It’s a financially responsible question I believe most people ask themselves at some point; especially when they find themselves with some extra cash that they’d like to put to good use. More than once after my wife and I have found ourselves with a new raise or bonus, we’ve questioned whether it would smart to use that extra cash to pay off some additional mortgage principal every month.

Why is that?  Because eliminating your monthly mortgage payment has classically been accepted as almost a sort of “pre-requirement” to achieving financial independence.  ABC’s “Shark Tank” co-host and personal finance author Kevin O’Leary has been quoted as saying “If you want to find financial freedom, you need to retire all debt — and yes that includes your mortgage,” according to CNBC.

And he’s not alone in his advice.  Completely paying down your mortgage debt has been a sentiment shared by popular financial gurus, advisers, and those approaching retirement for decades.

Even those seeking early retirement have made paying off their mortgages a top priority.  Read the stories of dozens of early retirees across the Internet, and you’ll quickly recognize that eliminating their mortgage debt was a huge component in reducing the amount of money they needed to accomplish their goal.

But then consider that we’ve all been in a very unique place in history in terms of interest rates.  Up until 2016, the U.S. Federal Reserve has held interest rates at nearly 0 for almost 6 years (in an attempt to try to stabilize the economy).  This means nearly anyone who got a new mortgage or refinanced within the past decade could be paying between 3 and 5 percent interest.

If you’re one of these people who was able to lock into a rate so low, does it then make sense to pay off your mortgage early when there could be better opportunities for you to use or grow your money?

In this post, we’ll look at both sides of the early mortgage payoff argument and weigh the pros and cons.  In the end, you can consider which points will help you the most, and what you think would be the best use of your money!

Why You Should Pay Your Mortgage Off Early

Some people get extremely passionate when it comes to idea of paying off your mortgage early.  And for several good reasons!

1. That feeling of finally being DEBT FREE!

When it comes to your finances, there is no better feeling than that of being “debt free”.

Say it with me … “debt free” ….

Imagine waking up and saying to yourself: I don’t owe anyone anything!  I could lose my job tomorrow, and it wouldn’t matter.  I’ve done what was needed to protect the greatest asset that my family and I depend on.  The house and everything in it will still be mine – all because I paid it off!

This simple but powerful psychological reason is one that has driven many people to accelerate their house payments at incredible rates.  Just like a career or weight loss goal, they simply want to be able to say “This house is mine!  I own it and no one can take it away!”

Who can blame them?  Wouldn’t it just feel great not to see that huge mortgage payment deducted from your checking account every month?

2. Saving yourself thousands of dollars in interest.

Now we get to the technical reason …

The definition of a mortgage is that it is a loan.  Loans carry interest.  When it comes to interest, there are only two sides:

• Those who pay interest.
• Those who receive interest.

Unfortunately, since none of us are lenders, we’re all on the wrong side of that equation!  And the longer you carry your mortgage, the more interest you’ll end up paying to the lender over time.  Who wants to do that?

Fortunately, mortgages are designed in a way that can exploited, and the way to do it is simple.  The sooner you payoff the principal, the less money in interest you’ll pay over time!

The savings are not trivial!  For example, something as small as $100 extra dollars per month could end up saving you over $20,000 in interest payments over time!  And that’s not to mention shaving almost 5 years off your payment schedule.

Want to see for yourself?  Try this free calculator from BankRate.  I highly encourage you to test it out and see just how much interest you end up paying on your house over the life of your mortgage. It can be extremely eye opening!

3. Building up equity

Unlike when you rent, every portion of your mortgage payment that goes towards the principal builds up “equity”.  Technically, this is the amount of the asset (your house) that you officially own.

Why does that matter?  Because when you go to sell your house, you’re entitled to this equity, which could mean tens or even hundreds of thousands of dollars! 

Let me tell you – when we sold our house, it was pretty nice getting a big fat check for over $30,000!  Depending on what your next move is in life after you sell your house, you could really use this money for a variety of reasons:

• Next mortgage down payment
• Payoff debt
• Finance a portion of your retirement

Effectively, you could almost think of it like paying your future self!

4. Locking into a fixed return rate.

Not a lot of people realize it, but paying down long term debt is just about the same thing as investing it.

How so?  Let’s take your mortgage, for example. When you pay down your mortgage early, it’s the equivalent of investing that money and getting the same rate of return. If your mortgage APR is 5%, then for every dollar extra you put down on the principal, you’re effectively saving 5% in interest.  (For an in-depth explanation of how that works, read my post Which is Better – Paying Off Your Mortgage or Investing the Money?)

Given our historically low interest rates over the past decade, and for some people this might be a more lucrative rate of return.  When was the last time you went to a bank and were offered a CD with a fixed rate of 5.0%?

Why not just invest in stocks for a higher rate of return?  Well … you could, and that’s one of the points we’ll discuss further in the next section.  But keep in mind: Paying off debt is like getting a “guaranteed” rate of return (the same as a bank savings account or CD).  Stocks are not guaranteed, and there is therefore more risk involved.

5. Reducing the amount of money you’ll need later or during retirement.

There’s a very good reason why so many financial guru’s and enthusiasts tell you to get rid of your house payment before you consider retirement.  Eliminating your mortgage payment dramatically reduces how much money you’ll need in order to retire.

For example, let’s say you have a $1,000 mortgage payment and $4,000 in expenses. In the classic calculation, you’d need $5,000 x 12 months = $60,000 per year which equates to a retirement savings target of $1,500,000. But if your mortgage was completely paid off, then you’d only have to cover $4,000 in expenses.  This means you’d only need $48,000 per year, which works out to a target nest egg of $1,200,000 instead; a difference of $300,000 less!

