There are tons of different mortgage options available depending on an individual’s circumstances. There are options based on where you are purchasing, your military service, low-income, first-time buyer, etc. You can also choose different options based on how much of a down payment you can afford. And finally, you can decide how long you will take to pay off the mortgage: typically either 15 or 30 years.
Most people get a 30-year mortgage. When you consider how little of each payment goes towards the principle during the first seven years, you realize that all you are really doing is renting from the bank. I refer to that as a Debt Mortgage. On the other hand with a 15-year mortgage you begin to immediately build equity in your house. That is why I refer to it as an Equity Mortgage.
With the 30-year Debt Mortgage, all you really do is pay to service the debt on the home, and you build almost no equity at all, unless you get lucky and the value of the house increases a lot. Since most mortgages only last about seven years – due to refinancing or moving – many people never get a chance to build any equity at all – at least early in their lives. By the time you account for all the expenses of owning the home, including the real estate fees and the interest, you realize that you basically rented the home – and paid a lot more each month than the actual monthly payment.
Let’s use a $200,000 home with a 10% (or $20,000) down payment. That equates to a $180,000 mortgage with a monthly payment of about $1,100. Now, say you have to move after just three years. By the time you account for real estate fees, your down payment and any money you put into the house including repairs, maintenance and landscaping, your $1,100 per month got you nowhere. In fact, you likely lost money in the process. You basically rented your home from the bank. And that is assuming the home went up in value and you were able to sell right away. If it takes six months to sell, then you are losing an additional six months worth of mortgage payments Plus what happens if home prices fall 5% during that time? Then your “rent” payment was not $1,100 but closer to $1,400 during that time.
With a 15-year mortgage, selling the home in year three you would net almost $30,000 after your $20,000 down payment. Now that is an Equity Mortgage. And in just three years! Even if the home drops in value you still walk away with $3,000 PLUS your original down payment.
Since most mortgages only last 7 years since we either move or refinance it is a bad idea to even get a mortgage unless you know you remain in that house for at least 5 years – or even much longer! So using the same example, after seven years of paying on the 30-year mortgage you would still owe 85% of the original amount borrowed, but only 60% on the 15-year. Why is this so? With the 15-year mortgage you start from your first payment with more than half your money going towards paying the principal. For the 30 year mortgage that doesn’t happen until halfway through year 12.
Now, let’s look at the overall cost of the mortgage. That Debt Mortgage at 4% would have payments of about $1,100 per month and will cost you $130,000 in interest over the life of the loan. But the payments on a 15-year mortgage would only be about $1,600 per month (about $500 difference) and you would only pay $60,000 in interest and be done in half the time! Think about that. You don’t pay anywhere close to double, but you cut the time and the interest in half!
Here are some quick tips to avoid costly mortgage mistakes:
- First make sure you know exactly how much you are willing to spend on your house each month. That is not the same as what the bank will approve. They may approve you for a lot more than you want or are even able to spend. I don’t know about you but I like to dine out on occasion, take vacations, and do simple things like put gas in my car without worrying about my card getting declined. So start with what you are comfortable spending.
- Second, be careful when using any type of online calculator or even when speaking with a real estate agent. Make sure anytime you are looking at total monthly payment it includes your taxes, insurance and any PMI if you put less than 20% down. These easily add up to increase your monthly payment by 20% or more. That means a calculated mortgage payment of $1,500 will actually cost about $1,800+.
- Finally, don’t factor in the tax savings. Its not as much as you think once you realize you lose the standard deduction anyway, plus any homeowner will tell you that you will spend a lot more on your house in terms of window coverings, shrubs, and maintenance than what you will gain in tax savings. So don’t make that part of your consideration.