Let's take a look at costly misperceptions held by millions of Americans.
- Most people believe making extra principal payments on their mortgages saves them money.
- Most believe mortgage interest is an expense that should be eliminated as soon as possible.
- Most believe home equity has a rate of return and enhances their net worth.
- Some homeowners are lured into thinking that bi-weekly payment plans are the answer.
- Others rely on a 15-year mortgage with higher monthly payments rather than a 30-year term.
In actuality, such methods are not the wisest ways to accomplish a "free and clear" home. Through proper mortgage planning, you can accumulate sufficient cash in a conservative, tax-deferred mortgage acceleration plan. If homeowners deposited any extra principle payments in a separate, liquid, and safe side fund, instead of giving them to their mortgage company, they would accumulate enough money to pay off the mortgage in as short a time frame as possible. Let me illustrate.
The $25,000 Dollar Mistake Millions of Homeowners Make
If I were to take out a new $150,000 15-year mortgage, my monthly payment would be $1,433.48. Equivalent to fifteen ANNUAL payments of $17, 202. However because of the tax benefit I receive (by deducting the interest on my mortgage payment on Schedule A of my tax return) Uncle Sam is in essence paying part of my annual mortgage payment with money I would have paid in taxes. This saves me $3,935 in taxes. This results in a net after-tax annual mortgage payment of $13, 267.
A homeowner consistently pays more mortgage interest each year with a 30-year mortgage than with a 15-year mortgage. Most people view this as a negative. That's why borrowers are motivated to take out a 15-year mortgage-in order to pay as little interest as possible
There is a Better Alternative
If we take the annual difference between the net after-tax payment on a 15-year mortgage and a 30-year mortgage each year, (see illustration below) and deposit that money in a tax-deferred, interest-bearing side fund (let's assume an 8% return), you will notice that by year fifteen, the conservative side fund will have accumulated $25,159.00 more than needed to pay off the mortgage!
Principal $150,000 Rate 8.00% Tax Bracket 33%
(1) (2) (3) (4) (5)
30 Year 15 Year 30 Year Difference Difference
End Mortgage Mortgage Mortgage Between Earning
of Loan Net Payment Net payment Net Payment 8.00%
Year Balance After Tax After Tax After Tax Compounding
1 $148,747 $13,267 $9,223 $4,044 $4,224
5 $142,605 $13,943 $9,380 $4,563 $26,188
10 $131,587 $15,155 $9,662 $5,493 $69,499
15 $115,171 $16,960 $10,081 $6,879 $140,330
$78,325
Excess Cash Beyond Mortgage Balance: $25,159!!
Do you see why I refer to this as the $25,000 mistake millions of Americans make? You can imagine what a bigger mistake it is if your mortgage is greater than $150,000.
This concept should illustrate that it would be better to use a side fund instead of paying extra principle on the mortgage because it follows the 3 Rules of Prudent Investing. Why?
Because the Liquidity (#1), the Safety (#2), the Rate of Return (#3), and the Tax Benefits you would achieve from your money available in the side fund account far outweigh any hypothetical disadvantages-especially in the event of a financial emergency.
To maximize the results of successfully managing equity, I recommend using a mortgage with an interest-only payment option and have a plan to follow that can help provide the discipline to set aside the difference in the mortgage payments.
In summary; The key is to understand how to have interest work for you rather than against you.
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Jeff - outstanding article! My wife (
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Robert.... very well done. I can see why they gave you a gold star, even before your first comment.
What you are talking about has a few different terms that we could refer to. The easiest to understand.... besides managing your money....but the next one would be "financial planner" per se. Or...in this case, a mortgage planner. Karl is really good at this and the terms. Karl, where are you? Brian Brady....get him since he is closer to you. LOL
Again, Robert, some awesome information. Hence the theory that this business is changing again and only those of us that are aware of this, are the ones that will use this to our benefit...and not just to appease the client because they wanted this program, not that program.... which leads me to another blog topic...an example of what took place with my client today.
Thanks for the blog and thanks for the thought. GOOD JOB... 5+