(If you’d like to see how I calculated this or why these numbers work, please check out this post.)

6. Lower taxable retirement income.

Again, thinking ahead to retirement, if you’re smart about how much taxes you’d like to pay when you’re retired, then you’ll want to make sure you pay off your mortgage before you enter into retirement.

The reason is this: When you retire, you’ll want to withdraw as little money as possible from your nest egg and Social Security so that you pay little to no taxes.

Suppose for retirement you decide you’ll need $30,000 per year pre-tax. Now let’s say that $10,000 of that $30K are your mortgage payments. If your mortgage was paid off, wouldn’t it be better to only need $20K instead of $30K. At $20,000, you’d actually owe no Federal taxes whereas at $30,000 you’d owe something.

Of course there are many ways to dance around paying taxes altogether during retirement, and this could be a complete non-issue. If you’re interested in knowing more about this, check out my how to have a tax free retirement. We actually worked out a scenario where you could withdraw $132,500 from your nest egg without paying any taxes at all!

Why You Should Not Pay Off Your Mortgage Early

While each of the above reasons above were pretty good, the reasons NOT to pay down your mortgage ahead of schedule can also be just as equally enticing.

1. Hedging inflation.

If you have a fixed rate mortgage, then your principal and interest payments will be the same for the next 15 or 30 years (depending on whatever kind of mortgage you took out).

While that may not sound very special, it actually has a very unique benefit to you in terms of inflation protection.
Consider this: As time goes on, all your other monthly payments will go up like your food, gas, utilities, car payments, insurance costs, etc, will go up.

But not your mortgage. Your mortgage is frozen in time. And relative to everything else you’re buying, that payment will actually “feel” like less the longer time carries on.

For example, let’s say you’re paying $800 today for principal and interest. For as long as you have the loan and do not refinance, you’ll always pay $800 every month. So if inflation increases by an average of 3% every year, that $800 will “feel” like the following over time:

Your future self might appreciate this!

2. Find a Better Rate of Return

Above we said that making a mortgage payment is basically the same thing as getting an investment with the same return rate. So let’s suppose that you refinanced your mortgage within the last year and got a fixed rate at 4.0%. If the average annualized return of the stock market (such as the S&P 500 index) is 8.0%, then that’s a difference of 8.0% – 4.0% = 4.0%. If you’re investing for the long haul, then rather than paying off your mortgage early, why not go for the market average and shoot for an 8% return instead of a 4% one?

3. Inability to tap into the funds due to loss of equity

What if we have another Great Recession like we had in 2008 and house values don’t go back to where they once were? What if they drop even further?

While debt is debt and you’ll have to pay off your mortgage no matter what your house value is, it may not strategically make sense to “park” your money in your house by paying your mortgage off early.

Consider if you made extra payments towards your house and you suddenly had to move for some reason. What if your house unfortunately sold for less than what you still owe on it? You’d never recover all that money you paid into your mortgage, and so you’d be out. According to this story from ABC News, this is unfortunately exactly the kind of thing that happened to one couple when they decided to use their 401k retirement funds to pay off their mortgage rather than waiting.

A better place may be to temporarily park your extra cash in an emergency fund or someplace where you can have access to it in case something came up.

4. Low interest rates.

When I refinanced my house a few years ago, I thought I’d never see interest rates that low ever again. Imagine my surprise when rates continued to fluctuate and banks were offering 15 year loans as low as 2.75%. Could you imagine a mortgage with a rate as low as 2.75%? That’s less than the average 3% inflation rate.

If you were lucky enough to lock into one of these ultra low rates, then you’re basically paying a historical low of almost next to nothing for your mortgage.

5. Fewer income tax return breaks.

You may not realize it, but your mortgage interest is deductible against your U.S. income taxes. Most other forms of debt (like a credit card or car payment) are not. While there is always a Standard Deduction, in some situations it may work out better for your tax situation to have more interest to declare.

Unfortunately this point can be somewhat weak in the pay off your mortgage early debate. Suppose you own a median priced house with around 20% equity in the house. In that instance the IRS Standard Deduction would automatically exceed whatever tax benefit you’d receive from itemizing.

6.Taking Care of Other financial goals.

Foregoing putting money into your 401k?

Not stuffing your emergency fund with the cash it needs?

Do you have high interest debt you should be paying off instead?

Maybe relative to these things paying off your house early just isn’t a huge priority.

Perhaps you’d rather dream big by starting a business, buying real estate, or fund other investment goals instead.

What is the Right Answer?

So after all of that, you’re probably wondering to yourself which of these directions is the right one to go in.

The short answer – it depends entirely on you.

Only you know your own financial well being. Perhaps some of the points we made here carry more weight to you than others.  Regardless, there is never really a good one-size-fits-all answer to these kinds of situations. All you can do is look at the possibilities and decide for yourself which ones fit your position the best.

Readers – What do you think? Have you ever given much thought to the question of should I pay off my mortgage early? Did you end up doing it? Or did you find other reasons why you should do something else with the money?

Photo credits: Unsplash, Pexels, Pixabay

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Question: If I’ve got a little extra money that I’d like to use responsibly to pay off one of my debts, which is the better one to put it towards: Should I pay off my car loan early or my mortgage?

Ahhh … the old “which of my debts do I pay down first” debate …

We tend to carry a lot of them in our society.  According to a 2017 report from GoBankingRates, the top three forms of debt for most people are their mortgage (65%), credit cards (50%), and auto loans (32%).

