Home Mortgages Require a Shift from Old Attitudes

I am old enough to understand the reason behind the advice my parents gave me, which is the same advice their parents gave them; "Get a low mortgage and pay it off as quickly as possible."  Ever heard that advice?  While once very sound, that admonition is no longer necessary in the United States today.

During the 1930's Great Depression when banks were losing vast sums of money, many "called" the loans given to borrowers who had home mortgages.  When the borrower could not pay off the mortgage, the bank could foreclose on the home.  Imagine living through such a time as our grandparents did.  Having a mortgage that could be called at any moment was a scary proposition and, no doubt, people wanted to get rid of that mortgage as soon as possible.

Through some of the New Deal laws initiated by Franklin Roosevelt, bank depositors and borrowers became protected so that such events could not occur again.

Yet, the admonition of "get a low mortgage and pay it off as quickly as possible" is still deeply embedded in the national psyche.  And it is very outdated and often misguided.

Here's the thing - a home is an investment.  It is an investment designed in part, to gain value over time.  That increase in value is called equity.  However, home equity has no rate of return.  Unlike stocks or money markets, where you expect to get a certain return on your investment, the same is not true for real estate.  Please check out my blog articles, Understanding the Home as an Investment and Taxes and Real Estate, where I discuss how low mortgages may actually be detrimental to sound financial planning.

To understand how Home Equity has no rate of return, suppose you have $50,000 to place as down-payment on a home worth $300,000.  And let's say the home appreciates at a rate of 3% annually.  In one year, the home is worth $309,000, so you have, on paper, made $9,000.  You might think that for an investment of $50,000, $9,000 would be an 18% return - pretty good by any standard.  But is that really what happened? 

No. 

To illustrate, let's look at it another way.  Suppose you purchased the same home with no money down.  In one year, how much is that home worth?  The answer is, it's still worth $9,000 more than you paid for it.  The real estate market does not care whether you put money (equity) down or not.  By the way, a $9,000 return on a zero investment is infinite.  That beats the 18% return hands down.  To boot, you still had $50,000 that could have been placed in an alternative, safe investment which, even at 5% would have created an extra $2,500.  So, $9,000 or $11,500, which would your rather have?

For sure, there are additional factors to consider, and everything from higher monthly mortgage payment, to market appreciation rates, to investment returns, to tax impacts all play a part in the determination of how best to finance a home.

There is one final matter to consider.  Investment diversification is very important.  Andrew Carnegie believed in putting all your eggs in one basket... then, watching that basket!  Anyone who suffered through the dot-com bust of the late ‘90s might beg to differ.  In the illustration above, putting the down-payment into the home reduces investment diversification and could prove to be a very risky proposition.

Greg Polashock is a Real Estate Home Mortgage Loan Consultant and Certified Mortgage Planning Specialist with Cherry Creek Mortgage and resides in Castle Rock, Colorado.  He can be reached via email at Greg@GregIsFinancingSolutions.com, by phone at 303-887-0672 or on the web at http://www.gregisfinancingsolutions.com/.