A Mortgage as an Investment
Most people have heard that ``owning a home is investing in your future'' or ``mortgage payments are a forced savings plan.'' In fact, owning a home presents a great opportunity to individuals to manage their debts like they manage other investments. However, owning a home involves more than simply taking a 30 year fixed rate loan and then sitting back waiting for market appreciation as you pay down your loan balance. Managing your debt like you manage your stock portfolio can save you thousands of dollars over the life of your mortgage.
Most people strongly believe that in building wealth and maximizing net worth, debts are as important as assets. For most of us, the biggest portion of debt on our personal balance sheet is our home mortgage. To wisely manage this debt, we should monitor our loans closely to minimize interest costs and maximize our net worth.
Reducing 1% off of interest costs on your loan is equivalent to increasing your investment returns from 9% to 10% in a year. You can double that savings if your loan is twice as large as your investment portfolio, which is fairly common in these modern times.
To analyze your mortgage like an investment consider the following:
The Hold Period, i.e. how long you plan to be in the home or with the loan
Your Future Interest Rate Assumptions
Interest Costs vs. Nominal Payments
Present Value vs. the Future Value of Money
Return on Other Investments
With all the new loan products available, one of the most important factors in deciding which loan product to choose is your hold period. Even a one year change in how long you plan to be in the home or with the loan can cause a dramatic shift in the overall analysis. Match as closely as you can your expected stay with the fixed period that you select for your loan. This is particularly easy with today's hybrid loans that give you choices of 3, 5, 7, and 10 year fixed rates then converting to Adjustable Rate Mortgages (ARMs). All of these loans are still amortized over 30 years so you needn't worry that the payments will be higher than a standard 30 year fixed loan.
The longer the fixed rate term on your loan, the higher the interest rate will be. A 5 year fixed to ARM will have a lower initial start rate than a 30 year fixed rate loan. If you only plan to own your home for 3 to 5 years, then there is no reason to pay the higher interest rates of a 30 year loan.
A useful question to consider is the following. Would you invest $200,000 in a 30-year fixed asset and never monitor the market again? Then why do many people start their search for a loan by deciding that a 30-year fixed rate is the best product for them? In fact, most people overpay on their mortgage interest by staying with a longer fixed period than is appropriate for their situation.
Why not consider a shorter fixed length and focus more attention on your single largest asset, your home. By devoting a small amount of time to managing your home mortgage, the benefits can outweigh the time invested.
Today's refinance process is becoming simpler and the process of securing the right loan has never been easier with the advent of Internet mortgage services. Easier access to information and services, combined with the forecast by many for steady to declining long-term interest rates, translates to a variety of shorter fixed-term products that will save you substantial interest costs over time.
Future Interest Rate Assumption
Your personal expectation for the future of interest rates is an important factor to consider when choosing a mortgage loan. If you feel that interest rates are going to skyrocket, then you'd certainly want some sort of fixed rate. If you believe that interest rates will remain relatively stable, the savings of an Adjustable Rate Mortgage (ARM) might be more attractive.
Uncertainty about interest rates causes borrowers to make decisions along risk comfort levels. Only you can decide which loan ``feels good'' and you should not let a broker or agent dissuade you from what is most comfortable for your risk profile.
Interest Cost Versus Nominal Payments
Monthly (nominal) mortgage payments include an interest payment and a payment toward the reduction of the loan's principal balance. Any loan analysis that simply adds up payments will become increasingly skewed over time due to this principal reduction. As an example, a 15-year fixed-rate loan may have a higher monthly payment since you are paying off the loan over a shorter period of time. However, the loan's total interest costs may be substantially lower.
Some products, such as ARMs tied to the 11th District Cost of Funds, offer the option of paying a lower payment and sometimes have payments that are capped from one year to the next. While this type of loan appears to have the lowest payment, in fact the principal balance can actually increase over time. This occurs when the cap placed on the annual payment increase results in a monthly payment that does not cover the true interest costs that you have on your loan. This is an example of what is called "negative amortization," which means that your loan balance can increase instead of decreasing over the years.
While this type of loan may sound dangerous, it can in fact be used wisely. If you temporarily have a reduction in income, possibly a spouse is home with a child or temporarily out of work, then consider how a payment capped loan can work in your best interest. It allows you to use the equity in your home instead of taking cash from your income or savings.
Although it's a little more difficult, the interest costs rather than the nominal payment need to be calculated for a true mortgage loan analysis. Use an amortization calculator or schedule to determine the interest costs over the hold period for the loans you are considering.
Present Value Assumption
If you had the choice of receiving a dollar today or a dollar in 30 years, you would probably take the $1 today. In other words, a dollar paid in 30 years is clearly worth less than a dollar paid today. When comparing various mortgage payments on different loan options, it isn't enough to simply add up all the payments over the total number of years. If you did use a simple addition formula, and then compared two different payment totals, you would be ignoring when the payments are being made on the different loans. By doing so, you would probably be lead to the wrong conclusion.
A discounted present value analysis, while it may sound complex, simply allows you to add up all the payments of two totally different loan products with different payment schedules while considering the time value of money.
An additional factor to consider when viewing your mortgage like an investment is the tax advantage of mortgage debt. Because a portion of your mortgage payment is deductible for income tax purposes, this should be taken into account when comparing disparate payment options. Mortgage interest along with the points (origination fees) paid up front to secure a loan are deductible items for taxes. Points are treated differently in a refinance versus a purchase loan. In a purchase transaction, the points can be deducted in the year that they are paid. In a refinance, they must be amortized (paid off in increments) over the remaining life of the loan. Once the borrower refinances, they can deduct the balance of the points from the previous loan at that time. (This is a somewhat simple summary, and we recommend you use a tax advisor for a more robust description.)
Return on Other Investments
Finally, in analyzing your mortgage, don't ignore the opportunity costs of not having cash in your other investments. If you are able to invest your cash in ways that produce higher returns than your interest expense of your mortgage, it may make sense to take a shorter fixed loan and invest rather than paying more on a 30-year fixed mortgage.
One web based mortgage source called E-Loan can analyze a borrower's information to recommend mortgage loans based on the above criteria. This is an easy way to keep your mortgage choice consistent with your other investment decisions. Some of the above factors like interest costs, present value assumptions, and tax deductibility are built into the program. Other factors are determined by user input.
In summary, it pays to monitor your loan and treat it as seriously as you do your assets. Since most people have mortgage balances that are substantially greater than their portfolio of assets, the limited time spent doing so will reap major benefits. Times have changed and the choices for mortgage loans have grown so there's probably a product available that you never even considered.