Usually questions like this are a no-brainer.  Simply look to your loans with the highest interest rate and pay those off first.  That means tackling your high-interest debt like credit cards and student loans.

But what about our auto loans and mortgages?  When it comes to debts like these, the differences can be a bit more subtle.  The interest rates are often lower, and the payments are more manageable (likely because they’ve been spread out over so many years).

All in all, debt is still debt!  And the sooner you can pay it off, the quicker you can crawl out from underneath the mountain of interest that is building up on top of you.

But for these two types of loans, is that all there is to it?  Are there are other implications to paying off your mortgage or car loan that can make one option more attractive than the other?

In this post, we’ll break down the numbers and compare what paying off your car loan vs your mortgage actually means in terms of money saved.  But we’ll also discuss a few other important points that could improve situation and add to your decision.  Let’s begin!

Auto Loan vs Mortgage – The Comparison

Before we can make a good comparison between your auto loan and mortgage, it helps to understand how these loans are constructed in the first place.

How Do They Work?

First of all, for both, most conventional loans work in a similar fashion:

Monthly payments are determined by finding the future value of the loan amount in a financial calculation that takes into consideration 1) an agreed upon annual interest rate and 2) how long it will take to repay the loan.

The general construction of the loan is that your initial payments end up being more heavily weighted towards paying back the interest and less towards your principal.  As time goes on, the proportions incrementally change towards less money going towards the interest and more going towards the principal.

In case you want to know, this is a process called amortization.  It’s designed so that the lender gets paid their interest more quickly, while it takes you longer to pay back more of your loan.

What does this mean for you?

1. You can influence the amortization schedule in your favor by making additional payments towards the principal, which means paying less interest in the future.
2. From a mathematical standpoint, we can conclude that the loan with 1) the higher interest rate and 2) the longer payment period will be the one you’ll want to accelerate.

In this case, your mortgage.

But how much better is this really?  Can we put some numbers behind it?

Of course!

Loan Constants:

Let’s setup a real-world example of a typical auto loan and typical mortgage.

For the auto loan, using statistics from CNBC and Value Penguin, we find:

• Average loan: $30,032 (we’ll round to an even $30,000)
• Average monthly payment: $503
• Average term: 68 months (we’ll go with 60 months for our model)
• Average interest rate: 3.93% for 60 months and 3.78% for 72 month (we’ll round to 4%)

Similarly, for a mortgage, using data from Experian we find:

• Average mortgage balance: $201,811 (again, we’ll round to an even $200,000)
• For our model, we’ll use a typical 30-year fixed rate mortgage with a 4.5% APR

Putting all of this together, our monthly payments equate to:

• Auto loan = $552.50
• Mortgage = $1,013.37

Finally, the last piece of the puzzle will be how much extra money per month we’d like to apply to either our mortgage or auto loan.  For this, I will select a simple amount of $100.

The Results:

Crunching all the numbers in Excel, at the end of the 5-year period, I come up with the following results:

Putting the extra money towards our auto payments saves us $531 in interest. Putting the extra money toward our mortgage payments has (so far) saved us $740 in interest.

Therefore, just as we assumed, paying down the mortgage was the better choice.

But take into perspective that this is only by a lead of $209 over a 5-year period. So even though there is a slight mathematical advantage with the mortgage, it makes almost no difference which loan you choose to pay down quicker!

But What About Interest in the Future?

One of the big arguments for people in favor of paying down their mortgage early is that accelerated payments will dramatically reduce how much interest they save over the life of the mortgage.

And they are correct.  Paying down your principal early on will shave years and tens of thousands of dollars off your total mortgage.  This, of course, depends on how much you pay and how often you make the payments.  There are any number of mortgage payoff calculators across the Internet where you can see this for yourself.

So what about our example?  How much money over the entire 30-year life of our mortgage will we save based on these first 5 years of our accelerated payments ALONE?

The answer: $14,111

Again … not bad.  But not exactly a great return either; especially not after waiting 25 years.

For example, we could have easily introduced a third scenario where we took those 5 years to save up $100 each month, and then invested it all in a stock market index fund over the next 25 years.  With an average annualized rate of 7%, it would have produced a return of $32,565.  That’s double the interest saved over the life of the mortgage.

(Again, no surprise since 7% is a better rate of return than the 4.5% interest rate on the mortgage.)

So again: While there is definitely a strong potential to save even more money in the future by making accelerated mortgage payments, it’s not an overwhelmingly convincing reason to put your extra money towards the mortgage payments over the auto loan.

In that case, if the amount of money saved doesn’t sway you one way or the other, than what would be some other good reasons?

Freeing Up Money to Pay Your Other Debts

Forget the interest calculations for a second …

What if paying off your auto loan or mortgage early gave you the ability to do something else worthwhile with your money?

What do I mean by this?

I’m talking about cash flow.  What if our goal should be to free up as much money in our monthly budget as possible, so that we can then use it to tackle our other debts?

This strategy is popularly known as the debt snowball method.  The process is always the same:

1. Pay off your debt with the lowest balance first (regardless of interest rate).
2. Now take the money you would have normally used each month to pay off Debt #1, and redirect it towards your debt with the next lowest balance (Debt #2). Continue until Debt #2 is paid.
3. Repeat the process with Debt #3 and so on until all of your debts are completely paid off.

As you can see, this technique creates a cascading effect where your budget stays the same, but your payments compound upon one another until your debts are all gone.

So what does this mean for your auto loan vs mortgage dilemma?

