Avoid the Deception – Mortgage Illusion #1: You Own Your Home

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When you think of an illusion, you may think of watching a magician perform some sleight-of-hand trick, such as pulling a rabbit out of a hat when it appeared there was no rabbit just moments ago.  This is an illusion, the appearance of a reality that isn’t really true.  Thesaurus.com gives other synonyms for the word “illusion,” such as “confusion,” “deception,” “delusion,” “fallacy,” “misconception,” and “myth.”  The opposite meaning, the antonym, is “reality.”

Many ideas are stated over and over so often that people will soon accept them as truth, even if they are truly illusions like pulling a rabbit out of a seemingly empty hat.

Don’t let yourself fall prey to these illusions, because it could be at your financial peril.  In this post and the next two, I will share with you three mortgage illusions.  Knowing the truth and acting accordingly will help your debt elimination plan and your ultimate financial freedom.

Illusion #1:  You Own Your Home

In some states, you do legally own your home, even if there is a mortgage lien against it.  In other states, the ownership is held in escrow until you pay off the mortgage.  But in effect, regardless of which type of state you live in, in a practical sense you do not own your own home until you do not have a loan against it.  The idea that you really own your home when you have a mortgage against it is an illusion.

If you don’t make the payments, you will discover who is really in control.  You will learn that the lender will take your home away from you — that you didn’t really “own” your home after all.

Not only that, but with a mortgage you are only “renting”, even if you have “purchased” your home.

All you have to do is look at your mortgage amortization schedule to see the truth.  In the early years of a mortgage loan (especially a 30- or 40-year loan) you pay mostly interest and very little principle (see the “How Much Interest Do You Really Pay?” chart below).   Notice that 83% of the first payment goes to interest.  Even after 6 years 76% of the payment is still interest.  There are even interest-only mortgage loans available now where all of the payment goes to interest!

How Much Interest Do You Really Pay?

On a $100,000 loan at 6% interest, $600 payment

Payment Number

Principle

Interest

Balance

1 – after 1 month

$100

$500

$99,900

24 – after 2 years

$112

$488

$97,500

72 – after 6 years

$142

$458

$93,100

120 – after 10 years

$180

$420

$83,700

180 – after 15 years

$243

$357

$71,100

222 – after 18.5 years

$300

$300

$59,700

252 – after 21 years

$348

$252

$50,000

312 – after 26 years

$470

$130

$25,500

336 – after 28 years

$530

$70

$13,500

Notice how much interest and how little principle is paid on the first payment.  This imbalance remains through most of the first half of payments.  It takes until the 222nd payment, 18.5 years, over halfway through the total payments, before the principle and interest portions of the payment equal each other.  And then it takes another 2.5 years until the loan balance has been paid down to half of its original balance, over two-thirds through the payment schedule.  The higher the interest rate, the later in the payment schedule these two events happen.

Also, the average family moves every 5 – 7 years, according to anecdotal evidence from many different sources.  When they move, they are probably trading in a loan with very little paid off for another new mortgage loan, again for 30 years.  In the same chart, “How Much Interest Do You Really Pay?,” you can see that after 6 years when 20% of the payments have been made, only $6900, 6.9% of the balance, is paid off.  They then start all over again in the early years of the payments on a new mortgage loan.  Make a habit of this and it’s just like renting – paying mostly interest and very little principle.  It can actually be worse than renting, because they have to pay for all the maintenance as well.

Do you really own your home if you owe money on it?  Legally, perhaps yes; but for the purposes of your financial freedom, no you do not.

My No Mortgage, No Loan Payments Forever! debt elimination plan will help you really own your home more quickly than you might have imagined.  My plan is not an illusion, or some magic trick, it is truth that really works when you follow it.

In another report, I will discuss Mortgage Illusions #2 and #3.

What Is Your Interest Rate?

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Interest rate is the primary factor most people look at when deciding on a loan.  Yet, as I explain in my No Mortgage, No Loan Payments Forever! seminar, focusing on the interest rate can blind you to more important factors about the financing.

But even when you do consider the interest rate, what is your real “rate,” anyway?  It’s not just the “rate” that’s quoted by the lender.  Let’s look at this a little more closely.  You want to consider the full implications of every “rate.”

Interest accrual rate.  This is the “rate” that most people are familiar with.  It is stated as an annual rate.  To actually pay that rate in total interest, you need to pay this loan off completely in one year.  Therefore, on a $100,000 loan at a 6% interest rate, you would pay $6,000 interest in one year ($100,000 x .06).  (As a slight variation on this, an amortized loan such as a mortgage is calculated monthly on the month-end balance.)

Annual percentage rate (APR).  The government mandates the APR be reported to you whenever the interest accrual rate is quoted.  The intent is to take into account some of the fixed costs of obtaining the loan, thereby supposedly allowing you to compare two loans side by side, “apples-to-apples.”  However, it is not as foolproof as originally intended (more on that later in another post).  I calculated the APR on this same $100,000 loan at about 6.259%.  It could be more or less depending on the closing costs.

 

Comparing the Rates

Making regular payments on your mortgage

Making double payments on your mortgage
Interest accrual rate

- 6.0%

- 6.0%
Annual percentage rate   (estimated)

- 6.259%

- 6.667%*
First payment rate

- 83.4%

- 41.7%
Total interest rate

- 115.8%

- 29.7%
Investment interest rate

- 115.8%

+ 40.9%
Numbers are based on a $100,000 loan at a note rate of 6.0% amortized over 30 years.  Note that negative rates mean that you are paying that   rate, positive rates mean that you are receiving that rate.
*This is another example of how the APR can be misleading.  As the time to pay off the loan decreases, the APR increases with all other factors remaining constant.  This is because the closing costs are spread out over a shorter period of time.  Nevertheless, event though the APR increases   for a shorter payoff time, you are still better off reducing the total payoff time on your mortgage.

