Tuesday, November 11, 2008

How to save $100,000

Riddle me this: How can you save $98,870 when buying a house?

The answer is: Using a 15 year mortgage instead of a 30 year mortgage.

In this particular scenario (obtained from Everbank), you purchase a $187,500 home, pay 20% down, and get a $150,000 loan with either a 30 year mortgage at 6% or a 15 year mortgage at 5.75%.

Terms of the 30 year mortgage:

  • Monthly payment of $900 (not including insurance and taxes)
  • Total payment of $323,722 in principal and interest
  • Total interest cost of $173,007

Terms of the 15 year mortgage:

  • Monthly payment of $1,245 (which is $345 more per month)
  • Total payment of $224,211
  • Total interest cost of $74,137
So for the 30 year mortgage, you pay $173,007 in interest, or with the 15 year mortgage you pay $74,137 in interest - a savings of $98,870!! And your home will be paid off 15 years sooner. Of course, the big catch is that you have to be able to afford the higher monthly payments.

Now, there are several arguments against taking a 15 year loan, or paying off your house early. These arguments include:

  • Your money would be better off invested in the stock market,
  • You miss out on some tax savings (if you itemize),
  • You can simply pay down the principal when you have extra cash, and
  • Your money is tied up in a non-liquid asset which might be difficult to sell.
Up until about a year ago, most financial planners projected a yearly stock market return of 8 - 12%. They compared that to a 6% return obtained by paying down your loan (or whatever the APY on your mortgage) and would tell you that you are clearly losing out. Over time, the financial planner tells you, you will actually make hundreds of thousands of dollars just by NOT paying off your house (and putting all your money in the stock market instead)!

This argument, combined with the mobility of the American populace, was extremely persuasive for the last twenty years. Why bother working to pay off a house when you are going to move in 4 years? Why pay down a 6% mortgage when you can get 12% in the stock market (or 20% in a good year)?

Now let's move to the present. Examine the argument that your money would be better off in the market. "Historically", if you look at specific periods of time, for example since 1950, the stock market does provide better average returns. But if you look at OTHER periods of time, the stock market was just another gambler's bet. In the last year, the S&P 500 has gone down about 35 - 40%. Add this to the fact that the average investor tends to buy high and sell low, and all those financial planner calculations start to look extremely fishy.

Now let's bring peak oil into the equation. Cheap fossil fuel energy is THE key that has enabled our economy to steadily expand for the last 100 years. Without that cheap fossil fuel energy (or miraculous alternative energy, yet to be discovered, which has an equivalent EROEI), the economy will not be able to grow. Over time, the economy will go through cycles of contraction and expansion, but the trend will be toward contraction - and the stock market can't grow if the economy is contracting. So I don't plan on guaranteed stock market gains of 8 - 12%.

There's another way to bring peak oil into the equation - what will you need in a life with less energy available? Is your money better spent paying down your mortgage early, or is it better spent on food storage and a new 90 mpg scooter? Is it better to have savings in cash - the more the better - or a paid off mortgage? Only you can decide.

My husband and I decided to go with a 15 year loan, because we plan to live in our home for many years, we want to have the security and peace of mind of a paid-off house, and we don't trust the stock market to grow at a steady rate. Another way to get most of the benefits of the 15-year loan would be to finance a normal 30 year mortgage, figure out what you would pay on a 15 year, and then pay that every month. Then, of course, you could always pay the lower number if you needed to.

We don't dedicate all our money to paying down our mortgage, because I also believe in having the flexibility of cash. We also do have some investments in the stock market, because you never know when the government might pour billions of dollars into the economy.... to prop up the stock market.

Whatever your situation, whatever your financial beliefs, and by the way you should not construe anything in this article as financial advice, make sure you understand all the financial implications of your mortgage before you sign on the dotted line!


LisaZ said...

Good thinking! We're hoping to refinance to a 20-year loan down from our 30 (which is four years old now) very soon. Not 15, but at least 10 years shorter and less interest. Alternatively, we will start paying more into our principal as soon as we pay off one last debt (in a year or less). That way if we have a financial hardship in these scary times we won't be obligated to pay more, but we can still save a lot of money by doing so.

Wendy said...

Thank you! I've been trying to say this very thing to my friends and family.

In these uncertain times, it makes a lot of sense to pay off the house, and not a whole lot of sense to be putting money into non-tangible "investments." Personally, I don't consider my house an "investment." I consider it a place to live, and in my opinion, the house I live in is far superior to living in a tent or in my car ... especially here in Maine ;). If I had not a dime, but still had my home, I could find a way to feed my family and earn a few dollars.

Millions of people were left penniless from the market crashes in the 30's, and when they also lost their homes, they were truly destitute. In her book, Possum Living Dolly Freed talks about living very happily and comfortably with very little money, but the thing that made it possible for her and her father was that they didn't have a mortgage. I hope I can have that same peace of mind very soon ;).

Verde said...

You know, I wish I was this smart 10 years ago.

Hausfrau said...

Needless to say, people should only commit to a mortgage if they can pay it... more and more foreclosures are occurring.... according to the websites I've been reading, prices are still headed down.