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Pay off the House
Old 04-12-2004, 06:02 PM   #1
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Pay off the House

Hope this is a logical place to put this thought...

Many books and sites I've read about ER say that most ERees decide to pay off the mortgage.

I can see getting rid of most expensive debt, but if I have a 30 year fixed mortgage at 4.75% and I assume that my general return on investments is typically higher than that, why would I want to pay off a 4.75% loan with money that could be earning me 10-12%?

Even with 3-4 years of bad markets like we've just seen, in the long run it seems to make sense to me to hang onto that loan.

But then I'm a neophyte at this. What logic do others use?
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Re: Pay off the House
Old 04-12-2004, 07:19 PM   #2
 
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Re: Pay off the House

I confess not having any debt (other than -0- %)
is mostly psychological with me. I might convince myself
that I could borrow on my real estate and make money
by investing elsewhere. Don't want to. The other day
my wife suggested buying some property nearby
and opined we could get a mortgage. I said "Woman,
bite your tongue!" To paraphrase Jack Nicholson
in 'As Good as it Gets'.............. We don't got no debt! We don't
want no debt!

John Galt
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Re: Pay off the House
Old 04-12-2004, 07:26 PM   #3
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Re: Pay off the House

Oh boy, we've beaten this topic to death and back several times...if you do a search on "mortgage" within the last six months, there are several threads.

One line of thinking is that you'll do better keeping the mortgage, and investing the money because historical returns exceed todays interest rates. But thats historical, who knows what future returns will be.

One line of thinking is paying off the mortgage reduces your initial portfolio, but your monthly withdrawal is a lot smaller, and you have more control over it. There is also a psychological benefit to owning the home outright. No matter how far the homes value drops, you can still live in it; stocks and bonds have no intrinsic benefit other than their value.

If you're past the halfway point in the mortgage (15 years on a 30 year mort or 7.5 on a 15 year mort), you've already paid most of the front loaded interest...it probably makes very little sense. If you're in the first few years of a mortgage, consider the above and make your decision, there is no clear cut formula unless you can predict the future or believe that the worst is in the past...
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Re: Pay off the House
Old 04-13-2004, 05:34 AM   #4
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Re: Pay off the House

Salaryguru gets at the central difficulty - separating the house as home vs a set of pure numbers on a spreadsheet.

Our house is like a dryer sheet - to be reused daily as much as possible. As a fish camp over water it has no 'book value' - is uninsurable and unmortgagable. I periodically run the numbers vs a 'normal house' and equivalent apartment rents in the area.

BUT - my SO says screw the numbers - if a Hurricane takes it that's ok - otherwise we ain't moving off the lake.
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Re: Pay off the House
Old 04-13-2004, 10:40 AM   #5
 
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Re: Pay off the House

My SO often says "Screw the numbers" (or words to
that effect). Sorry but I am a "numbers" guy.
Always have been. That's mainly how I was able to
ER without any serious preparation, and how I am able
to remain a happy loafer 10 years later. I ALWAYS
run the numbers, backwards and forwards. If you
"see us havin' fun just a lyin' in the sun" (BTO),
chances are my brain is still computing interest rate
spreads, ROIs, expense ratios, tax implications, etc.
Don't pity me though as it is automatic and requires no
effort on my part.

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Re: Pay off the House
Old 04-13-2004, 10:45 AM   #6
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Re: Pay off the House

I started a thread a while back - same subject.
Lots of good feedback. I decided that when the value of my mortgage loan gets down to the value of my Ameritrade account, I will sell my Ameritrade stocks and pay off the mortgage. I'll feel much better with no debt. I'll still have my 401k, my pension, and by that time, social security should be available, plus some mutual funds.
My mortgage rate is 5.25%. Might be possible to earn more than that ( minus the taxes ), but I think it's unlikely. Would need to earn roughly 7.5% or more to make it worthwhile to keep the loan. Don't think I can do that well.
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Re: Pay off the House
Old 04-13-2004, 12:35 PM   #7
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Re: Pay off the House

The bottom line is that rate of return and the alternative (I guess) use of the home as well as it being an asset.

Historical returns run around 8% before taxes, your tax rate will determine the "real" return. Twenty-five percent is the average, so you'll be seeing about 6-ish%. On average. Over long periods of time. There have been several ten and twenty year periods where the real rate of return was zero. Even at the historical rate of return compared to mortgage rates, over 30 year spans, you might eke out a percent or two advantage.

