Ric Edelman has educated his clients for years on the benefits of integrating their mortgage into their overall financial plan. In his book, The New Rules of Money, Ric tells the story of two brothers, each of whom secures a mortgage to buy a $200,000 home. Each brother earns $70,000 a year and has $40,000 in savings.
The first brother, Brother A, believes in the old way of paying off a mortgage, which is as soon as possible. Brother A bites the bullet and secures a fifteen-year mortgage at 6.38% APR and shells out all $40,000 of his savings as a 20% down payment, leaving him zero dollars to invest. This leaves him with a monthly payment
of $1,383. Since he has a combined federal and state income tax rate of 32%, he is left with an average monthly net after-tax cost of $1,227. Also, in an effort to eliminate his mortgage sooner, Brother A sends an extra $100 to his lender every month.
Brother B, in contrast, subscribes to the new way of mortgage planning, choosing instead to carry a big, long-term mortgage. He secures a 30-year, interest-only loan at 7.42% APR. He outlays a small 5% down payment of $10,000 and invests the remaining $30,000 in a safe, moneymaking side account. His monthly payment is $1,175, 100% of which is tax deductible over the first 15 years, and 64% over the life of the loan, leaving him a monthly net after-tax cost of $799. Every month he adds $100 to his investments (the same $100 Brother A sent to his lender), plus the $428 he’s saved from his lower mortgage payment. His investment account earns an 8% rate of return. Which brother made the right decision?
The answer can be found by looking into the future. After just five years
Brother A has received $14,216 in tax savings, however he made zero dollars in savings and investments. Brother B, on the other hand, has received $22,557 in tax savings and his savings and investment account has grown to $83,513.
Now, what if both brothers suddenly lose their jobs? The story here turns rather bleak for Brother A. Without any money in savings, he has no way to get through the crisis. Even though he has $74,320 of equity in his home, he can’t get a loan because he doesn’t have a job. With no job and no savings, he can’t make his monthly payments and has no choice but to sell his home in order to avoid foreclosure. Unfortunately, at this point it’s a fire sale so he must sell at a discount, and then pay real estate commissions.
Brother B, while not particularly happy at the prospects of searching for a new job, is not worried because he has $83,513 in savings to tide him over. He doesn’t need a loan and can easily make his monthly payments, even if he is unemployed for years. He has no reason to panic, as he is still in control. Remember… Cash is King!
Now, let’s say neither brother lost his job. We’ll check in on them after fifteen years have passed since they purchased their homes and evaluate the results of their financing strategies.
Brother A has now received $25,080 in tax savings, he has $30,421 in savings and investments (once his home was paid off he started saving the equivalent of his mortgage payment each month), and owns his home outright. Not too bad, right?
Now let’s check on his Brother. Brother B has received $67,670 in tax savings and has $282,019 in savings and investments. If he chooses to, he can pay off the remaining mortgage balance of $190,000 and still have $92,019 left over in savings, free and clear.
