 |
Answers |
 |
Should You Leverage Your Home or Pay It Down Rapidly?
Sep. 24th, 2009
YUMA, AZ – There is a great debate within the inner-mortgage circles these days.
Should we, as loan professionals, encourage clients to borrow as much money as possible for the longest period possible? Or would consumers benefit more from putting down large amounts of cash and pre-paying principal?
The answer can be found when looking at an individual’s savings and investing habits.
Leveraging Your Property. In order to understand why you'd want to borrow as much as possible for your home purchase, you must first grasp the concept that equity has a zero rate of return. Here's an example:
If Consumer "A" buys a home for $300,000, and puts 20% down, then they have $60,000 in equity. Over the next 5 years, the property appreciates $100,000 in value. Consumer "A" now has $160,000 in equity, but a net $100,000 gain.
Consumer "B" buys a home for $300,000, and puts no money down. At the end of 5 years, that same home is now worth $400,000. Consumer "B" has $100,000 in equity, which is the same appreciation as Consumer "A", a net $100,000.
As you can see, down payment has nothing to do with net rate of return. What becomes important is how you choose to manage the $60,000 that was not used as a down payment. One could you pay off credit card debt, eliminate a car payment, or even fund retirement plans. If one use it for frivolous activities, such as buying toys or going to Las Vegas, it would be more prudent to use that money as a down payment. This becomes forced savings.
Cost to borrow is also important. Lets assume the borrower in question is in the 25% tax bracket, and they obtain a mortgage at 6.5%. Their true cost to carry that mortgage is 75% of their interest rate due to the income tax write-offs, or 4.875%. This is why some lending professionals suggest putting as little down as you possibly can, thus maximizing your tax write-offs, and increasing the size of your investments. This principle has been applied for many years in the life insurance game. The old saying goes, "Buy term and invest the rest." The key component is taking the money that would have been used as a down payment and creating an asset accumulation account. Based upon that scenario, this individual would need an investment paying 5% annually to come out marginally ahead. This account should earn a significant enough rate of return to enable you to pay your mortgage off entirely and achieve the ultimate goal of being debt-free.
It's important, however, to understand that regardless of how rapidly you pay your home off, you're not getting any greater rate of return on your investment than if you paid it off slowly.
Conclusion. So how does one determine which scenario is best? The choice depends entirely upon the individual and their budgeting habits.
The Disciplined Consumers who are savvy, and are comfortable taking chances from an investment perspective, would do well with the first scenario. Over the course of time, it's been proven that your rate of return over the long haul will be far greater than the rate you'd pay for a mortgage in today's rate environment. It's important to seek the advice of a skilled investment advisor to ensure success with this strategy.
The Not So Disciplined Consumers are advised to take the second scenario. This is best for those who have a difficult time managing their money or who'll sleep easier at night knowing they have the lowest payment possible
If you find this subject intriguing and would like to know more, I recommend that you read a book titled, Missed Fortune 101, by Douglas Andrew. It's an outstanding read that is very simplistic and goes into far greater detail than I can cover in this column. Douglas is a financial planner who advises safe-structured investments such as whole life policies and tax-free fixed income instruments.
Derek Egeberg is Certified Mortgage Planning Specialist, CMPSR, with over 9 years of residential lending experience. If you have any further questions on this topic or any other, you can contact Derek at [928-314-1008] or email Derek@TheApprovalCoach.com.
More Articles
