Tag: financial literacy

Debt Calculator: How Much the Snowball Method Will Cost You

Debt Calculator: How Much the Snowball Method Will Cost You

The Debt Snowball repayment method will always cost you the same or more interestA charge for borrowing money, most often based on a percentage of the amount owed. More than the Debt Avalanche method if you have more than one debt and they have different 

How to Read Stock Charts

How to Read Stock Charts

Wouldn’t it be great if you could improve your investment returns by owning securities when prices are increasing and selling them before they crash? If you learn how to read stock charts, you might have a chance at doing so. People take many different strategies 

A Reverse Mortgage for Retirement Planning

A Reverse Mortgage for Retirement Planning

A reverse mortgage can be a valuable financial management tool for seniors and their families.  However, if misunderstood or misused, borrowers and their heirs can encounter any one of a number of different challenges.

In this post, I’ll define “reverse mortgage” and provide illustrations of several of its variations.  I’ll explain the considerations that determine how much you can borrow.  I close this post by identifying the characteristics of people who would or would not benefit from a reverse mortgage and listing many of the risks of reverse mortgages.

What is a Reverse Mortgage?

A reverse mortgage loan lets you borrow money using the equity in your home as collateral.  As with all other loans, interest accrues between the time the borrower receives the money and when it is repaid.

In some respects, it is similar to a home equity loan.  The main differences between the two types of loans are:

  • A reverse mortgage does not need to be repaid until the borrower no longer lives in the house. Reverse mortgage borrowers are allowed to repay a portion or all of the amount owed at any time.  By comparison, a home equity loan must be paid on a schedule often of five to 15 years.
  • Only homeowners at least 62 years old are eligible for reverse mortgages. All homeowners, regardless of age who have enough equity in their homes, are eligible for home equity loans.
  • interest on reverse mortgages is never tax deductible in the US. Home equity loan interest can be tax deductible, depending on the use of the money.

What are the Options?

There are four ways in which people commonly receive their reverse mortgage proceeds:

  • A single disbursement.
  • Monthly payments in a fixed amount for a stated term.
  • Monthly payments in a fixed amount until the loan is repaid.
  • In amounts and at times chosen by the borrower, up to a maximum limit. This option is very similar to a home equity line of credit.

Some lenders allow you to combine one or more of these options.

A Single Disbursement

Single-disbursement or lump-sum reverse mortgages are eligible for a fixed interest rate.  The homeowner borrows a stated amount from the lender.  interest accrues on that amount until the homeowner no longer lives in the house.

For example, a homeowner might borrow $200,000 at a 4% interest rate.  The amount that the homeowner or its heirs will owe when the reverse mortgage is repaid will be $200,000 increased by 4% per year.  The graph below shows the amount owed based on the number of years until the reverse mortgage is repaid.

Reverse Mortgage Single Payment Accumulation

The entire amount above $200,000 (blue portion of bars) is the accumulated interest on the loan (green portion of bars).

Fixed Payments

A single distribution can be very helpful when a homeowner needs money for a specific purpose, such as to help a family member, pay for home improvements or repairs, or a short-term medical cost.  In many situations, though, homeowners need money regularly to help meet their expenses.  In that case, the homeowner can choose to receive a fixed amount of money each month either for a stated period of time or until they no longer live in their home.  Reverse mortgages with periodic payments usually have variable interest rates that adjust based on some benchmark rate.

Stated Term Example

A reverse mortgage with fixed payments for a stated term might help a homeowner who wants cash flow to pay off the balance of an existing mortgage or other loan.  Once the mortgage has been repaid, the homeowner might not need the additional income.

As an example, let’s say a homeowner needs $1,000 a month for 10 years.  To keep the example simple, I’ll assume that the interest rate stays the same over the term of the loan at 4.5%.  The graph below shows the amount that will need to be repaid when the homeowner no longer lives in the house.  The total height of each bar represents the amount that would need to be paid if the loan were repaid in each year.  The blue portion of the bar corresponds to the amount of money that the homeowner has received from the lender.  The green portion of the bar corresponds to the accumulated interest.

Reverse Mortgage Annual Payments for Term Accumulation

“Forever” Example

A reverse mortgage with fixed payments that continue until the homeowner no longer lives in the house might help a homeowner who wants cash flow to pay on-going living expenses.

As an example, let’s say a homeowner needs $1,000 a month indefinitely with 4.5% interest.  The graph below shows how the loan balance increases over time.

Reverse Mortgage Annual Payments Forever Accumulation

The first ten years on this graph are identical to the previous graph.  After ten years, though, the principal amount increases in this graph, whereas it flattened out in the previous graph.  With the additional principal, the interest amount goes up even faster.

