The Big Omission-What Mortgage Lenders don't want you to know
Buying a home has always been called the “American Dream.” But as you will soon see this dream is more of a dream for lending financial instutitions (LFI) and not for the owners. I am not saying owning a home is a bad idea but it may not be the investment dream that you thought it might be. This guide is going to help you decide whether refinancing a home is a good idea for you or not. When someone says they are a homeowner this may or may not be true. In my opinion you are only the owner once you have paid off the mortgage. Until then you are in a rent-to-own situation. Your monthly payment is equivalent to rent. Stop paying the mortgage and guess what you no longer have a home. Same as with a rental situation, stop paying the rent and in a few months you will be evicted. The main difference is you may be able to reclaim some money when you sell your home. Having a mortgage is a boon to LFIs. Not only do they collect large sums of money from you in interest but you also carry all the risk with the home. If it burns down you are on the hook, if it needs new windows, HVAC, repairs, and any other personal liability is placed on you. The bank is freed from this all while collecting your rent (monthly mortgage payment). This guide is to help you decide whether it makes financial sense to get a mortgage, how to choose the right mortgage, and look at whether mortgaging is a good investing venture. * See chart below *
Things to keep in mind
There are many things to keep in mind when deciding on what mortgage to get. There are good and bad reasons to get one. There are also many things that need to be considered that might increase or decrease your total costs over the life of the loan. These considerations contain many variables. Here is a list of some things.
Could your money be invested in another form with a better return
Choosing a shorter term mortgage/How long do you plan to live in the house
Mortgage Downpayments / Closing Costs
Private Mortgage Insurance (PMI)
Homeowner Association Fees (HOA)
Ongoing and one time housing repairs and improvements
IRS First-Time homebuyers credit
IRS Tax deductions (mortgage interest), Exclusions, and Credits
Making extra mortgage payments (if allowed)
Flexibility to move to a new location
Having to move if the landlord decides not to renew your lease
Fixed monthly mortgage payment versus a rental payment that may increase
What if your family grows or shrinks
Inflation and deflation of the dollar
Once the mortgage is paid off you are still left with paying taxes, repairs, insurance, etc
Your time in maintaining your home (own a home and you have a never ending to-do list)
Their interest is Interesting
You may have asked yourself why do banks and financial institutions loan such large amounts of money at what seems to be a really low interest rate. Current savings account interest rates hover somewhere around 1.10%. Current mortgage interest rates hover somewhere around 30 year at 3.79%, 20 year is at 3.41%, and a 15 year at 3.03%.
Mortgages use a different interest calculating scheme called amortization. One might think if you have a 3.00 % interest rate you multiply your loan amount * interest rate to determine the amount of interest owed over the loan lifetime. Well that is not the case. Amortization is a mechanism where you pay a monthly payment based on your interest rate. However the amount of money applied to the principal (loan amount) is minimal. The amount applied to your principal increases each month you pay. But this increase is really slow. Most of the mortgage payment goes towards paying interest not towards lowering your principal (amount you owe). A $300,000.00 loan for 30 years at 3.79% would result in total interest of $202,619.33. In this case the interest alone is 2/3 the cost of the mortgage. The total cost for purchase would be $502,619.33. So at a minimum you would have to sell your house in today’ dolllars for more than $502,619.33 to make a return on your investment. If you take into account inflation then you would need to sell for much more to make a profit.
The Big Omission
So what is the Big Omission? It seems that everyone is always chasing the lowest interest rate. Banks commonly ask you when wanting to refinance the following questions: “Are you looking for a lower monthly payment or looking to lower your interest rate?” After the purchase of two homes and 5 refinances no bank has ever asked me “are you looking to lower the overall interest you pay.” This is the question they should be asking in my opinion. Unfortuntately I have been a victim of this Big Omission. I have refinanced to a lower interest rate which gave me a lower monthly payment. What I did not know is that this has minimal impact to my overall interest payments. Yes, there are cases where a lower monthly payment is important even while getting a small deduction in overall interest owed. For instance you are no longer able to afford the monthly payment but you want to stay in the same house. This is a valid reason but you should keep in mind how much overall interest you are paying. Fortunately for me on my last refinance I took into account the Big Omission. So my last refinance I not only lowered my monthly payment, I also decreased the number of years to payoff, and I also lowered the overall interest that I would end up paying by about $150,000.00.