Without knowing your purchases, odds are very good that the amount of money you still owe on your auto loan is less than your mortgage balance.  Therefore, with this strategy, you would:

1. Use your extra budget to pay down the auto loan as quickly as possible.
2. Once the auto loan is completely paid off, you then continue to take that same monthly amount of money and reapply it to your mortgage.

I can tell you from personal experience that I have used the debt snowball method in the past and it works really well!  I’ve paid off small debts that carried 0% interest just so that I could free up and extra $200 (or so) per month to use towards paying off our other expenses. Nothing feels better than completely paying off large loans!

So if paying off your loans more strategically using something like the debt snowball method is your goal, than in this case paying off your auto loan in the smarter choice.

Which Asset Depreciates Slower?

Another way to look at this debate is to consider which item will be more likely to give you a return on your money in the future.

In other words, focus on paying off the asset which depreciates the slowest.

Think of it this way: Let’s go 5 years into the future.

What will the value of your auto be?

Likely next to nothing.  For the typical automobile, you might get a few thousand dollars at trade-in (if you’re lucky).  Generally, all of the money you sunk into your vehicle loan will be effectively be gone.

Now consider what your house would be worth if you had to sell it?

Chances are your home will be worth approximately the same or possibly more than what you paid for it.  That means that you’d have at least some equity to recoup.

When we sold our house after living in it for 11 years, we sold it for just about the same price as we paid for it.  But since we had been making mortgage payments for so many years, our balance was low and we earned several tens of thousands of dollars in the transaction.

Therefore, if you think of putting your money towards something that will show a better return in the future, then paying off the mortgage quicker makes more sense.

Eliminating PMI

Did your mortgage come with PMI?

If you put down less than 20%, then chances are it does.  PMI stands for “private mortgage insurance”.  It’s basically an insurance policy that the mortgage lender takes out on your mortgage in case you default, and they make YOU pay for it!

If you’ve got PMI, one of your goals financially should be to get rid of it as soon as possible.  Any money you put towards PMI is effectively gone the moment its paid.  It does nothing to reduce either your principal or interest.

When we had our first mortgage, it came with PMI that worked out to almost $100 per month.  That’s more or less a payment of $1,200 per year that went towards nothing tangible on our behalf!

So how do you get rid of PMI?

Simple: Pay down your mortgage principal quicker.  Once your loan-to-value (LTV) ratio gets down to 80% or lower, you can possibly refinance and have PMI removed.  That’s more money that’s back in your pocket!

Therefore, if you’ve got PMI and want to eliminate it, then putting your extra money towards the mortgage instead of the auto loan would be better.

Tax Deductibility

Though it’s not a heavy hitter, one more topic to consider is which loan can work out better for your taxes.

As you might already know: Mortgage interest on your primary home is tax deductible for those people who itemize.  The interest you pay on your auto loan is not.  Therefore, this can make paying off the auto loan more appealing since you’ll want your mortgage loan to last longer.

Again, this benefit will vary from house to house.  In this article from Investopedia, they found the amount of savings between itemizing and taking a standard deduction to be anywhere from $100 to $1,500.

Conclusion: Do What’s Right for You

Still unsure of which option is the better one to go with?

It’s okay.  You don’t have to be.  Basically, just go with whichever one feels right to you.

You could look at your loans mathematically, strategically, or even from a tax benefit perspective.  But either way, only you know your financial situation.  Therefore, you have to do what works the best for your well-being.

No matter which way you decide to go, the good news is that you’re using your extra money to pay off your debt early, and that’s a “win” no matter how it gets done.

Readers – Which would you rather do: Pay off your auto loan first, or put the extra money towards your mortgage principal?  What are your reasons for deciding to do one or the other?

Photo credits: Pexels, Pixabay

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If mortgage rates go down, how long do I have to wait to take advantage of that opportunity? 

How soon can I refinance my home and lower my monthly payment?

When you’re a frugal son-of-a-gun like me who’s heading towards financial freedom like a locomotive that’s full steam ahead, the answer is: As soon as it makes financial sense to do so!

More specifically: Right away!

Yes, that’s right.  After having moved less than a year ago, we’ve already successfully completed a refinance of our home mortgage.  This is a move that will save us almost $70 per month!

But the more appealing aspect: It cost us literally nothing out of pocket, and it will pay for itself within 2 years!

Should you refinance your mortgage so soon after just moving into your new house?  Let’s go through the steps to see how I arrived at my decision, and we’ll see if that makes sense for you as well.

Always Looking for Ways to Save!

One thing about me is that I’m constantly challenging our household expenses to look for better and creative ways to save more money.  For example, we dropped our cell phone insurance with Sprint when I ran the numbers and discovered we could practically buy a new smart-phone for the price they were charging us!

Literally no expense is safe.  And I’m always keeping my eyes peeled for new opportunities.

Well, as luck would have it, I found one of those opportunities!

Paying Attention to the Rates Pays Off

Recently, while reading through my usual regimen of daily personal finance articles, I started noticing in the sidebars that there were advertisements for mortgage rates that were significantly lower than mine.

The mortgage I had just signed up for was a year 30-year fixed rate of 4.25%.  After doing a little bit of research and making some phone calls, I had discovered that the going rate was now 3.75%.

Hmmmm.  A 0.5% difference?  Is that really enough to go through all the trouble of pulling the trigger on a total refinance?  I had always heard the conventional wisdom that your new rate had to be at least 1% lower to make sense.

What about closing costs and fees?  How would they factor into this situation?

It was time to do the thing that I do best: Crunch the numbers!

Comparing My Refinance Rate to My Old Mortgage

Using the ballpark estimates I had received from various lenders, I put the numbers into a spreadsheet and did the math.

