05.30
When people are shopping for a home, many times they’re thinking about what they plan on doing in the home in 5 years, 10 years, 15 years, or even longer. This can be understandable, as people many times don’t want to think about having to move again and they know that a given size / location of house will be where they end up at anyway, so they might as well move into that house as soon as they can afford the monthly payments. While that might make some sense, it can have you paying far more mortgage interest than you really need to.
At the end of the day, one thing you want to realize sooner rather than later is that in terms of your primary residence, most people will end up buying their primary residence over the course of their work life. That means you’ll end up paying 100% of the principal of whatever mortgage(s) you take along with some unknown amount of mortgage interest. Now, since it’s your primary residence, current US tax law does let you take a deduction on the mortgage interest you pay, but that doesn’t make it free, it just means you’re paying with pre-tax instead of post-tax dollars
To try and illustrate the point, let’s say that you make enough to buy a $300k home currently based on a 30 year mortgage. At 5%, that’s a principal+interest of 1610.46 per month. You don’t really need the $300k house right now, just could get by with a $200k house. We’ll say 5 years from now you actually need that $300k house. Obviously the longer you put off buying that more expensive house, the more mortgage interest you would save, but I’m picking 5 years since it seems on the order of reasonable that, say, a couple gets married and moves into their first house and 5 years later they’re having (or have had) kids and need the bigger house. I’ll also go with $0 down to keep things simpler, but it should be obvious that a $300k house with $0 down is the same as a $350k house with $50k down – all that really matters (in terms of mortgage interest paid, which we want to reduce) is the amount that you’re mortgaging, since that’s what the monthly payment and amoritzation table is based on.
For these numbers, I’m using BankRate.com’s mortgage calculator, but any of them should tell you the same numbers with the same inputs, of course.
Scenario 1: Buy the $300k house immediately.
If you do so, in those first 5 years (60 months) you’ll pay principal+interest of 50 * 1610.46 = 96,627.60 (almost $100k!). What did you earn with that ~$100k? $72,114 went to mortgage interest and $24,514 was actually applied to principal. That means that (approximately) for every 4 dollars you paid on your mortgage, 3 of those dollars went straight to the mortgage company’s coffers, and only 1 of the 4 actually went to paying off the house. That’s pretty harsh.
The totals after the 30 year mortgage is up would be ~$280k paid in interest for your $300k house, so you basically paid for it twice.
Scenario 2: Buy a $200k house for 5 years, then a $300k house afterwards.
Now, if you only stuck with the 30-year fixed-rate mortgage and 5% rate (I’m not penalizing the $300k scenario above with a jumbo rate, just to again keep it simpler for comparison), you would end up with somewhat similar numbers to the above, at least on ratio. You would have paid principal+interest (monthly mortgage payment) of $1073.64, for totals of 64418.40 over 5 years, 48076.06 as interest and 16342.54 in principal, so if you do nothing else you get the same ratio that for every 4 dollars you spent on your mortgage, you only got 1 applied to your actual balance (principal) on the house.
But wait, there’s more! Notice that although we bought the $200k house, we could have afforded the $300k house. The important part being that we could have afforded 1610.46 each month to go to our mortgage! Our $200k mortgage only had us requiring 1073.64 – since we know we can afford more, what if we just paid additional principal each month of 536.82, so our total mortgage payment would be the same? How would that change the numbers?
In such a scenario, the numbers look remarkably different. As we know from before, over those 5 years we would have paid ~$100k total for the mortgage (60 months * 1610.46 per month). But, the principal paid would be 52849.56 and the mortgage interest would have lowered a bit to 43778.23. Instead of only about 25 cents of each dollar going to pay off the house, now 55 cents is! Over those 5 years, most of the money actually paid down our house, which we now owe less than $150k on!
Now it’s 5 years later – if we need that $300k house now, we have over $50k in equity instead of less than half that. If we took a 25-year mortgage (which is effectively where we would be at in the first scenario after 5 years) at this point, we could put another 165.64 in principal each month and still have a total mortgage payment of 1610.46 – because of this we finish off the 25-year mortgage in 20.5 years (saving us 4.5 years of mortgage payments, but we still end up with the same house).
Now for the best news: our total mortgage interest paid? Down to $191,728.65. That’s right, just delaying the 300k house by just 5 years saved us ~4.5 years of mortgage time and ~$90,000 in mortgage interest!
So remember, kids, only buy as much house as you actually need, and only when you actually need it.. If you’re going to need more house later, that’s fine, buy it then. It can make tons of difference.
For those that for whatever reason don’t believe in pre-paying on their mortgage (there are a few out there), this is still a good idea – you’ll have that extra money each month to do other things with – invest, buy more stuff for the house, donate to charity, whatever. The key point is that money won’t be going to purely fund the profits of your mortgage company, and that’s a Good Thing.