Is it really an investment
Without considering rental income properties and only looking at a primary residence, I say it depends. There are cases where it might be an investment but in most cases I would say it is not an investment. There are cases where you might be able to recover your principal and there are cases where you may break even and there are cases when you might make money. An investment is something where at sale you have more money than what you put in. Mortgages typically are good at preserving principal. I would argue in most cases owning a home (mortgaging) is usually a losing investment. The term and size of the mortgage is an inverse relationship. Longer term loans result in smaller monthly payments but higher overall interest. Thirty year mortgages are the most popular type. However most homeowners move after 6-7 years of living in the home. There is some recent evidence that people are staying longer in their homes. Deciding whether it is an investment or not can be a debate. In the most simplest terms the sale price of a house should be more than the cost of the mortgage. If you were investing in the stock market you would want at least an 8% rate of return. For a house the same principle applies.
What are people doing
This information comes from Freddie Mac. These statistics are not completely accurate but are appoximations I have made looking at their statistics. Thirty year mortgages are the most common. Thirty year loans are more attractive since the monthly mortgage payment is typically lower than shorter term loans. Around 50% of people refinance from a 30 year loan to another 30 year loan. Around 20% of people refinance from a 30 year loan to a 20 year loan. In 2014 24% of refinance loan amounts were 5% or higher than the original loan amount. The median change in interest rates for all loans was about 0.85 (I assume most rates went down not up). The median age of refinanced loan is 6 years.
What should you do
The following table shows the initial mortgage and 7 refinance options. Assume the first loan (A) was made December 2015 and was refinanced January 2022 (7 years). Loans B-H are possible choices for a new refinanced loan.
30 year Loan A is the initial loan. This is the loan you want to refinance
30 year Loan B is 451.88 less a month and reduces your interest by about 10k
30 year Loan C is 475.86 less a month and reduces your interest by about 20k
20 year Loan D is 60.36 less a month and reduces your interest by about 110k
20 year Loan E is 82.06 less a month and reduces your intest by about 115k
20 year Loan F is 124.20 less a month and reduces your interest by about 125k
15 year Loan G is 313.22 more a month and reduces your interest by about 165k
15 year Loan H is 292.11 more a month and reduces your interest by about 170k
If you can afford the monthly payments the 15 year loans are the best since you pay the least in interest. Most people I have talked to cannot afford the payments on 15 year loans. Most people gravitate to 30 year loans since payments are normally more affordable. The skeptic might say that LFIs price mortgages in such a way as to allow for affordability while maximizing their profit. The 30 year examples show that you can significantly lower your monthly payment but make a small dent in the amount of interest owed. The 20 year loans are good examples of how you can lower your monthly payment and make a huge dent in the amount of interest paid. The 20 years do not lower your monthly payment by a large amount but they are reduced. The upside is the huge savings in mortgage interest. Imagine what you could do with the unspent 100+ thousands of dollars.
So the Big Omission of the LFIs in my opinion is a matter of greed. Around 50% of people refinance back into 30 year loans from a 30 year loan. They may decrease their monthly payment but they did not decrease their overall cost. The LFIs continue to reap large amounts in interest while the consumer thinks they are getting a good deal with a lower monthly payment. I have never been asked about lowering my total overall costs by LFIs. Talking with friends over the years the conversations have centered on lowering the monthly payment or paying the house off early. I cannot recall one instance when someone mentioned the interest you were paying. Well that is not completely the truth. There has been a lot of discussion with friends on how much interest we have to pay. There was never a connection made on how we might lower the overall interest. Possibly it is me or the friends I keep for this lack of insight. I tend to believe it is the purposeful ommissions of the LFIs that keep our attention away from this conclusion.