Mortgage Question: Need a double-check

[Peaceful_Warrior]

For the purchase of our home, I'm looking at two mortgage programs - and I'm fully aware I'm comparing apples to oranges. However, I also know that from a strictly financial perspective there is a way to compare these... I think I'm just getting my head spinning around so much that I'd like some outside input onto this subject.

Removing emotion from the equation, which of the following programs is *financially* wiser for having more total assets at the end of 10 years?

So here goes......

We're not buying with anything down - purchase price $208,000. Numbers below assume roughly equivalent total closing costs. We currently plan to keep the home for about 10 years.

"Program 1" is a 100% traditional 30 year mortgage at 7%. "Program 2" is a 100% IO (fixed for 10 years, amortized over remaining 20) at 6.5%

Program 1 payment: ~$1,375 (Principal + Interest)

Program 2 payment: ~$1,275 (Interest + PMI )

So the difference in the two programs is ~$100 per month. I could invest that difference of $100 over 10 years ($12,000) at say 6% and and up with ~$13,500 (Results of taking Program 2 and investing the difference) before taxes.

After 10 years with Program 1, I would have accumulated ~$30,000 in equity that is illiquid, but in theory would be tax-free when I pull the money out. However, I also have to account that for Program 1, my mortgage interest deduction would be reduced every year... and this difference I would have to subtract from the $30,000 tax free.

Based on my initial assessment, it seems like a no-brainer that "Program 1" is better for assets at 10 years, even though it costs more per month.

Financially speaking, what am I missing?

 

[FIRE'd@51]

I see Program 1 as better also. Effectively, you are investing the $100 per month at 7% with Program 1, instead of 6% with Program 2, which is why you have more equity after 10 years with Program 1.

Also $208,000 x .07/12 = $1213 per month, so you are paying $62 per month PMI which is a frictional loss. Since you don't indicate any PMI with Program 1, you are actually investing $162 more per month at 7%.

BTW, my financial calculator says your monthly payment with Program 1 is $1384 (not $1375), using $208,000 as the loan amount, so that adds another $9 to the difference, giving $171 per month.

Investing $171 per month for 10 years at 7% gives approx $30,000.

All my numbers are pre-tax.

 

[EngineeringMyFinances]

Maybe I'm not understanding the terms of the loan, but I calculate the interest on program 2 as .065/12*208000 or $1127/month making the difference between $1275 or $148 as your PMI. Although I don't understand why you'd pay PMI on one loan and not the other as I thought that PMI was based on Loan-to-Value > 80%. Also, PMI might or might-not be deductible depending on how they fiddle with the tax code.

And anything you've paid on your loan when you sell your house is tax free, you'd only be taxed if at all on any gains over your purchase price. IIRC, $250k of gains on the sale of your personal residence is tax free right now, do a little Googling and check that out.

If I've plugged the numbers into Excel properly, if you saved $100/month for 10 years, you'd need to get 16% interest to have $30,000 at the end of that 10 years.
Didn't figure the tax impact, don't think it'd overcome an effective 16% interest rate. I'd rather pay taxes on a 16% return than a 6 or 7% return.

Unless there are other factors I don't see here, looks like program 1 is the better deal long run.

 

[Peaceful_Warrior]

I see Program 1 as better also. Effectively, you are investing the $100 per month at 7% with Program 1, instead of 6% with Program 2, which is why you have more equity after 10 years with Program 1.

Also $208,000 x .07/12 = $1213 per month, so you are paying $62 per month PMI which is a frictional loss. Since you don't indicate any PMI with Program 1, you are actually investing $162 more per month at 7%.

BTW, my financial calculator says your monthly payment with Program 1 is $1384 (not $1375), using $208,000 as the loan amount, so that adds another $9 to the difference, giving $171 per month.

Investing $171 per month for 10 years at 7% gives approx $30,000.

All my numbers are pre-tax.

Right... the $1375 is approximate since I was rounding for easier "off the top" assessment.

Also, mortgage one is "Lender Paid PMI" I believe, which is why it's not included. Apparently this is popular now.

Fortunately, PMI is now tax-deductible if I do go with a PMI mortgage.

Agreed all numbers are pre-tax, which is why I mentioned I'd have to deduct the lessening tax deduction from the $30,000 so the actual assets would be more accurate.

It is frustrating though because I prefer to not have my assets tied up in home equity for several reasons but looking at the numbers I'm having a hard time seeing the IO as the more optimal deal here.

 

[bongo2]

Yup, program 1.

Here's another way to think about it. For the extra $100, you get about $170 of equity in payment #1. Maybe you can do better than tying up your money for 7%, but that initial 70% advantage is going to be hard to beat.

 

[Peaceful_Warrior]

Yup, program 1.

Here's another way to think about it. For the extra $100, you get about $170 of equity in payment #1. Maybe you can do better than tying up your money for 7%, but that initial 70% advantage is going to be hard to beat.

That's a great way of putting it... I know intuitively that's what I was thinking, but quantifying it and seeing that having 70% "company match" (so to speak) at 0% is probably a lot better than any returns I could yield through 0% match at even 8 or 10%

Based on the above realizations, right now, I've got the lender of Program 2 seeing if he can provide me the same Program 1 with better rates than the associated lender.