Even at this modest 0.5% rate drop, switching from one 30 year mortgage to another would drop my monthly payment by $69.

But over the life of the loan, I’d eventually save $23,318 in interest!

When you look at it from this perspective, it makes sense on all fronts to proceed!

Reducing the Closing Costs

Closing costs are always the big “what if” in any mortgage or refinance discussion because they can vary by SO MUCH!  Your estimate can be chucked full of so many different types of fees and categories that it’s hard to really know if you’re comparing apples to apples across different lenders.

Thankfully I found an easy way to take care of it all: Use my current mortgage provider.

My current mortgage provider was able to work with me on our closing costs in the following ways:

1. They had a “summer special” going on that included $500 off the origination fee.
2. The rate they offered included “negative points” – meaning they paid me for taking a slightly higher rate.
3. They were able to use the home estimate that we had just used 10 months ago when we bought the house. This saved us from having to purchase another home estimate, and (more importantly) set the value of our house right where we needed it to be so that we could move forward with the loan!

All in all, our closing costs came out to $1,645.  Given the amount of savings per month we’d be getting, essentially we’d break even on this expense within the first two years!

Score!

Why Not a 15 Year Mortgage?

When I first had the thought of refinancing my mortgage, the thing I really wanted to do was go all in and get a 15 year refinance.  Not only would that have given me the lowest, best possible mortgage rate, but after calculating it out I would have saved almost $115,000 in interest alone!  That’s literally the value of a whole separate house!

The problem: It would mean committing to an increased mortgage payment increase of $408 every month.

Unfortunately, at this time with my aggressive early retirement saving habits, that’s just simply not something that we can permanently adjust to right now.  While the prospect of saving so much money over time is enticing, I will always recommend that the first thing anyone should do is to align their finances with their own personal goals.  Since early retirement means more to us than having our house paid off more quickly, I decided the 30 year mortgage will do fine.

Besides, with potential long-term investments having the possibility to yield a lot more than 3.75%, it may make even more financial sense to invest the money rather than pay off our house early.

Plus, it’s important to remember that at any time if your finances change you can always essentially create your own fake 15 year mortgage by simply making early principal payments periodically.  Sending in just a few bucks here or there once a year can knock 5 or so years off your term, but gives you the flexibility to opt out if you can’t quite do so every time.  Bankrate has a fun, free calculator that can let you test out some numbers and see for yourself.

Always Be Challenging Your Bills!

There you have it!  I would have never guessed that I would have refinanced my home mortgage so soon in less than a year, and only for half of a percent less.  But as you saw, we crunched the numbers and it made sense.  Not only will it save us more money every month, but the closing costs will take care of themselves within 2 years and we’ll save a boat-load over the life of the entire mortgage!

The important lesson to learned: Always, always be challenging your bills.  No matter what they are for or what they cost, there will always be opportunities to make them lower.  It’s simply up to you to be on the lookout for them and make it happen.

Related to our mortgage, it was just earlier this year that I challenged our property taxes and got them lowered by a very significant amount!

There are so many different ways to cut your expenses every month.  Everything from just a few extra bucks to a few thousand can make a difference.  If you’d like to hear of some more examples, I’ve got some more good suggestions to share in my ebook “Save MORE, Earn MORE!”  Honestly, once you start auditing yourself and diverting those savings towards your other financial goals, you’ll soon appreciate the effort you’ve invested!

Readers – How many of you have wondered how soon can I refinance my home?  How quickly did you act, and how much did it save you?  What other things have you done recently to cut down your monthly expenses?

Featured image courtesy of Pexels

The post How Soon Can I Refinance My Home Mortgage?  I Just Did Within the First Year! appeared first on My Money Design.

This is only the second house my wife and I have purchased in our adult lives.  Our first one was back when I was 24 years old.

With our first house for sale on the market at almost the same price we paid for it back 11 years ago, this got me thinking:

What if we hadn’t bought a house when we first got married, and did something else with our money?  Would we be better off financially?

Although this is a fun little question to ponder, it’s actually a very real and tough choice for lots of young working professionals today.  Many of them are faced with the decision of whether to find a place to rent or settle down with a good starter home.

Well, even though getting your first home can be very exciting, I’m going to show you that perhaps waiting a few years to become a home-owner might make better financial sense.

Let’s first take a closer look at some of the myths that push us to buy a home as soon as possible.

Do Houses Really Appreciate in Value?

There are so many things in our lives telling us that buying our first home is a good idea:

• Our parents tell us it’s a great investment.  (Back in their day, it probably was!)
• We know we’re doing a smart thing by no longer throwing away money on rent for a place that we’ll never be able to call our own.
• You’re finally somewhat accepted as a responsible grown adult who is capable enough to manage a mortgage.
• Best of all – it feels great to be the king of your own castle!

From a financial perspective, let’s zero in on that first point.  Folks from the baby-boomer generation (and older) love to tell you that “buying a house is an investment”.

Like I mentioned, my wife and I are currently putting that theory to the test.  We’re trying to sell our house of 11 years at approximately the same asking price that we paid for it originally.  The sad reality is that more than likely, by the time it finally sells, we’re probably going to end up with slightly less than that amount.

Now factor in all the numerous upgrades and investments we’ve put into our house over the years, and we’re surely not going to be make any of our money back.

Dr. Robert Shiller of Yale has pointed out this sort of phenomenon with house prices before.  According to his research, the average real rate of appreciation of home values was only 0.2% between 1900 and 2000.

