6 Mortgage Myths

[sgeeeee]

Here's a topic that is always good for some lively debate. And as far as I can tell it has nothing to do with the election:

http://pf.channel.aol.com/bankrate/r...rtgagemyth1104

"Six Mortgage Myths That
Can Cost You Money
By Holden Lewis
October 21, 2004"

Myth 1: A 30-year fixed is always the best way to go.

Myth 2: Pay off that mortgage as soon as possible.

Myth 3: You need a down payment of 20 percent or at least 10 percent.

Myth 4: You have to pay mortgage insurance if you don't have enough money for a 20 percent down payment.

Myth 5: You can't get a mortgage if you have blemishes on your credit.

Myth 6: The term of the mortgage has to be the term on the note.

[azanon]

#4 is generally not a myth, unless one uses the technique of getting a second loan to come up with the 20%. *As a general rule, you have to pay PMI if you put less than 20% down, for most lenders. My lender, USAA, requres 20% down, for example.

[retire@40]

Quote:

Myth 2: Pay off that mortgage as soon as possible.

I'm curious why paying off your mortgage as soon as possible is a myth?

[cute fuzzy bunny]

Cant use the link, it wants me to log in with an aol screen name.

Myth #7: believing anything from an online article where the author makes sweeping generalizations without comprehending anything having to do with anyones individual situations, circumstances or needs.

[sgeeeee]

Quote:

#4 is generally not a myth, unless one uses the technique of getting a second loan to come up with the 20%. *As a general rule, you have to pay PMI if you put less than 20% down, for most lenders. *My lender, USAA, requres 20% down, for example.

"What's called 'piggyback financing' is now almost 50 percent of home purchases," says Peter Bonnikson, senior vice president for E-Loan. A piggyback loan lets you avoid paying for mortgage insurance.

Piggyback financing consists of two loans. The first is for 80 percent of the purchase price. Then there's a second "piggyback" loan for the rest of the purchase price, minus the down payment. An 80-10-10 mortgage has a 10 percent down payment and a 10 percent piggyback loan; an 80-15-5 has a 5 percent down payment and a 15 percent piggyback loan; and an 80-20 doesn't have a down payment at all.

The piggyback loan has a higher rate than the primary mortgage for 80 percent of the price. But for people with good credit, piggyback financing usually costs less than getting one mortgage for more than 80 percent of the price and then paying for mortgage insurance.

Bonnikson favors piggyback loans because "one, they can maximize the house that they can buy, but two, they also maximize the tax deduction." That's because the mortgage interest on the piggyback loan is tax deductible, whereas mortgage insurance premiums are not. (An attempt this year to extend the tax deduction to mortgage insurance failed in Congress.)

Walters says: "There's two reasons why some lenders would push people to take PMI" -- private mortgage insurance. The first reason is that the lender doesn't offer piggyback loan programs, "so limited options make for clear choices." Other lenders have investments in mortgage insurance companies, so they profit from increased business, he says.

[sgeeeee]

Quote:

I'm curious why paying off your mortgage as soon as possible is a myth?

Accelerating mortgage payments is another area where emotion often trumps reason, Walters says. "We're not talking about finances; we're talking about psychology, or at least where the two meet," he says.

Walters advises people to imagine a scenario where they have a 5- percent ARM and are able to deduct the interest from their federal income taxes. That lowers their effective interest rate to somewhere in the neighborhood of 3.75 percent. Instead of paying extra principal on such a mortgage, it makes more sense to pay down higher-interest debt, such as for credit cards and auto loans, or to invest the money where it can earn a return greater than the mortgage interest rate after taxes.

"The way people deal with money and risk is often irrational, and they put much more of a premium on security and safety than they do on getting a return," Walters says.

It's perfectly fine to pay off a mortgage early if doing so satisfies a long-term financial goal. Doug Perry, senior vice president of Countrywide Home Loans, says a lot of aging baby boomers want to eliminate their mortgage debt so they can retire debt-free. That makes sense, especially for retirees who won't exceed the standard deduction on their income taxes and therefore won't be able to deduct their mortgage interest.