Borrow as Needed

If your cash needs are variable, you can borrow from your reverse mortgage at times and amounts that you choose.  There is a cap on the amount you can borrow.

As an example, let’s say a borrower needs $2,000 every other month, up to a total of $200,000.  The graph below shows the total amount owed.

Reverse Mortgage Borrow as Needed Accumulation

The graph below compares the above example with one in which the borrower is able to repay $500 in the intervening months.

Reverse Mortgage Borrow as Needed With Repayment Accumulation

The left bar in each pair shows the amounts owed when $500 is repaid every month.  The right bar shows the amounts when there are no repayments.  The $200,000 maximum is hit in year 17 in the bars on the right.  The yellow portion of those bars stays flat, while interest continues to accumulate.  By repaying $500 every other month, the maximum is not reached in the 20-year period shown.

How Much Can You Borrow

The examples above show that the total amount owed on a reverse mortgage can grow rapidly.  In the single distribution example, the amount owed exceeded twice the principal by the 19th year.  Lenders want to ensure that there is a good-sized cushion between the market value of the home and the amount due when the borrower moves out or dies.  As such, the lender creates models similar to the ones I used to make the graphs to estimate the maximum amount that the borrower will owe.

Once it has built that model, it considers the following aspects of the home and the borrower.

The Age of the Youngest Borrower

Lenders generally assume that the loan will not be repaid until the youngest borrower dies.  The older the youngest borrower, the shorter the likely time until the loan is repaid.  All other things being equal, the lender will loan more to an older borrower than a younger borrower because there is less time for the amount owed to grow.

The Interest Rate

The higher the interest rate, the faster the outstanding balance increases.  Therefore, lenders will loan more when the interest rate is lower than when it is higher.

The Equity in the Home

The maximum amount that the lender wants to ever be owed is the amount of equity in the home.  If there is no mortgage on the home, then the lender will be willing to have the estimated future total amount owed be equal to something close to but less than the market value of the home.  If there is a primary mortgage, the reverse mortgage lender will be paid after the primary mortgage lender.  As such, it will only allow the maximum amount it estimates to be owed to be somewhat less than the difference between the market value of the home and the principal remaining on the primary mortgage.

The Ability of the Homeowner to Maintain the House

The lender wants to take every precaution to ensure that the market value of the house doesn’t decrease.  It therefore considers whether the homeowner is financially able to keep the house in its current condition.  If it has concerns, it will reduce the amount it is willing loan.

The Ability of the Homeowner to Pay Expenses

The lender is also concerned with whether the homeowner is financially able to pay for homeowners’ insurance, property taxes, any homeowners association fees and primary mortgage.  If the home is damaged and there is no insurance or not enough insurance, the value of the lender’s collateral goes down.  If the homeowner can’t pay its property taxes, homeowners association fees or primary mortgage, the property might be foreclosed eliminating the lender’s collateral.  As such, if the lender is concerned about the borrower’s ability to pay these expenses, it will reduce the amount it is willing to loan or not make the loan at all.

Reverse Mortgage Fees

There are more fees involved in a reverse mortgage than most other loans.

The biggest of these expenses is the mortgage insurance premium.  Mortgage insurance protects the lender if the outstanding balance of the loan exceeds the market value of the home.  It is equal to 2% of the value of the home up front plus 0.5% of the amount borrowed each year.  The up-front fee would be $6,000 on a $300,000 home.  If the amount of interest and principal outstanding is $100,000, the yearly fee would be $500.  The yearly fee increases as interest accumulates and the principal increases.

Reverse mortgages have origination fees paid to the lender that, by law, cannot exceed $6,000 in the US.  In addition, the lender can charge servicing fees to monitor and manage the loan and to prepare account statements.

Most borrowers are required to participate in housing counseling before entering into a reverse mortgage.  The borrower must pay for this counseling.

The borrower will need to pay real estate closing costs, just as if it were selling the home to a third party.  These costs can include an appraisal, title search, inspections and all of the other costs involved in selling or purchasing a home.

Who Would Benefit Most?

Retirees

In the right situation, a reverse mortgage can provide significant benefits to retirees.  Specifically, people who could find a reverse mortgage to be a great benefit are those who:

  • Have a lot of equity in their home.
  • Are healthy enough to think they won’t need to move to a nursing home ever, or at least not soon.
  • Can’t support themselves on their existing savings and income.
  • Understand that the loan balance will offset the proceeds of the house when it is sold.
  • Can afford to pay the ongoing loan fees, property taxes, homeowners’ insurance, homeowners association fees and maintenance after they’ve received the proceeds of the loan.

