|
|
A Bad Deal For All Fifteen Years
An excellent sign for the economy is the switch from consumption to saving by the Baby Boom generation. However, some popular vehicles for savings are exceptionally poor ideas -- particularly the fifteen year mortgage.
Demographers and marketing types have known for a long time that savings behaviour really starts with the age 35 to 44 group. By that age, the impossibilities of retirement and mortality are imaginable, if not yet in sight. And in 1992, that age group contains the fat part of the Baby Boom bulge.
And here come the fifteen year loans. In this year's mortgage refinancing boom, national statistics show nearly half of loan volume to be fifteen year maturity.
The motivation behind short term mortgage demand rests on the marvelous thought of owning a home free and clear, the illusion of interest savings.
The interest savings argument goes like this. The sum of all the interest on a 30-year, 8.50%, $100,000 mortgage is $176,808.85, while for a 15-year 8.00% $100,000 the amount is $77,253.12. Glory be! A little higher house payment, and save ninety-nine thousand bucks.
This arithmetic-sum-of-future-interest "savings" is bad finance on two grounds: inflation and opportunity cost.
Inflation tends to wipe out far-distant interest savings. If the past is any guide, a dollar paid in interest in year 26 of a 30-year loan will not be worth as much as one piad in year two. Today's dollar is worth about one fifth of the value of a dollar 26 years ago.
Opportunity cost analysis asks the question, what else could I have done with the principal I paid back early? What would happen if I saved the same cash instead of sending it back to the lender?
Opportunity comes in two pieces: cost and benefit, both of which must be converted to after tax rates. The cost of a mortgage after taxes is the face, or nominal rate multiplied by the "real" fraction of your income.
If you are in a 33% tax bracket (28% federal plus 5% Colorado equals 33% -- the lowest top bracket in the Babay Boomer lifetime), the real fraction of your income is 67% (the two thirds you get to keep, sort of). Therefore, the after tax interest cost of an 8.5% mortgage is 5.70%.
Opportunity benefit, for comparison purposes, is the yield on your long term savings. That's long term as in IRA, 401k, Keough, diversified mutual funds, not CDs, money market fund, or other short term transaction accounts.
If you can't earn more than 5.70% on long term savings, fire your planner.
Don't believe it? Since the 1930s, there is no decade in which a diversified group of mutual funds has failed to earn 10%. IRAs and other tax sheltered savings do even better because you don't have to pay taxes as you earn interest. Tax shelter aside, I don't think you can find a 401k in Boulder County which is earning less than 10%.
If you have the discipline to pay an extra few hundred dollars a month, save it, don't send it to the lender.
"But I want to own my home free and clear."
No you don't, and for safety reasons, not just investment ones. Besides, in your sixties you'll move to someplace warm, and a house without stairs.
Except for rich people, a free and clear home is dangerous. Houses make great investments, but terrible stores of liquid savings.
In this refinance cycle, many people discovered to their horror that they could not borrow their home equity. Job changes, self-employment, credit, or -- as we age -- health problems can mean that the only way to get at that painfully hoarded home equity is to sell the place.
Bankers will follow you around all day on a sunny day, trying to loan you an umbrella; but if it ever commences to rain in your life, we won't loan you a dime.
"But the lender told me a fifteen year would build up equity so fast."
This is sales fog. Equity paid into a home changes nothing. If you have $10,000 in the bank, and send it to your lender, you owe $10,000 less and have $10,000 less in the bank. Your net worth changes not one iota.
"I's, when tens of millions of loans from defunct S&Ls were dumped into the system. However, If you ever have trouble with your servicer, call the retailer where you got the original loan. Retailers speak servicing jive, and have a trick or two around the phone trees to humans.
|