[sgeeeee]

Quote:

Cant use the link, it wants me to log in with an aol screen name. Myth #7: believing anything from an online article where the author makes sweeping generalizations without comprehending anything having to do with anyones individual situations, circumstances or needs.

Sorry about the link. I didn't realize aol kept non-aol subscribers off the site. The full article supplies significantly more detail. Although this subject is complex and the optimum solution is unique to the individual, I thought the article (and even the title) were actually pretty accurate. Notice it is titled, "Six Mortgage Myths that Can Cost You Money". In other words, if you accept these broad generalizations as fact in all situations, it could produce a less than optimum financial solution. In the description of each myth, the article points out that the "myth" does not necessarily apply to everyone.

Of course any article about financial issues that appears in any media will have limitations. This is a pretty basic overview of a few issues related to mortgage.

[retire@40]

Quote:

Walters advises people to imagine a scenario where they have a 5- percent ARM and are able to deduct the interest from their federal income taxes. That lowers their effective interest rate to somewhere in the neighborhood of 3.75 percent. Instead of paying extra principal on such a mortgage, it makes more sense to pay down higher-interest debt, such as for credit cards and auto loans, or to invest the money where it can earn a return greater than the mortgage interest rate after taxes.

I like sticking to the topic. The myth doesn't say don't pay down your mortgage so you can pay off higher interest rate credit cards. It just says it's a myth to pay off your mortgage as soon as possible.

But let's take the scenerio you posted. If you get your net after-tax mortgage interest rate to 3.75%, comparing apples to apples, where are you going to get a risk-free return after-tax return of 3.75%?

[cute fuzzy bunny]

Quote:

where are you going to get a risk-free return after-tax return of 3.75%?

Nowhere.

[sgeeeee]

Quote:

I like sticking to the topic. *The myth doesn't say don't pay down your mortgage so you can pay off higher interest rate credit cards. *It just says it's a myth to pay off your mortgage as soon as possible. But let's take the scenerio you posted. *If you get your net after-tax mortgage interest rate to 3.75%, comparing apples to apples, where are you going to get a risk-free return after-tax return of 3.75%?

Over the 30 year life of the mortgage you are likely to get much better than 3.75% return in a number of places -- almost any equity and/or real estate markets.

Deciding how to make the best 30 year financial decision based solely on the rates and returns today could be a significant error. Historically that has certainly been the case. You can see this with FIRECALC by running the cases with and without a mortgage. For many historical situations, holding a 30 year fixed mortgage at current rates would have produced both higher SWR and higher average terminal value than paying off the mortgage would have produced. Try it.

[retire@40]

Quote:

Over the 30 year life of the mortgage you are likely to get much better than 3.75% return in a number of places -- almost any equity and/or real estate markets. *

The key word is "likely." Since you cannot guarantee at least a 3.75% after-tax rate anywhere today, it doesn't make sense not to pay off a mortgage even at a 5% rate today (and that's assuming you are in the 25% tax bracket AND that you itemize on your tax return.)

That said, I know what you are saying and my personal feelings are that the equity markets will probably grow at a rate better than 3.75%, but since we are comparing a "guaranteed" interest expense savings to a "guaranteed" income vehicle, that vehicle cannot be the equities market.

I'm a bit muddled. I can get a guaranteed 3.75%
after tax return for myself any number of places.
Are we only talking equities here? Too lazy to go back and read all the posts (would rather reread my own stuff ).

John Galt

[Ishmael]

After reading some of the earlier threads on this topic, I had drawn the conclusion that that old saw needed to be revised: The three things one should never talk about in polite company are religion, politics, and whether to pay off the mortgage. Talk about some heated exchanges--I was afraid to bring up the subject although I'm still confused.

I ER'd last month quite unexpectedly, if you catch my drift, and don't have all my financial ducks in a row, yet. With my new found time I've been struggling with the question of whether I'd be better off paying off the mortgage (I've got plenty of bond investments to do so) to reduce cash flow needs, or keep the mortgage as an inflation hedge.

I've got a fixed rate mortgage just at under 5% with a remaining principal balance equal to about 15% of my liquid assets.

