.
Will the bank let you do it?
The short answer is that we did it and made our intentions clear when shopping for a loan. While we got our loan through the private sector, this strategy is very easy to employ using VA or FHA loans. We looked at all three types of loans before going with the private sector loan. This strategy does not work nearly as well if you have only 10% to put down and have to put at least 5% down to get a loan. In fact, under those circumstances, you are better off putting 10% down and enrolling in a bi-saver program. Remember that because of the expense of homeownership you should delay a home purchase until you have 20% down. If you have 20% down and the bank “forces” you to put 5% down you still win. By then applying 10% of the unpaid principal to the first payment you will put a total of 14.5% down, preserving part of your down payment and will save slightly more in interest costs over the life of the loan than if you had played the bank’s game and put 20% down and enrolled in a bi-saver program.
Here are the illustrations:
Home price is $197,000 – 20% ($39,400) = $210388.62 total interest payments at 6.75%
Home price is $197,000 – 20% = $157,600 loan amount. Bi-saver program = $160,673.16 total interest payments + fee expense for program
Home price is $197,000 – 5%(9850) = $187,150 loan amount. Apply $18,715 to the first payment = $160, 226.52 + 0 additional expenses. Using this method a homeowner would still have $10,835 dollars of their down payment to have as cash reserves.
The more philosophical answer is this: You shouldn’t have to ask permission for how you spend your money.
A roof over ones head is a necessity; home ownership is merely one option that meets that need. As an investment or a forced savings plan, home ownership is a poor choice. Wait to purchase a home until you have sufficient capital reserves and can apply strategies to decrease your overall costs on the back end of the loan and preserve your wealth on the front end.