Your real rate of return on paying off the mortgage is the mortgage rate. Guaranteed. And I'm unaware of any guaranteed investment vehicles that carry a 5.something% rate of return. If someone knows of one, let me know. My money heads there the next day.

As far the future, many experts agree that future return rates will be lower than they have been. If you believe experts. One says 3-3.5% "real" return, another says 6-9 before taxes, or 4-7 after, depending on your situation.

Factoring in the mortgage deduction is also worthwhile, although many folks including me and my parents, pay no taxes so a deduction would be worthless.

I'm also afraid I have to apply some rationality to the "irrational" fear of losing ones home for the folks who love history lessons when they're favorable, but ignore them when they're not. Many times in our history, the economy got bad enough that a lot of people DID lose their homes. However I'm not even remotely concerned about that. What I *am* concerned about is sustained high withdrawal rates during extended downswings in the market. As mentioned about 97 times now, I can reduce my withdrawal rate to about 8-9k a year for a couple of years with only a few luxuries absent, and to $12k with very little off of my current lifestyle.

With a mortgage, I cant do that. So having a declining portfolio that started off 200k larger and having to take large bites of principal out of it to pay the debt served would kinda suck in a 5-7 year bear market. You know, the kind you frequently see in our history lessons when equities are highly overvalued. Like they are now.

So unless you have a really small portfolio (under 500k), are paying less than 4.5% on the mortgage now, or are past the halfway point in payments, it bears considerable thought to pay it off.

And again, my homes value can go down 100% and I can still live in it for 50 years. My stocks and bonds go down 100% and I have wallpaper.

If its just too complex and wigs you out, but it still seems attractive, then take dollars directly from the fixed income portion of your portfolio and apply it to the mortgage. The mortgage is more guaranteed and pays a higher rate than anything of comparable risk in the fixed income area and is immune to interest rate risk. An unbeatable combo, which is probably why banks get rich on mortgages

I'm getting that feeling of Vuja-De. Thats where you get that feeling that you've done this before and never want to do it again.
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Re:  Keep the mortgage
Old 04-13-2004, 04:38 PM   #8
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Re:  Keep the mortgage

Thanks, SG-- I had a 100% success rate for the payoff case, which drops to 96.2% if I keep the mortgage. The ending values were very close to each other, an encouraging sign. You're right about the additional gains from the tax deduction.

Another advantage of a big mortgage tax deduction is giving us plenty of MAGI room for Roth IRA conversions in the next few years.
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Re: Pay off the House
Old 04-13-2004, 04:48 PM   #9
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Re: Pay off the House

Salaryguru - While I tend to agree with your conclusions, there is another issue that must be considered in each case. That is the question of where the money comes from to make the mortgage payments and the tax consquences thereof. If the money comes from a deferred account then the person might be pushed into a higher bracket and/or find more of their Social Security payments become taxable.
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Re: Pay off the House
Old 04-13-2004, 05:02 PM   #10
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Re: Pay off the House

I know you like the historic numbers and the calculator, so I'll restrict myself to that.

One of us must be doing the wrong thing, because I tried to duplicate your results and using the same inputs got:

With mortgage: $2,691,421
Without : $2,492,105

A nice advantage, but not overwhelming, to keeping the mortgage.

However, if I change the scenario to a more realistic interest rate, since I dont see any 4.75% 30 year mortgages, and the national average as of today is 5.5 (not to mention most people who havent done a refi lately may be in the 5.5-6.5 range, but just to stay conservative):

With@5.5: $2,640,540

Oops, we have to include another 1021 per year in taxes, at a meager 15% to cover the excess withdrawal:

Now we're at: $2,509,532
[Edit: actually this would be income taxed federally at 25%, and I didnt incorporate state taxes - this would make it $2,483,848]

But you would get a tax benefit from the mortgage interest, which would be different for each of us, and would wipe out the need for that extra tax money per year in year 1, and then decline to zero by year 30. But then again I know some of pay nothing in taxes, so there would be no benefit at all to some.

But here's the kicker. I cant imagine anyone would pay off a mortgage and still retain a 50/50 stock/bond split since they basically invested 100k in their 5.5% guaranteed rate instrument (the home), so a 60/40 split of the remaining 1 million would be more likely, and the volatility more sustainable due to the lower withdrawal rate.

"Real" average terminal value without a mortgage, using a 60/40 split stocks/tips@2%: $3,086,169

Higher terminal value.
100% survivability.
Never lose your house.
Ability to reduce withdrawal rate during down times.
Ability to reduce fixed income proportion and increase equities proportion without increasing realized volatility risk.

