How We Sabotage Home Equity
Home ownership has long been a core part of the American Dream – and its made possible, in large part, by the home mortgage. But what if our typical handling of a mortgage is actually preventing the ultimate goal of home ownership for those pursuing financial independence, a 100% paid for house and a hefty chunk of equity? In fact, what if many of us are actually sabotaging our home equity growth?
This post is about a common *mistake* I see a lot of people make when buying a new home – and its one I’ve made myself. It has to do with how mortgages actually work via a process called amortization. Most people are chiefly concerned with only their total payment, but may not be aware of how that payment is comprised of both interest and principal amounts which change over time (though the payment itself, at least with fixed-rate mortgages, is the same every month).
A Quick Mortgage Primer
The majority of our payment is interest in the initial years of a mortgage. As time goes by and the balance decreases, the interest portion decreases along with it and, eventually, we start owning more and more of our home with each payment.
Let’s look at an example. Say we have a $250,000 30-year fixed-rate mortgage at 4.25% interest – the total monthly payment is $1,230 ($14,758 annually) for principal and interest. During the first year, 71% of the total payment is interest ($10,544)! Let’s fast forward to the end of the first seven years. We’ve made $103,307 of payments and our balance is only $216,372 – which means just 32% of our payments have gone toward paying down principal.
If we go out another 7 years, our interest payment over that time will have been $58,051, which means about 44% of our payments went to principal – progress is now starting to be made! It’s not until the fifteenth year of our loan that we finally pay more toward principal than interest. Here’s a chart showing how the payment composition changes over the life of the loan.
As we can see, we want to get to that later half of the mortgage where our payments are mostly comprised of principal! But what often happens is, just when we’re starting to really get traction, we sell our house and buy another one. This is where the sabotage occurs.
The median length of home ownership seems to be about six to ten years depending on the data source and how they measure this statistic. This means that, on average, the typical homeowner is selling and buying another home at least once per decade – which is simply too often to build home equity through mortgage payments when we finance each new home purchase with another 30 year mortgage (and isn’t “building equity” often a justification for buying instead of renting? Food for thought!).
As someone pursuing financial independence, its important to optimize every aspect of our finances for wealth building – this area is quite the hindrance to that goal if handled unwisely! Many people get stuck perpetually being in the first few years of a home mortgage. How big is the effect? Let’s take a look at an example:
- A 25 year old buys a home with a $250,000 30-year fixed-rate mortgage at 4.25% interest and stays there for 30 years.
- A 25 year old buys the same home with the same terms. Then at age 30, moves again. Then moves again at age 40. Each time financed with a 30 year mortgage at 4.25% with the same fixed payment amount.
We already know Buyer 1 is going to pay less in interest. But how much less?
Let’s take a look at only 30 years (age 25 to 55), and to keep it simple I’ve ignored things like closing costs, home appreciation, and changes in interest rate.
When Buyer 1 is age 55, there is a completely debt-free home and it came at the cost of $192,746 of interest. When Buyer 2 is 55, they’ve paid…. $281,857 of interest! And not only has Buyer 2 paid $89,111 more interest than Buyer 1, there’s also still a loan balance of $163,483 – which means there’s A LOT more interest yet to be paid!
This a simple example and the real facts will definitely alter the end result. However, this quick analysis is fine for illustrating the point – focusing only on total payment and continually buying homes with a new 30 year mortgage is a fantastic way to sabotage home equity growth and pay a lot more interest!
The Custom Term Mortgage
Is there a way around this? Turns out, there is! Enter the custom term mortgage.
Someone who is 25 now is unlikely to stay in the same house for the next 30 years. There are a lot of legitimate reasons why we sell one home and buy another, but its important to keep this idea in mind of not focusing solely on the total payment.
If we can essentially ‘lock in’ the amortization schedule of our very first mortgage, we have a much better shot of turning out like Buyer 1 in the example above. Fortunately, these days you can actually get custom term mortgages from a lot of lenders – which means that if you have 23 years left on your current mortgage, you can get a 23 year loan instead of a new 30 year loan. Although not often advertised, these are available. However, definitely make sure the pricing makes sense (for instance, a 22.5 year mortgage should be roughly the average interest rate of a 15 year and 30 year mortgage) – it would not be worth taking a 20 year loan that had the same interest rate as a 30 year loan, or that had considerably higher fees.
In our example, our hypothetical Buyer 2 could have taken a 25 year mortgage on that second home, and then a 15 year mortgage on the third house. Of course, to end up in the same place as Buyer 1 he would also need to only finance the outstanding debt at that time, which is unlikely – but hey, I’m illustrating a point!
When looking to purchase a bigger/nicer home, I’d encourage people to at least look at the payment amount on a mortgage term equal to their remaining term on their existing home. That way it gives them a better idea of the true cost of resetting a mortgage – it is very easy to be enticed into a larger home with a new 30 year mortgage with a payment that feels very similar. However, as we’ve seen, this has a BIG long term effect!
The lesson here – think twice before hitting the reset button on a 30 year mortgage! If you want your home(s) to be a source of long term wealth creation and you would like to be debt-free in retirement (or before), its really important you not simply look at the total payment when evaluating a new home purchase or refinance.