 

First payment rate.  You probably know that your first payment on a mortgage loan is mostly interest and very little goes to principal.  On this same $100,000 loan, the monthly payment is $599.55.  The interest portion of this payment is $500.00.  This means 83.4% of your first payment goes to interest, with the remainder to principal ($500.00 / $599.55).

Total interest rate.  If you pay on that same loan for 30 years, you will pay $115,838.19 interest on the $100,000 you borrowed.  This is like a 115.8% interest rate ($115,838.19 / $100,000).

Investment interest rate.  For example, if you pay this same loan off quickly by doubling your required payment, you could pay it off in about 9 years instead of the normal 30 years for a total interest cost of $29,714.37.  If you then take that same double mortgage payment and invest it every month into a relatively safe investment at a 6% rate of return, you would end up with about $638,000 after 30 years (the same time you would have normally paid off your mortgage).  This means that instead of having paid out $115,800 over 30 years, you will have gained about $608,300 ($638,000 from the investment less $29,700 interest paid on the mortgage).  By paying $431,600 over those 30 years you would gain about an extra $176,700 on that money (plus you would still have the $431,600 you paid in.)  That is like a 41% investment rate in your favor ($176,700 / $431,600)!

As you can see, the one “rate” usually considered is not the only rate that matters.  While it is the “rate” used to calculate the payment and the total interest cost, considering the other “rates” gives you a much truer picture of your real cost.  Be sure to keep all the “rates” in mind when you make financial decisions.

Of course, the importance of these other “rates” has major implications for becoming totally debt-free quickly.  By following my No Mortgage, No Loan Payments Forever! plan you can drastically reduce the negative effect of the other “rates” and increase the positive effect of the “investment interest rate” — all for your financial benefit.

Why Pay Off Your Mortgage?

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I have often shared with people the extra power in prepaying your mortgage and how extra payments on your mortgage can have a significant benefit for you.

Yet many in society claim that you should keep your mortgage and use the money that would otherwise go to paying it off for other purposes, such as investing. Back when many people had excess equity in their homes, some people went even further and said that you should “free up” the equity that was “trapped” in your home and use it for some “worthwhile purpose.”

Cash or CreditOne of the arguments that you may have heard was this. Why would you want to pay off your mortgage that is at a 4, 5, 6, or 7% interest rate when you could get 10% in the stock market? That looks pretty good on the surface. You could make an extra 3-5% on your money just by keeping your mortgage and investing in stocks! And since that sounds so good, why not borrow more money on a bigger mortgage, invest that and make even more money!

If only it were that good. Here’s why.

First ask yourself, why do you want to accumulate money? Is it just to have money? Or is your goal in having money really to provide security for yourself and your family, to be free of stress—to know that the home you live in is yours, that you don’t have to worry about losing a job—that with money in savings life can be more peaceful. If your goal is to accumulate as much money in whatever way you can, you will likely be creating more stress for yourself. A larger mortgage with the money invested in the stock market or mutual funds is a more stressful lifestyle—if that is what you want it might be worth considering, but I don’t think most people want that kind of stress. Plus, you’ll see later that you can probably accumulate as much or more for your future security and you don’t have to do it in a risky and stressful way.

Understand that paying off your mortgage is an investment. Since your mortgage is costing 4-7% of the unpaid balance every year, paying it off is just like getting a 4-7% return on your money. Money that you don’t have to pay out is just like you earned it. Plus it’s guaranteed. That return is not going to fluctuate like a stock or mutual fund would. You know how much you gain by paying off debt—keeping the money is just like you earned it.

This brings the next point: when comparing your 4-7% mortgage to a possible 10% investment, consider whether you are really comparing “apples to apples.” As I mentioned, paying off your mortgage has a different level of risk than investing in the stock market. You could earn 10% on the stock or mutual fund, but you could also lose money on it as many people did in 2000. How would you like to be one of those people who believed that the great stock returns in the 90′s would never end, so they borrowed money, invested it in stocks, only to see much of that investment evaporate—yet they still owed the money to the creditor! In the investment world, when investments of different levels of risk are compared, investors do a complicated statistical analysis to adjust for varying risk levels between investment alternatives. Therefore, an aggressive growth mutual fund would be weighted differently than a slower growth fund—that is the only way you can attempt to compare “apples to apples.” When you compare the stock or mutual fund investment with the mortgage and apply such an analysis for the different risk, you will find that it tends to even out the potential returns. The risk level of each investment is an important factor to consider.

Here’s another reason paying off your mortgage is more secure: what if you lose your job or your income is reduced? If you invest in the stock market with money that could have paid off your mortgage, you have to make a big mortgage payment each month. If your income is reduced, you still need to make the big mortgage payment, but now with less income. On the other hand, if you have paid off your mortgage, now you are less vulnerable to reductions in income—you can better survive something bad happening.

Also, remember that it’s not smart to keep a mortgage simply to get the tax deduction. More about that in another article.

After having said all of that, you can likely accumulate more money by paying off your mortgage first, rather than keeping your mortgage and investing.  More information on that will be coming in another article as well.