Or you could dramatically simplify the calculations by replacing 100k of the 2% tips with 100k of 5.5% mortgage, calculate the 3.5% advantage over 30 years, and leave it at that. While TIPS offer inflation protection, so often do home valuations.

By the way, if you can find 2% tips other than at highly inflated prices (I see them selling for a 25% premium to face value right now), let me know.
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Re: Pay off the House
Old 04-13-2004, 05:32 PM   #11
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Re: Pay off the House

One additional thing. If you look inside the data instead of at the happy endings, both the realistic no-mortgage and mortgage scenarios over the 30 year terms had inter-period and end state valuations in the 200k-400k range when the markets ran into long term problems.

It wasnt a one time, or two time thing, it happened several times and during the real "hard times" that lousy valuation persisted for many years.

So stepping outside of the "hard science" - - would you have the guts to stick with your ER if your 1.1 million bucks turned into a quarter million almost overnight, and then laid there a while?

How about if you didnt owe a mortgage, had your home paid off and watched your 1.0 million turn into 200k? Even though I could ratchet down the withdrawal as everything would be discretionary (except taxes), a simple or part time job would easily fill in my withdrawal needs.

Even if I was 80, I could still do wal-mart greeter or the ole quick-e mart for 20 hours a week and make ends meet.
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Re: Pay off the House
Old 04-13-2004, 07:50 PM   #12
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Re: Pay off the House

Hey that roulette thing worked out for that guy...but I wouldnt try it.

The point is, if you're in your 70's and you've been out of work for 20 years, the economy goes into the sewer and you need to make (in todays dollars) 47k to pay the bills and make the mortgage...you dont have a big range of jobs and you'll most likely be pulling a full 40 hours until your portfolio straightens up. Knock 8-9k off of that (mortgage, taxes, and you can stop paying homeowners insurance if you dont have a mortgage), drop non essentials and cut down on the food bill a little, and you only need a crappy part time job. Or you can go to bed secure in the knowledge that in time periods from 1871 to 1973, your portfolio would have come back, and just hang on for dear life. Pretty gutsy if you can do it. Great deal if you make it. A shelter and a cardboard sign if you dont.

One last thing occurred to me on my way back from grocery shopping.

These analyses presume you're staying in the house for the full mortgage term. Most people dont, in fact the median is 7 years before someone moves.

In the 7 years at the preface of a 30 year mortgage, you've gained very little principal and paid mostly interest. In other words, you've effectively paid rent to the bank.

If you do this 3-4 times during that 30 year period, your interest payments as a raw percentage are a lot higher than 5.5%. Unless your home(s) see good increase in value - - and that only happens in some areas of the country - - this analysis stops looking anywhere near favorable.

Looking at my scenario, my last house was purchased cash and I lived in it for...almost exactly 7 years. I had briefly considered a partial mortgage on it. Had I done so, I would have preserved 162,000 for investing purposes. I would have paid $60,870 in interest to the bank, and gotten back roughly a third of that back as a deduction, so about $40k out of pocket. I would have accumulated $12,854 in equity.

During that same time period, the 162k invested in the total stock market index would have made me roughly 44k. In the S&P 500, a slightly better 48k.

This during the most incredible run-up of our stock markets history, followed by a couple of bear market years.

Doing the same thing starting in 1929 and investing in the DJIA would have lost me about 70k. Do it anytime in the 60's and depending on where you start and stop you hit somewhere between break even and losing 50 grand. You're still out the 40k in interest after the tax deduction.

Granted your investments, from a historical perspective, should recover, but remember also that your next home restarts the mortgage clock and your interest payments resume.
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Re: Pay off the House
Old 04-14-2004, 11:17 AM   #13
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Re: Pay off the House

SG - Oddly enough I ran a couple of scenarios again and got some additional different numbers.

Perhaps someone else will run them and give us their results.

What I did:

Open Firecalc window by clicking on the link.
Fill in 41000 in "withdrawals".
Fill in 1100000 in "starting portfolio".
In "withdrawal change 1, I put 6260", changed the year to 0 (zero or 1 produces the same results), and unchecked the "check this box to do inflation adjusted dollars.
Changed the equities percent from 75 to 50.
Checked the tips box and changed the rate to 2.0%
Changed PPI to CPI
Checked the "first year withdrawal" box.
Clicked "summary results"

Results are 100% success, average terminal size $2,373,551 with a mortgage at the 4.75% rate you cant get.