Alternatives for people in this situation include:

  • Selling the home and either renting or downsizing. Selling a home and moving involves both financial and emotional costs.  In addition, the savings from renting or downsizing might be less than the equity that comes from selling the home.
  • Selling the home and moving in with relatives. This option will tend to be less expensive for the seniors, but will likely place a financial burden on the relatives.  Also, this option is not available to many seniors because family members don’t have extra space or due to tension across generations.
  • Borrowing money from another source. Not all seniors in this situation have a high enough credit rating or enough income to borrow money without collateral.  Even if they are able to borrow money, these debts will reduce the value of the seniors’ estates in the same way as a reverse mortgage.

Older People Getting Divorced

I know of one person who considered using a reverse mortgage during a divorce.  In that situation, the husband needed to buy the wife’s 50% interest in the house.  The couple had no mortgage on the house.  The husband had some money, but not enough to cover the wife’s 50% interest.  I never found out whether he used a reverse mortgage for the financing, but I thought it would have been a very creative use of a reverse mortgage.

People who Should Avoid Reverse Mortgages

Indications that a reverse mortgage might not be a good solution for you include:

  • The terms and conditions of the loan don’t make sense.
  • You can’t afford the costs.
  • You might move soon (at which time you need to re-pay the loan) because you are in poor health or other reasons.
  • It is important to you that you leave the entire value of your home to your heirs.
  • You have other sources of money to cover your expenses.
  • Someone, other than your spouse, lives with you who you want to be able to live in the house after you die.

Risks of a Reverse Mortgage

There are many “horror” stories about reverse mortgages.  The vast majority of them result from borrowers not fully understanding the terms and conditions of the loan.  As with any other financial decision, a reverse mortgage can be a great choice or a terrible one depending on the borrower’s circumstances.  The most important consideration, though, is whether the borrower and its heirs understand all of the financial ramifications and risks of a reverse mortgage.

Reduces the Value of Your Estate

Many people do not consider the impact of a reverse mortgage on the value of the borrower’s estate.  The outstanding balance of a reverse mortgage acts like any other debt in determining the total value of an estate.  The amount heirs will inherit is the difference between a person’s assets and debts.  Therefore, as the outstanding balance increases, the value of the estate decreases.

Other than the transaction costs, a reverse mortgage has a similar impact on the value of an estate as dipping into other assets to cover expenses or borrowing money from another source.  The former reduces the value of the assets and therefore the value of the estate.  The latter increases debts.  Therefore, the reverse mortgage, in and of itself, doesn’t reduce the value of the estate.  It is the purchases that are made with the money that cause the value to decrease.

Treatment of Spouses

Some couples put the name of only one spouse on the reverse mortgage.  If that person dies, the surviving spouse may end up in a challenging financial situation, depending on the terms of the reverse mortgage.

In some cases, the house does not need to be sold until the non-signing spouse dies.  It is important to read the reverse mortgage documentation carefully if you plan to have the mortgage in only one name.

In most or all cases, the non-signing spouse cannot borrow any more money from the reverse mortgage.  If the couple had been using a fixed-payment or as-needed option to cover its expenses, the non-signing spouse will need to find another source of income.

Moving Out of the House

One of the requirements of most reverse mortgages is that the borrower or surviving spouse must live in the house.  Some borrowers decide, after entering into a reverse mortgage, that they want to downsize or move closer to a family member.  Or, they unexpectedly need to move into a nursing home.   A borrower might be caught by surprise if he or she was planning to use the full market value of the house towards a new residence or nursing home costs.  Some lenders give a 12-month grace period before the loan needs to be repaid for borrowers who move into a nursing home to sell their homes.

Foreclosure

Reverse mortgages have many conditions with which the borrower must comply to avoid foreclosure.  These conditions require you to:

  • Pay property taxes, any primary mortgage payments and any homeowners association fees on time.
  • Keep adequate homeowners’ insurance on the home.
  • Maintain the home to keep it in its current condition.
  • Live in the home.

Outliving the Amount Borrowed

Many people plan to live on the proceeds from their reverse mortgages for the rest of their lives.  Unfortunately, some people spend their loan proceeds before they die.  This risk isn’t unique for reverse mortgages, as it exists for many other approaches for savings for retirement, as well.  What makes the problem more challenging with a reverse mortgage is that the borrower has already used the equity in his or her home.

Need to Sell House Quickly

The borrower’s heirs must re-pay the reverse mortgage shortly after the death of the borrower.  One of my friends has a nephew who ran into a real problem with this issue.  He was not aware of this aspect of his parents’ reverse mortgage.  He didn’t sell the house as quickly as was required.  The bank came very close to foreclosing on the house before he was able to sell it.