We say “real rate” because that’s adjusting for inflation.  So in reality when your parents bought a house for $100,000 and later on sold it years later for $150,000, it wasn’t really because the house increased in market value.  It was more likely due to the economic forces of inflation.

No matter how you slice it, 0.2% is a pretty crumby rate of return.  If I told you I had an investment opportunity for you at that rate, you’d tell me to get lost!

So then what else could we do with our money that would be better?  Is there something else that would have made me richer if I had waited 10 years later until age 34 to buy a home?

Absolutely there is!

Saving for Retirement vs Buying a House:

To illustrate my point, let’s create two unique scenarios.  Let’s look at what would happen by the time you turn age 64 if:

1. You started saving a certain amount for retirement right away at age 24, stopped saving that amount at age 34 so you’d have more money to buy a house, and then never saved any more money for retirement ever again.
2. You bought a house at age 24, did not start saving for retirement until 10 years later starting at age 34, and then continued to save that certain amount for the next 30 years until you reached the age of retirement.

(I say set “certain amount” because I’m not insinuating that you wouldn’t save anything for retirement in either of these situations; only that this amount would be in addition to what you plan to save.  Glad to clear that up.)

To keep things consistent, let’s assume we’re working with the same figures in both situations.  If you’re not living in a house and paying a mortgage, then you’re likely renting a place to stay.  So here are our assumptions:

• Rent per month: $500
• Mortgage per month: $1,000
• Difference per month to save for retirement: $1,000 – $500 = $500

Scenario A – Delaying the House Purchase and Saving Right Away:

In our first situation, you start saving for retirement right away.  That means at age 24 you’re stashing $500 per month into a tax-sheltered savings account (like a 401(k)).

By the end of 10 years at a compounded rate of 10% per year, your 401(k) would be worth $95,625.

Then at that point you decide to stop saving this $500 and instead use it to help finance your new mortgage and home purchase.  So you stop contributing this amount to your 401(k).

That $95,625 stays in your 401(k) and continues to grow and compound for the next 30 years until it reaches a balance of $1,668,591 by the time you’re ready to retire at 64.

Not bad for only 10 years of making contributions!

Scenario B – Buying a House Right Away and Waiting to Save:

Now let’s play out the other scenario.

At age 24, you buy a house right away and no money to set aside for retirement.  However, 10 years in to your career (now at age 34), you decide to start setting aside $500 per month for retirement.  And you continue to save for the next 30 years until you’re ready to retire at age 64.

Surely after 30 years of contributions, you’d have a higher 401(k) balance, right?

… Wrong!

It Matters A LOT When You Start Saving for Retirement:

In scenario 2, that $500 per month you were saving for 30 years would only be worth $986,964 by the time you’re age 64.

So effectively, scenario 1 is the winner with a balance of $681,627 more by the time you’re ready to retire.

How is this possible??

Saving Early is the Key:

This whole phenomenon is due in thanks to the power of compounding returns.  And the fuel that feeds compounding returns is “time”.

Because you started saving and building up your retirement account 10 years earlier in scenario A, you had far more money to compound and grow by the time you hit age 34.  In fact, you had so much money saved that it was able to outpace any additional savings over the next 30 years.  This is very similar to a situation I illustrated in an earlier post where at some point you could literally stop saving your money (if you wanted to) and still end up hitting your retirement goals.

Obviously, I’m NOT ever recommending that you stop saving for retirement; we just did that here to illustrate an interesting point.  Can you imagine how much money you’d really have in scenario A if you had continued to save more retirement for the next 30 years?  Your nest egg would be incredible!

This is why I always recommend to people to start saving as early and as big as possible.

Stocks Return More Than a House:

The other thing that really helped was the return rate of your investments.

Stocks, the things that make up most of our retirement accounts, have an annualized rate of return at about 10% according to NYU.  Even adjusting for inflation, that’s still a decent 7% year over year return.

Combining this fact with the recent phenomenon of low interest rates is also the reason why I choose to invest my money rather than pay off my mortgage early.

Houses Aren’t Really Investments, They Are a Place to Live:

Now I know supporters of the house will claim that the house rose in value over the course of 40 years too.

But did it?

Go back to the beginning of this article.  Remember that Dr Shiller found housing to produce an inflation adjusted rate of 0.2%.  So even though you may be able to sell your house for more (eventually) than what you paid for it, this is likely only due to inflation; not because it was a great investment.

Compare that to the return of the stock market and its unfortunately no contest for the stocks.

What Can We Learn From This?

Really this whole exercise is NOT to dog on anyone buying a house at an early age (or any age really).  Like I said, I bought my first house at age 24 and have lots of great memories.  I’m all in favor of home ownership.

Like all things on My Money Design, this article was meant to make you “think”.  It’s meant to challenge conventional wisdom and really do a deep-dive into the numbers to see which financial opportunity is really the best.

When you crunch the numbers as did and really examine both scenarios, you quickly realize just how powerful saving earlier rather than later can be.  In fact you can almost double the size of your nest egg depending on how much you save and how your investments perform.

But does that mean we should all wait until our 30’s to buy our first home?

Of course not!  Ultimately, the choice is yours.

There are plenty of “qualitative” reasons why you may want to buy a house.  It’s not always about what makes you the most money.

Just remember that a house is a house; not an investment.  You should buy a house because you love it and can see yourself being happy there for the next 10 or 20 years.  If you want an investment, there are other places you should look.

Readers – Which would you rather tell a young a person in their 20’s: To buy a house or save for retirement?  Looking back, which would you have rather done?

Images courtesy of Mark Moz | Flickr and FreeDigitalPhotos.net.

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That’s the question that’s on everyone’s mind when they first go new-home shopping: What size mortgage can I afford?