I change the mortgage number from 6260 to 6813 to represent a more realistic 5.5% interest rate.
I click summary results

I get 99.2% success rate, average terminal size $2,322,670 with the mortgage at 5.5%

I change the box with 1100000 to 1000000.
I change the 6260 to 0
I click "summary results"
I get 99.2% success, average terminal size $2,175,743 without a mortgage

I change the equities box from 50% to 60% to represent my existing "investment" of 100k in a guaranteed 5.5% fixed income instrument...the 'non mortgage', and click "summary results".
I get 99.2% success, average terminal size $2,725,414 without

Whats odd is that these are all different numbers than what I got yesterday. Looks like they're all about 300k smaller. Weird.

Can we get some 3rd party confirmation of what they get for numbers, and if one of us has goofed, advise what the mistake is?

Aside from funny results, if you like the odds and numbers, you need to use a realistic interest rate for the mortgage and a realistic rate on the TIPS.

You also need to acknowledge that the data set for this historical calculator has two issues. One is that it starts in 1871 at a VERY favorable time period, right after the civil war, when the market was at an all time low. It also excludes full results from periods from 1972 on as we dont have 30 years of results to work with past that point and theres no "wrap around" or insertion of calculated, random or presumed data.

Hence, the early 30 year periods are somewhat tainted by overly optimistic data, and there are *no* recent periods in "modern" economic climates.

This is why I frequently run firecalc with 10 or 15 year periods and then feed the results in for a second run to get 20 or 30 year periods that include some recent historic data.

In this manner I was able to subject my reduced withdrawal rate scenario to the worst 10 years of the depression FOUR times with 100% survivability the first three times and a failure in year 8 on the fourth time, and 100% survival of four series of two ten year worst periods in 1929 and 1964, alternating. In other words, since I fully control my withdrawal rate, I can survive even sequential disasters and not be forced to punch a clock at the quick-e mart.

GDER's point is also valid - when interest rates are even marginally higher than the all time lows they're at these days, there really isnt any argument at all for a mortgage.

The mortgagee also has to ask the oft avoided emotional questions of having big brass ones when the market drops and stays down for a while - - especially if they have 200k of their 1.1 million committed as is more likely - - and how they plan to come out of a long term retirement and earn enough to pay the bills if we have a 1929 or 1964 type scenario. And will they sleep at all better at night owning the home outright, no matter how "irrational" that might seem.
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Re: Pay off the House
Old 04-14-2004, 12:22 PM   #14
 
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Re: Pay off the House

The decision to put a significant percent of your assets into a home is an asset allocation question. If interest rates go up and the value of your investment (home) goes down, your total portfolio has just dropped in value. If rates go up to 8-10% and you have a 5% mortgage, you can alternatively invest in interest bearing secutities (because you have the cash) and have a net gain by holding the mortgage. While some people would consider paying off your home as a conservative strategy, others would consider putting significant $$ in a single asset as non-conservative.

From listening to the posts on this subject over the past several months, I believe it is safe to say it is a personal choice to pay off your mortgage, and that any attempt to rationalize it with statistics is probably unrealistic since a number of doomsday assumptions can be used to skew the results to your way of thinking. Bottom line -- no one knows for sure what will happen to your market investment in the future, and if it helps you to sleep better at night to pay off your mortgage you should probably do so.
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Re: Pay off the House
Old 04-15-2004, 05:47 AM   #15
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Re: Pay off the House

Heh. heh. Calculations! We don't need no stinking calculations! My SO made me an offer I couldn't refuse -24 years ago. About 7 Hurricane evacualtions give or take, one tornado and numerous rebuild/remodels/replaces - still here.

I still run the rent/buy numbers as a backup plan every few years. Home is a pure expense item with no weight - ER portfolio wise.

It's a lifestyle thing.
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Re: Pay off the House
Old 04-15-2004, 10:59 AM   #16
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Re: Pay off the House

Th,
If you're looking for a guaranteed rate > 5%,
a 7 year cd from Pen Fed is paying 5.1%.
Of course you'd have to tie up your money for 7 years and who knows what the cd rates will be later this year after the Fed Reserve raises interest rates.
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Re: Pay off the House
Old 04-15-2004, 11:02 AM   #17
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Re: Pay off the House

A non-passion-infused addition to this discussion:

Not being all that quick with the numbers, I tend to think about this more globally. I admit to liking the idea of a paid-off house, and I'm planning to pay off my 6% first and hold onto my 3.5% home equity for a while. Not yet really close to retiring, just a 50-year-old wannabe.