Variable Interest Rates

As with some primary mortgages, many reverse mortgages have variable interest rates.  If interest rates increase, the amount owed could increase significantly.  The graph below compares the total amount due in each year under the interest rate assumption used above of 4% with the amounts owed in a scenario in which the interest rate increases 0.5 points per year until it reaches 8% for a lump sum principal amount of $200,000.

Reverse Mortgage Single Payment Variable Interest Rate Accumulation

After 20 years, the interest on the variable rate loan is almost $50,000 higher than on the loan with a constant 4% interest rate.

Closing

There are many more details and options available with reverse mortgages.  Investopedia and the Federal Trade Commission are both independent sources for more information.  As with any financial transaction, I strongly recommend that you consider a reverse mortgage for yourself or a family member only if you understand all of the details and risks.  Reverse mortgages can be very helpful tools in some situations, but horror stories abound.

Smart Account Choices Juice Long-Term Growth

Smart Account Choices Juice Long-Term Growth

Compound interest allows your investments to grow exponentially in value.  This post provides six online compound interestThe amount of interest paid is calculated as the interest rate times the sum of the principal and any interest earned or owed. More calculators to help you understand 

How Short Bets on GameStop Took Big Slides

How Short Bets on GameStop Took Big Slides

The financial news in the past week or so has been full of stories about GameStop, AMC Entertainment Holdings (AMC), Blackberry, Reddit, r/WallStreetBets, hedge funds, short squeezes, margin calls and Robinhood, among other things.  Many of these stories explain parts of what is happening.  However, 

Don’t Sweat those Mortgage Terms

Don’t Sweat those Mortgage Terms

A mortgage is key to buying a residence for most people.  Mortgage loan documents are often lengthy and full of technical terms.  As such, many people either don’t read them in their entirety or don’t understand the details.  As with all contracts, I recommend that you read your mortgage from beginning to end before you sign on the dotted line.  If you don’t understand something, find an independent expert who does.  That expert can be a financially savvy family member, friend or a lawyer.  It probably isn’t your lender, real estate agent or title agent.

In this post, I explain the basics of residential mortgages and how they compare and contrast to loans in general.  I illustrate how monthly mortgage payments are calculated.  Probably most importantly, I identify a number of features of mortgages that could cause financial challenges if you don’t understand them or aren’t prepared for them.

A Mortgage is a Loan

A mortgage is a loan.  The key components of loans, described in this post, hold for mortgages.

Similarities

Mortgages have the following characteristics of loans:

  • You are a borrower and borrow money from a mortgage lender.
  • You make a down payment. The down payment is the amount that you pay towards the house at the time you buy it.
  • The principal is the amount you borrow. That is, it is the difference between the price of the house, including closing costs, and your down payment.
  • The loan has an interest rate. With each payment, you pay interest on the remaining principal.  The following factors can lower your interest rate:
    • Your down payment as a percentage of the purchase price is higher.
    • The term is shorter.
    • Your credit score is higher.
  • Your mortgage payment includes both principal and interest components.
  • Each mortgage has a term. The terms of most mortgages in the US are either 15 or 30 years.  In Canada, the payments are sometimes determined as if the loan has a 30-year term, but the actual term is only five years.  More about Canadian mortgages later.

Differences

The primary differences between loans generally and a mortgage are:

  • Mortgages tend to be much larger than most other personal loans.
  • Your residence acts as collateral for the loan. That is, if you don’t make your loan payments, the lender can foreclose on your home (take ownership of it).

Monthly Mortgage Payments

The three factors that influence the amount of your monthly payment are:

  • Initial principal (loan amount) – a lower initial principal leads to a lower payment.
  • interest rate – a lower interest rate leads to a lower payment.
  • Loan term – a longer term leads to a lower payment.

The table below compares the monthly payments on a $100,000 mortgage for interest rates ranging from 2% to 5% for 15- and 30-year terms.  These interest rates and terms are fairly typical these days.

term (years)interest rate
2%3%4%5%
15$644$691$740$791
30370422477537

 

As can be seen, moving from a 30-year mortgage at 2% to a 15-year mortgage with a 4% interest rate doubles your monthly payment ($370 vs. $740).

To give you some context for how high monthly payments can be, I took out my first mortgage in 1982.  The interest rate was 16.875% for 30 years.  On a $100,000 mortgage, my payment would have been $1,416.  The mortgage was even more onerous than that, as it had other features that I’ll discuss below.