It’s a prudent thing to ask and sensible when it comes to your finances.  Part of the whole Great Recession in 2009 was an issue with home buyers taking on far too high of a mortgage value than they could afford.  (That and getting themselves into mortgage products that were probably not the most ideal for their situation).

So to avoid another house buying implosion, a smart consumer will first take a look at their financial situation in the mirror and see what makes the most sense for their situation.  Here’s a few tips to help you decide how much debt you can afford to take on.

What Size Mortgage Can I Afford?  The General Rule of Thumb:

In the absence of all other information, one general rule of thumb you could use to gage how much house you can afford is to multiply your gross household income by 2 or 2.5.

For example: If the two of you make $200,000 combined before taxes, then you should be able to afford a mortgage that costs somewhere between $400,000 and $450,000.

While that’s a pretty simple guideline to follow, many other variables will of course dictate whether or not you’ll actually qualify for a mortgage.  They are the front-end and back-end ratios.

Front-End Ratio:

The front end ratio is used to look at how much mortgage you can afford based on your gross income.

What you do is to add up your total monthly mortgage payment, which includes the principal, interest, and escrow (PMI, insurance, and taxes).

Now compare that number to your monthly combined household income.  Most financial planners agree that this ratio should not exceed 28%, although lower is safer.

By following that advice, if your income is $5,000 per month, then your total mortgage payment should not exceed $1,400 per month.

The place where some people run into trouble is when mortgage providers will still give you the loan even though you’re at 30% or even 40%.  Remember to keep your best interests ahead of what a loan provider is or is not willing to offer you.

Back-End Ratio:

Another factor mortgage lenders take a hard look at is something called the back-end ratio or debt-to-income ratio.

This ratio compares all your debts (your mortgage, credit card payments, child support, other loans, etc.) and then again compares them to your gross income.

Your debt-to-income ratio should not go beyond 36%.  Again, if you assume a monthly income of $5,000, that means you shouldn’t have more than $1,800 each month of debt payments.

Just like with the front-end ratio, you have to watch out for yourself.  Some lenders will still approve you for the loan even if your back-end ratio is as high as 45%.  You have to know for yourself what you can afford.

Other Mortgage Size Variables to Consider:

There are lots of other things that could make or break how much house you can afford.

The down payment for example is one of the biggest factors.  Most home lenders want you to put down at least 20% (even though a lot of them are willing to work with less).

Suppose you have a lot of money saved up for a home down payment.  In that case you could afford to buy more house than someone with less start up money.

Another thing that makes a big difference is the mortgage interest rate.  The mortgage interest rate can have a significant bearing on the magnitude of the overall monthly mortgage cost.  In general, the lower the rate the better; although remember that not all mortgage products are the same and some might have interest rates that fluctuate.  Use a helpful online home loan comparison site to see what mortgage rates and deals are available.

The final thing that should be considered when you’re asking yourself what size mortgage can I afford is to consider your lifestyle.

• Are you fugal?
• Do you have a lot of other expenses?
• Do you live in a high-cost area?
• Are you going to use part of the house for rental?
• Would you rather invest the money?
• Etc.

There are dozens of questions pertaining to your unique lifestyle that will actually determine how much home you can comfortably afford.   Make a list of your priorities and see where the size (and cost) of your perspective house falls in line with them.

Images courtesy of FreeDigitalPhotos.net

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It’s getting to be a sad site walking around our little neighborhood. All around us there are houses that have slipped into foreclosure.  It’s obvious when it happens.

First the house gets really quiet.  Then the yard starts turning brown and overgrown.  And then it becomes official – the bank comes along and posts a legal notice in the window letting everyone know that the people who used to live their let their conventional home loan slip into default.

It’s not a pretty thing to see.  That house used to be a happy place.  Those used to be our neighbors.  Maybe we’ll never know what unique situation occurred that forced this to happen.  There are certainly a lot of things that could be the reason:

Why Do People Default On Their Home Mortgage?

There are a lot of reasons why houses go under:

• The people could no longer make their payments.
• The couple that used to live there got a divorce.
• The family moved into another house and could not unload the old house in time.
• Sometimes the default is intentional.  If the value of the house is less than what the owner still owed on it, they might just “give up” and take the hit by quitting their payments.

We could debate for hours the root causes of these problems.  Some people like to insist that the mortgage industry sabotaged the general public by giving them loans that they couldn’t afford.  But I’m not so sure I buy that.

Didn’t everyone have access to the same information I did on conventional home loans when I got my first mortgage?

Didn’t they take the time to understand the difference between a fixed rate mortgage and an adjustable rate mortgage (ARM)?

Didn’t they sit down, look at their income, and make a grown-up decision about how much they could afford every month?

The Housing Market Rebound:

All those foreclosures and home loan defaults are the mistakes of the past.  And you can never change the past.  You can only go forward into the future.

But that’s what scares me.  As the economy shows signs of strength and the housing market makes a rebound, it would be foolish not to ask:

Are we going to let ourselves make the same mistakes again?

Like all things in history, we are doomed to repeat our mistakes until we make a conscious decision to prevent ourselves from ever letting it happen again.  It would be easy to blame certain mortgage products or services, but what about ourselves?  How can WE educate ourselves into not creating another housing bubble?

Conventional Home Loans Don’t Have to Be Complicated:

I remember when I first started pursuing buying my first house, my Dad gave me one simple piece of advice:

Know what you’re signing up for.