The threads I've found on this board seem to tell me that I would need to be earning 5% on a risk-free investment just to break even considering the 5% I'm paying on the mortgage. I'm wondering, though, if implicit in this assertion is an assumption that inflation is 0%? To put it another way, wouldn't I also break even if I were earning 0% on my risk-free investments if inflation was running at 5%?

I'm not the financial expert that many of you all seem to be, so I could use your advice on whether this makes any sense. (and since I'm pretty slow to catch on, I'd appreciate it if you'd type slowly and clearly if you chose to respond).

I know 5% is unattainable today in what anybody would consider a risk-fee investment, and certainly inflation is much below 5% as well. But, to my (perhaps confused) way of thinking, perhaps the two together need only exceed my mortgage interest rate to make it beneficial to keep the mortgage? Say if I-bonds were paying 3.5% and inflation was running at 2.5% (I haven't checked either recently but I think they are around there), wouldn't that 6% beat the 5% I'm paying and argue for holding on to the mortgage?

I'd like to hear what you think.
Thanks,

[sgeeeee]

Hi Ishmael,

A lot of people feel more comfortable paying off the mortgage than taking a chance that they earn at a rate higher than their mortgage rate over the rest of the life of the loan. Of course, another way to look at this is that paying off the mortgage is taking the chance that inflation and/or returns on investments run up over the next 30 years and make the payoff more costly than you thought.

Historically, the odds are with those who keep making payments on loans with rates less than about 5.25%. But, of course, past performance is no guarantee of future results.

The comparison you need to make to a fixed mortgage rate is the absolute rate of return on your investments. If inflation were to increase to 6% with a 0% return on investments, you would be better off invested than paying off your 5% mortgage. That's really one of the biggest advantages of keeping your mortgage. It is a form of inflation protection that payoff does not offer.

One of the biggest financial dangers to the recent retiree is an extended downturn in the markets. But since markets that fall usually rise again, the best way to protect yourself from this danger is to have money in the market when healthy returns resume. The larger the nest egg invested in the rising markets, the more rebust the recovery. By keeping your money invested rather than sunk in a home, you improve your potential recovery from the period of poor returns.

You can use FIRECALC to look at how you would have done historically by paying off your mortgage or how you would have done by continuing payments. Each case is different and payoff is the best choice for many people. It's worth the effort to look at the results. But you also have to do what is comfortable to you. If that monthly payment drives you crazy, then pay off the loan.

[azanon]

Not paying off loans is more risky than some people think. You're basically "margining" in effect, when you have the cash flow to pay off a loan, but instead invest the money somewhere else. If you really think this is the way to go, what is stopping you from margining through your brokerage as well? You'll find the rates are actually quite comparable to a mortgage. Yeah the interest on mortgages is tax-deductible, but for someone cheap like me, its hard enough to break the standard deduction to even get that benefit in its entirety.

I like David Ramsey's no-nonsense approach to debt; he basically thinks its dumb. Paying off my debt will be a high priority for me in my early career.

[sgeeeee]

Quote:

Not paying off loans is more risky than some people think. *You're basically "margining" in effect, when you have the cash flow to pay off a loan, but instead invest the money somewhere else. *If you really think this is the way to go, what is stopping you from margining through your brokerage as well? *You'll find the rates are actually quite comparable to a mortgage. *Yeah the interest on mortgages is tax-deductible, but for someone cheap like me, its hard enough to break the standard deduction to even get that benefit in its entirety.

*

I don't see the comparison here at all. A big difference between keeping a mortgage and margining stock investments is what you are betting on in each case(your house vs a specific stock). You can evaluate the risk historically using FIRECALC and it's just not that great. With a 5.5% or lower mortgage, your odds historically are that you are taking more risk by paying off the mortgage than be keeping it.

Quote:

I like David Ramsey's no-nonsense approach to debt; *he basically thinks its dumb. *Paying off my debt will be a high priority for me in my early career.

That may sound like no-nonsense to you, but a hard stance against real-estate debt sounds incredibly nonsensical to me. If every person and every business took that attitude, almost no one would ever own property. You should do what you feel comfortable with, though.