FHA, VA, Traditional Residential Mortgages

In the US, there are three common ways in which residential mortgages are issued:

  • Insured by the Federal Housing Administration (FHA).
  • Insured by the Department of Veterans Affairs (VA).
  • Uninsured (known as conventional mortgages).

BankRate has a nice chart comparing the common provisions of these approaches.  You can obtain all three types of mortgages from a bank or mortgage broker.  From the lender’s perspective, the presence and type of insurance affect the riskiness of the mortgage.  If it is insured, the lender considers the mortgage much less risky and can offer a lower interest rate.

VA-insured mortgages (i.e., VA loans) tend to be the most flexible. They do not require a down payment or mortgage insurance.  The interest rate on VA loans does not depend on your credit score.  There is an upfront fee and you must be a veteran to qualify for a VA loan.

FHA-insured mortgages are slightly more flexible than conventional mortgages, especially if you have a somewhat low credit score and/or only a small down payment.  FHA loans require a down payment of at least 3.5% of the purchase price for people with credit scores above 580.  For people with credit scores between 500 and 580, the down payment must be at least 10% of the purchase price.

FHA-insured mortgages have an upfront fee to cover private mortgage insurance (discussed below), whereas most conventional mortgages do not.  FHA-insured and conventional mortgages can also have annual private mortgage insurance (PMI) fees, whereas there are no annual PMI fees for VA-insured mortgages, just an upfront charge.

Mortgage Broker vs. Mortgage Banker

The two most common ways to get a residential mortgage are to use a mortgage broker or to contact a mortgage banker directly.

A mortgage banker is an entity (often a local, regional or national bank) that issues mortgages.  That is, a mortgage banker uses its own funds when loaning you money.  The mortgage banker may borrow the funds from another lender or can sell your mortgage.  Nonetheless, when you borrow money for a mortgage, it is the mortgage banker who is providing the cash.

A mortgage broker is like an insurance agent.  The mortgage broker learns about your borrowing needs.  It then contacts a number of mortgage bankers to try to find you the best deal.

Briefly, the advantages of using a mortgage broker are that it can save you time and will likely provide access to more mortgage bankers than you can contact as an individual.  The disadvantages are that, as is the case whenever there is an intermediary, you may pay extra fees and the intermediaries’ interest may not align directly with yours.  Investopedia provides a more detailed summary of the pros and cons of using a mortgage broker.

A prudent strategy is to contact several mortgage bankers directly, as well as to work with a mortgage broker.  You can compare the offers and see which one best meets your needs.

Other Provisions

One of the most important things you can do before you sign your mortgage documents is to read and make sure you understand the entire contract.  One of the contributing factors to the lending crisis of 2008 was a lack of understanding by borrowers of the terms of their mortgages.  There are several features that could be present in your mortgage contract that could cause you issues down the road.  In this section, I’ll identify and explain several of them.

Balloon Payment

A balloon payment is a large payment for the remaining principal balance at the end of the term.  When there is a balloon payment, there two time periods of importance.  The first is the term of the loan.  It determines the date that the balloon payment is due.  The second is the period over which the initial principal is amortized.  It determines the monthly payment and how much principal is paid during the term.  When there is a balloon payment, the term is always shorter than the amortization period.

I’ll use a $100,000 mortgage with a 3% interest rate, a five-year term and a 30-year amortization period as an example.  The monthly payment on this mortgage is $422.  At the end of the five-year term, the remaining principal is $88,906.  If your mortgage had these terms, you would have to pay the bank for the remaining principal of $88,906 at the end of five years.  You could either take out another mortgage or pay the balance from your savings.

I am told that this type of mortgage is very common in Canada.  In fact, my daughter’s mortgage has a balloon payment at the end of five years.  The contract indicates that the bank will offer her another mortgage, but with an interest rate that reflects the then-current market interest rates and her then-current credit score.

If interest rates go up or her credit score goes down, her monthly payment could increase significantly.  If she takes out another 30-year mortgage and her interest rate doesn’t increase, her payments will go down because the initial principal will be lower ($88,906 vs $100,000 in the example).  However, if she repeats this process every five years with 30-year amortization periods indefinitely, she will never pay off the full amount of her mortgage!

Interest-Only Loans

The payments for some mortgages include only interest on the initial loan amount.  The monthly payment is equal to the annual interest rate times the principal divided by 12 (months in a year).  The principal never decreases on an interest-only mortgage, as there is no principal in the monthly payments.  Interest-only loans usually have a balloon payment after a fairly short period of time (say, five years).  The balloon payment is equal to the initial amount borrowed.

An advantage of an interest-only loan is that the payments are lower.  The disadvantage is that you still owe the same amount at the end of the term as at the beginning.