What he meant by that was understand the terms of your mortgage BEFORE you actually sign your life away on the dotted line.  A mortgage is a contract that you make payments on for a very long time.  It will dictate how much or how little extra money you have every month to spend on other things within your family budget.  It is not a decision to be taken lightly.

The funny thing about mortgages is that they are really not all that complicated – so long as you don’t make them any harder than they need to be.  Essentially you are borrowing money for a fixed period of time at a known interest rate that you will have to pay back little by little each month for the next 30 years or so.  However, it still blows my mind how many people do not take the time to figure this out ahead of time.  That’s really too bad since you could easily use any number of Internet mortgage calculators to run different scenarios about how much you can afford.  Online mortgage calculators are an easy way to see just how much you’ll actually spend each month on your conventional mortgage as well as learn about other things like taxes, insurance, etc.

Remember: Your home is your castle.

It’s what you come home to at night.  It’s where you keep your family safe.  It’s where you create memories that last a lifetime.

Don’t jeopardize all that with laziness or lack of planning.  One thing I constantly promote on My Money Design is that you and only you are responsible for what you do with your money.  If someone offers you a financial deal that you don’t understand, you don’t take it.  It’s more important to understand what it is that you’re getting yourself into than it is for the chance to get wealthy.

Your house is no different.  It’s your responsibility to figure out how much home you can afford, how long you’ll be making those payments at that rate, and what the implications will be if you fail to do so.  If you need help, don’t be afraid to ask.  Don’t be afraid to get multiple opinions until you find one that you can trust.

Don’t let your piece of the American Dream slip away from under you.  Control what is yours, stick to the basics when it comes to the conventional home loan, and set yourself up for success.  Why settle for anything less.

Related Posts:

1)      Should I Pay Off My Mortgage Early or Look for a Better Return?

2)      How Much Money Would I Make If I Rented Out A House?

3)      Adventures in Refinancing, Chapter 5

Images courtesy of MMD | FreeDigitalPhotos.net

The post The Conventional Home Loan – Don’t Mess It Up This Time Around appeared first on My Money Design.

So you’ve finally made it!  You’ve worked and sweat, and you and your family are finally ready to purchase the house of your dreams.  Building a new home can be a fun and exhilarating experience!  But all the steps to building a house can also be a stressful process if they are done incorrectly.

Before you make the biggest purchase of your life, take the time to really understand how your new house will be constructed and what you can do to preserve it.  It can be fun to pick out how everything will look inside when you’re done, but paying attention to all the basics could end up saving you a lot of headache and money further down the road.

Here are some tips for building a house and making it into a great home. Check out the tips below or use this simple guide to take you through the complex home buying process step by step.

Tips and Steps to Building a House You Love Forever:

Research the Builder:

Unfortunately, not all builders are the same. The home of your dreams shouldn’t be left in the hands of just anyone. It needs to be made by a partner you can trust. Research the web and Better Business Bureau before signing the dotted line with a home builder. A great company should be able to provide you with copies of their license, a list of awards, referrals, and many other things that they would gladly want to share with prospective clients.

Location:

Where you build your new home is just as important as what it will look like. Be sure to consider important factors like taxes, school systems, crime rates, reputation, and much more before settling on your site location.

Also, really give some thought to how much land you think you would like to have. A larger yard can be really nice and work out great in the long-term for fun activities as well as help your resale value. But it can also be a burden if you aren’t prepared to keep up with the maintenance. Consider the pros and cons from both sides.

Think Long-Term:

When you’re first deciding how your new home should be, the costs of all the extras – deeper basements, larger garages, more windows, custom designs, etc. – can be overwhelming. However, after you’ve lived in your new home for a few years, chances are that you’ll wish you had went for those upgrades!

Although some upgrades like landscaping, decks, and even windows can be added at a later time, it certainly is easier to include these things in the initial build – especially if they pertain to the overall structure of the home! Discuss your priorities for your new home and determine which upgrades would make the most sense to add while the home is being built. Remember – it’s a lot more difficult to turn an 8 foot basement into a 9 foot one after the home has been constructed!

Foundation:

Nothing is more important to the structure of the home as the foundation. Be sure to ask your builder what type of material and process they plan to use. Plenty of time should be allowed for curing as well for proper settlement. Also check that there is some type of warranty associated with the foundation and structure of the construction.

Appearance:

We all want our home to look like a million bucks! Be sure that the builder you select has a wide variety of options and can customize the look of your home to your personality. Give your home character by adding features like brick, color, porches, lights, and even windows.

Mortgage:

Though it may not be a part of the physical house, your mortgage payments and loan terms will be something that weigh on your finances for years to come if you don’t shop around for a good.  Looking at the rates of reputable companies can help you decide what you can afford to spend every month.

Energy Efficiency:

Building a new home is a great time to take advantage of an energy-efficient infrastructure. Be sure that the correct wiring and plumbing is made available for the most modern and energy-efficient appliances. Choose high levels of wall insulation, window insulation, energy-efficient appliances, etc. P.S. – And don’t forget to take advantage of any Federal tax credits!

Inspection:

Even a new home requires a thorough inspection. Again, find someone you can trust to assist you with the walk-through. Work with the builder by creating a list of any issues you find, and agree to set some target dates for satisfying these tasks.

Readers – What are your tips for building a house?  Did you build a home or move into an existing one?  If you built, what kinds of things did you run into that you wish someone had told you about sooner?  Of the people you know, what experiences have they had building their new home?   

Related Posts:

1) Adventures in Refinancing, Chapter 5

2) Which is Better – Points or No Points on Your Mortgage?

3) Before Retirement, Eliminate Your Biggest Expense

Photo Credit: Microsoft Clip Art

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