But I have a question. If one pays off the mortgage, and the market tanks and stays down for a long time, wouldn't a retiree who is no longer very young enjoy the added possibility of a reverse mortgage? Not much of a solution for the 52-year-old ER, but possibly the 80-year-old TH might not have to head down to Wal-Mart?

I'm surprised nobody added this to the mix, but perhaps it doesn't fit easily into calculators.

Anne, who is still working most days, but scored a goal on the ice yesterday!
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Re: Pay off the House
Old 04-15-2004, 11:38 AM   #18
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Re: Pay off the House

Bennevis...the penfed rates are pretty good, arent they?

Of course, you would give up 15-30%+ of the interest as tax at the ordinary income rate, and inflation would eat up almost all of the rest. Those are great for keeping your cash buffer stable with inflation and maybe gaining a percentage a year.

Anne - a goal scored is a very, very good thing. Did you catch the goalie napping or did you just jam it in? Of course luck cant be a factor when dealing with a little piece of hard rubber and a bent stick

Reverse mortgages and home equity lines of credit are always options, and I've always kept a HELOC on my property that I could tap from. Besides the reverse mortgage helping an older retiree maintain a quality lifestyle, if it really goes to hell in a handbasket I can pull from my heloc and buy beaten down equities for pennies on the dollar. I'd probably be too chickenshit to do it, but the option is there.

The pitch and tone of some of these discussions certainly could be better. A good way to improve them would be for people to understand that a challenge to their ideas isnt a challenge to them personally. Leaving out the vague name calling would also be a positive step.

But its really a lot simpler than we make it out to be.

At the time of deciding whether to mortgage or not, its a bipole decision: can you make more money with the cash in an investment with similar or lower risk and/or can you remove the mortgage amount from an asset class in your portfolio with a similar or higher risk and a similar or lower return?

If you're already IN the mortgage, its not so clear cut.

But like I said, in the end I think we all already decided what we were going to do and made up whatever set of rationalizations made us feel comfortable with it. Without a crystal ball, nobody knows.

I do know however that the next person who asks about mortgages may be mortified when they're greeted with a hail of empty beer cans, wine boxes, and old dust encrusted dryer sheets.

We should probably clean up this mess and put it in the FAQ section.
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Re: Pay off the House
Old 04-15-2004, 05:48 PM   #19
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Re: Pay off the House

Wow. *Thank you all for the thoughtful replies.

I'm brain dead from working too much and sleeping too little, so I will read them all more carefully on the weekend when my brain might actually be able to absorb meaningful facts.

In my case I'm only 2 years into a 15 yr. refi, however the loan is relatively small - *$50 k, so the payments are not difficult to make. *I have about 70% equity in the house.

I also keep open the idea of working "some." As an architect I could do a quick house plan or two, and make some extra cash as needed. *Even if/when we are ER'ed we will probably end up fiddling with real estate becuase it's almost a hobby for us. *

I definitely see an emotional preference for no debt - in fact I am adamant about that myself, never finance a car or carry a cc balance, and have zero debt except the mortgage. * But I try to let my rational side do the retirement planning.

If the right brain got control I'd be on a Mexican beach in a heartbeat. Hmmm.
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Re: Pay off the House
Old 04-15-2004, 06:41 PM   #20
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Re: Pay off the House

If your refi rate was 6% or higher, it might be worth considering, although that small a mortgage and already having paid two years of mostly solid interest, and it being a 15 year...maybe not.

If the rate is a LOT higher than 6%, you might consider one of the 5/1 fixed/ARM's out there for around 4%. Pay the thing off in the 5 years a chunk at a time. Split the difference.

There is that emotional piece, but I made my decisions based on rational numbers and judgement. I cant make 5-7% in fixed income, so I reduced my bond holdings to pay down the debt. I probably would be in 45-50% equities, instead I'm about 58%.

What absolutely floors me? The guy who bought my old McMansion did 100% financing with a jumbo first at the limit and a second for the rest of thel half million. What was really weird is that he did the first and second with two different banks, and I thought most banks were really hesitant to write a jumbo first with a substantial second going to another bank. In the event of default one of them would probably have to buy out the other.

Granted money is cheap these days...but the guy is going to be pushing about a $3600-3800 mortgage payment...
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Be fearful when others are greedy, and greedy when others are fearful. Just another form of "buy low, sell high" for those who have trouble with things. This rule is not universal. Do not buy a 1973 Pinto because everyone else is afraid of it.
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