Pre-Payment Penalties

Some mortgages limit the timing and amounts of pre-payments.  If you make pre-payments at any time other than those allowed by the terms of the mortgage, you might have to pay a penalty.  As such, if you think you might want to re-pay your mortgage more quickly than the standard schedule, you’ll want to make sure that it doesn’t contain any pre-payment penalties or that you can work within their limits.

As an example, pre-payments on my daughter’s Canadian mortgage can be made only on regular payment dates and, in any 12-month period, cannot exceed 21% of her initial loan balance.  The pre-payment choices are a lump sum payment of 15% of the initial loan balance, a 15% increase in payments per calendar year and doubling of one or more payments during the calendar year.   She can use any or all of these options to pay the principal on her mortgage faster, but is limited to only these options.

Points Up Front

Points are a fee whose amount is determined as a percentage of the initial principal.  They are less common now than they were when I took out my first mortgage.  Nonetheless, you want to be alert for them.  In my case, I had to pay three points to the lender when my mortgage originated plus all of the other fees at closing.  On a $100,000 mortgage, three points is the equivalent of $3,000.  In addition, I paid the interest on the mortgage as part of my monthly payments.

Adjustable Rates

Some mortgages have adjustable interest rates.  Mortgages with fixed interest rates (fixed rate mortgages) are more common now than they were.  Adjustable-rate mortgages or ARMs were more popular when interest rates were high and changing rapidly.

My first mortgage, in addition to the three points, had an adjustable interest rate.  In my case, the interest rate was set at the beginning of each year and changed based on a benchmark rate.  There was a maximum amount by which the rate could change in one year and another cap on the total increase over the life of the mortgage.  When the interest rate changes, your monthly payment is recalculated based on the new interest rate and the remaining principal and term of the loan.

For more details and an actual example of an adjustable rate mortgage, I suggest taking a look at this post.  If you think interest rates are going to stay at their currently low levels for the entire time you plan to own your home, then the recommendation to using an adjustable rate mortgage is reasonable.  If, however, you plan to own your home for a long time or think interest rates will increase by more than a point or two from current levels any time soon, I disagree with the author’s recommendation.

Risks of Adjustable Rate Mortgages

In this currently very low interest rate environment, you want to be very careful about adjustable rate mortgages.  As an example, let’s say you borrowed $100,000 using a 30-year mortgage with a 3% initial interest rate.  As indicated above, your monthly payment will be $422.  If the interest rate increases to 4% in the second year, your payment increases to $485.  If it increases again in the third year to 5%, you will have an even higher monthly payment of $552 or 31% more than your initial monthly payment.

Canadian Mortgages

You face a similar, but not quite as dramatic, risk of monthly payment increases if you have a mortgage similar to my daughter’s in Canada.  Her payments wouldn’t go up as much at the end of five years for each point increase in the interest rate because the balance remaining at the end of the five-year term is amortized over a full 30-year term and not the remainder of the 30 years in the original term.  However, if I remember correctly, there is no cap on how much the interest rate can increase from one five-year period to the next.

Appraisal

Before a lender commits to a mortgage, it will almost always require an appraisal of the property.  The lender sets the interest rate on a loan based on its perception of the risk you won’t repay it.  The ratio of the amount of the loan to the appraised value (loan-to-value ratio) is part of the risk assessment.  The higher the loan-to-value ratio, the riskier the loan to the lender.  If the appraisal is less than your purchase price, you may need to either increase your down payment or renegotiate the purchase price.  That is, you will be required to bring the loan-to-value ratio in line with the lender’s initial terms.

Private Mortgage Insurance

Some lenders require private mortgage insurance (PMI) on certain residential mortgages.  If you have an FHA loan or your conventional loan has a ratio of down payment to your purchase price of less 20%, the lender will likely include a charge for PMI with your monthly payments.  There are ways to avoid this charge that you’ll want to research if you have a smaller down payment.

PMI is insurance that protects the lender in case you default on your loan.  You get the benefit that the lender is willing to give you a mortgage.  Other than that, you get no benefit from PMI even though you pay for it.  PMI often costs between 0.5% and 1% of the outstanding principal of your mortgage annually.  Once your loan-to-value ratio has increased enough, you can ask your lender to cancel this insurance.

Bundling of Expenses

Some lenders require that you bundle your property tax and homeowners insurance costs into your mortgage payment.  This bundling increases the lender’s confidence that these bills will be paid.  If you don’t purchase homeowners insurance and your home is damaged or destroyed, you are much less likely to re-pay your lender for the mortgage.  And, if you don’t pay your property tax bills, eventually the local authorities can foreclose on your property which could significantly diminish the value of the lender’s collateral.