[cute fuzzy bunny]

For starters, counting the tax break on the mortgage interest without factoring in the tax on the increased withdrawal rate to pay the mortgage and mortgage interest is taking the good and leaving the bad.

If you dont have a mortgage and you're withdrawing $25k a year, you're paying income tax on $25k a year. If you have a mortgage of $15k a year, you're withdrawing $40k a year and paying income tax on $40k, then getting the mortgage interest back as a deduction. Best case it nets out to zero during the first few years of the mortage, whereas you get no deduction in the last few years. Hence paying off that 5% mortage gives you a risk free 5% return. Period. Not 3.75%. Its also a TAX FREE 5% return, note please that you have to pay taxes on your investment gains before using them to compare to your mortgage payments.

Second point, for the 575,293rd time, comparing the "return" of paying off a mortgage - a risk free investment - with a mix of stocks and bonds historic return is not an apples to apples comparison. Retire@40 hit the nail on the head...

Pay the mortgage off with a portion your bond allocation which except for high yield corporates, you cant get average mortgage rate returns on...definitely not risk free ones. Keep the higher resulting stock allocation. Win every time. Up market, great. Down market, even better...you had less money on the line.

So SG, do you bring this up every 3 weeks like clockwork just to give me something to do? You do realize that insanity is defined by doing the same thing over and over and expecting a different result? Havent we discussed this enough? Isnt there a FAQ on this already?

John...let me know where I can get 5%+ liquid returns risk free. I have one hell of a lot of money headed there tomorrow morning. Nearest things I can find are 20 year TIPS and high yield corporates, both of which barely make more than 5-5.5%, neither of which is risk free, and both of which create very interesting tax problems. I can get 4.61% on a 5 year CD, but lose six months interest if I tap into it.

Treasuries are close to risk free, but dont have anywhere near the returns.

This is absolutely not an emotional or psychological thing. Of course, it depends very much on your personal scenario. People building to ER should try to get as much money invested as possible and keep a reasonable mortgage while they still have a paycheck/income stream they're already paying income tax on - I presume most of these folks are not setting aside 300-400K+ into treasury bonds. Those who have complex tax situations where a mortgage deduction somehow helps a lot more than the additional withdrawal hurts, great. Those who somehow get their hands on 3%-4% mortgages or who want to jump through hoops to squeeze a quarter percent arbitrage, do it.

Got a million bucks or more? Own 400k in investment grade bonds earning 3-4% a year as part of a 60/40 portfolio? Have a 150-200k mortgage at 5%? Nuts.

Believe the stock market is going down a lot or sideways for a long time? No brainer to take a risk free return by taking some money out of the market and putting it into your house.

Hey TH! Excellent post. So, it was the 575, 293rd time?
Thanks for keeping on top of this

John Galt

[Ishmael]

Quote:

John...let me know where I can get 5%+ liquid returns risk free. *I have one hell of a lot of money headed there tomorrow morning. *Nearest things I can find are 20 year TIPS and high yield corporates, both of which barely make more than 5-5.5%, neither of which is risk free, and both of which create very interesting tax problems. *I can get 4.61% on a 5 year CD, but lose six months interest if I tap into it.

What I've been struggling with is whether I should be considering the effect of inflation when I do my payoff vs. not payoff analysis. The dollars I would spend in the future to make the mortgage payments would have less purchasing power than the dollars I would spend today to pay off the mortgage. But is that a relevant consideration?

If inflation is running at, say, 2.3% wouldn't I just need to make another 2.7% on my investments to offset the 5% I'm paying on the fixed rate mortgage? And if I'm able to itemize deductions on my taxes, the reduction in taxable income from the mortgage interest would exceed the increase in income from the 2.7% earnings on my investments. That could be an added benefit.

But maybe this is just voodoo economics?

Thanks,
Ish

Hello Ish! I see no voodoo, just good questions.
TH will help you sort it all out. I'm going fishing

Hope everyone has a great day
(dems, libs and other left of center types included)

John Galt