The benefit of this bundling of expenses is that you don’t have to remember to make the separate payments for property taxes and insurance.  It can be particularly beneficial as both insurance and property taxes are often large bills that need to be paid only once or twice a year.  Many people find it easier to budget for those large expenses by paying them monthly.

The drawback of having your expenses bundled is that the lender often overestimates the amount of these expenses, so you pay more each month and get back the difference on a periodic basis.  It also makes it a bit more inconvenient if you want to change insurers.

Related Topics

If you are later in life or have parents who own their home, a reverse mortgage is a variation of a mortgage that might be an option.  Reverse mortgages can be very useful in the right situation but are often misunderstood leading to disastrous financial consequences.

Rental Property: Real Life Experiences

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Many people view residential rental property as a great investment.  I’ve never had any interestA charge for borrowing money, most often based on a percentage of the amount owed. More in committing the time I perceive is necessary.  I’ve also not made much money on 

Property and Casualty Insurance

Property and Casualty Insurance

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The Home Equity Fallacy

The Home Equity Fallacy

Building home equity can increase your financial security, but it isn’t necessarily the best way to maximize your net worth.  That is, building home equity quickly isn’t necessarily the right choice for everyone, not even those who have the financial wherewithal to do so.

I’ve frequently heard two statements relating to home ownership that hold true for some people, but I consider them to be fallacies when applied to everyone.

  1.  It is always better to own than rent.
  2.  If you own, you should pay off your mortgage as quickly as possible.

There are definitely people, including me, for whom one or both of these statements are true.  However, in the current mortgage interest rate environment, neither is true for people whose primary financial goal is to increase their net worth!

In this post, I’ll talk about the theory behind how rent is determined, provide a simple framework for comparing options for ownership and renting, and apply that framework under a number of different scenarios to see what happens to your net worth.

Your Priorities and Situation

Before digging into the analysis below, you’ll want to identify your priorities.  The analysis below assumes that your primary financial goal is to maximize your net worth.  It also assumes that you are indifferent between renting or owning from a lifestyle perspective. And, it assumes you have the ability to handle the risks of home ownership.  All of these considerations are discussed in more detail in this post.  You’ll need to consider the extent to which these assumptions apply to you before you use the findings below to inform your decisions.

In many situations, the analysis suggests that either renting or paying down your mortgage (i.e. building home equity) slowly will maximize your net worth.  However, many people, including me, prefer to have as large a home equity as possible.  Characteristics that might put you in the same category as me are that you are:

  • Living off your investments and a preference to eliminate a monthly mortgage payment from your cash expenses.
  • Averse to risk, leading you to not want to find that your investments have decreased in value at the same time you need to liquidate them to make mortgage payments.
  • Someone who likes the comfort of knowing that, in all but the most extreme scenarios, you have a place to live.
  • Planning to use the equity in your home as collateral for a reverse mortgage to finance retirement expenses.

Because I have all three of the characteristics, and because my first few home purchases happened when mortgage interest rates were between 9% and 17%, I paid off my mortgages as quickly as possible.  I also paid cash for my most recent two residences with the proceeds of the sales of their predecessors.

Finances Rent vs. Owning, in Theory

In theory, the economic cost of renting should be more than economic cost of owning.  First, the owner needs to make a profit to cover opportunity cost of owning the property.  Second, the owner is taking on risk from the uncertainty in their ability to find renters and the cost and timing of repair costs for which the owner needs to be compensated.

An important consideration, though is the difference between the economic costs of ownership vs. renting and the cash flows of both options.  Specifically, your down payment and the portion of mortgage payments that go towards principal are not part of the economic cost of owning your home.  The principal portion is a transfer from cash to equity in your home.  As such, from a cash perspective (as opposed to an economic perspective), you will often need to pay more in cash to cover the costs of home ownership than to pay rent.

The economic cost of the equity in your residence is the opportunity cost of not being able to invest it elsewhere.  This amount differs from the amount of your down payment and mortgage payments.  The value of your home may increase, so your opportunity cost is the difference between the return you would earn if you invested your money in a different asset, such as the stock market, and the appreciation in the value of your home.

Appreciation from Ownership

When I was young, most people assumed that the price of houses went up every year.  Reality has shown that not to be the case, both when looking at regional and local conditions and also when looking at US nationwide housing price changes.  The chart below shows the average price changes by year from 1988 to 2019, the length of the period available for the Case-Schiller US National Home Price Index on the Federal Reserve website.

Historical Housing Price Changes

As you can see, in most years, the price of houses went up.  However, in 1992 and from 2008 through 2012, the prices went down with the worst year, 2009, reporting a 12.6% decrease in home values.

Other Considerations

A comparison of the financial aspects of renting and owning also has to consider what you are willing to rent as compared to what you might buy.  The inferences above apply only if you are renting and buying the same residence.  If, on the other hand, you are willing to rent an apartment but are only willing to buy a house, the rental option can become much more attractive.  There are economies of scale gained from running an apartment complex that aren’t available to owners of single family homes.  Also, you might be willing to rent a residence that is smaller than one that you might buy.  Again, if that is the case, the rental option might be more attractive.

Rent vs. Own – Simple Illustration

To help you understand the finances of renting and owning your residence, I’ll start with a simple illustration.  In it, I compare three options:

  • Buy your residence
  • Rent the same residence
  • Rent a smaller property

Key Assumptions

Here are the key assumptions for the three options.

Buy Your Residence

I selected a 1,500 square foot house in Des Moines, Iowa for my illustration.  A typical house that size there has a current market value of about $240,000.  The countrywide annual average appreciation is 4% every year.  I have assumed that you pay 15% as a down payment and have a 30-year fixed-rate mortgage at 3%.

Utilities are assumed to be $200/month and property taxes and homeowner’s insurance total 1.5% of the market value each year.  In addition, I’ve included 2% per year for maintenance and repairs and 0.5% per year for updates.  These costs are assumed to increase with inflation at 3% per year.

I’ve assumed $1,000 of closing costs at both purchase and closing plus a 5% sales commission when you sell.  Last, I’ve assumed that you leave $10,000 in cash in an emergency fund at all times.

Rent the Same Property

The same house rents for about $1,400 a month, including utilities.  I’ve added renter’s insurance at $120 per year.  Both of these costs are assumed to increase at 3% a year for inflation.

Under this strategy, I assume that you invest the down payment plus emergency fund money at a 7% return per year.  The mortgage payments plus other costs of home ownership are more than rent and renters insurance, so I’ve assumed you also invest the difference at 7% per year.

Rent a Smaller Property

If, instead of a house, you choose to live in an 1,100 square foot apartment, your rent is only $1,100, including utilities, increasing with inflation.  As with the previous strategy, differences between the costs of home ownership and the cost of renting the smaller property are assumed to be invested at 7% per year.

Net Worth Comparison

This section contains a simple comparison of your net worth under the three options described above – own your home, rent a similar home or rent something smaller.  For this illustration, I’ve assumed you own your home for ten years.

Ownership Cash Flows

The chart below shows your annual cash flows using the assumptions above if you buy a home and sell it in ten years.

Ownership Cash Flows

The dark blue bar on the left is your down payment, buyers’ closing costs and the $10,000 of cash you set aside for an emergency fund.  The subsequent ten bars show your mortgage expense (orange), property taxes and homeowner’s insurance (gray), utilities (yellow) and maintenance, repairs and updates (light blue).

After ten years, under the simple assumptions, you can sell your home for $355,000.  From that, you pay 5% in real estate agent commissions and $1,000 in seller’s closing costs.  In addition, you don’t need the $10,000 in your emergency fund.  Thus, at the end of ten years, you get $346,000.  From that, you need to re-pay the remaining $150,000 of mortgage principal, so your net worth is $196,000.  Of that $196,000, $106,000 is from appreciation in the value of your home and $40,000 is from the principal portion of your mortgage payments.

Annual Cash Flow Comparison

The chart below compares the annual cash flows from the three options over the ten-year time period.

Buy vs Rent Cash Flow Comparison

The blue bars show the total of the cash flows in the previous chart from owning your home.  The yellow bars show your cash flows for renting the same home and the gray ones for renting a smaller residence.  These last two sets of bars include rent and renter’s insurance.  I note that the blue bars are taller than the yellow bars because they include your down payment and the principal portion of mortgage payments, both of which allow you to build equity in your home.

Net Worth Comparison

If you own your home, your net worth increases from the appreciation in the value of your residence.  Because you have borrowed some of the money to pay for your house, your percentage growth rate of your home equity is higher than the appreciation rate of the house itself.  This result is called leveraging, as you get the dollar value appreciation of your house while investing only a portion of it yourself.

If you don’t own your home, you can invest the difference between the cash flows represented by the blue bars and those represented by either the yellow or gray bars.  For this simple example, I’ll assume that you earn a 7% annual average return on your money by investing it in the stock market.  To further keep the example simple, I ignore income taxes.

The chart below compares your net worth under the three strategies at the end of ten years.  In the Buy Your Home option, your net worth is equal to your home equity after you sell.

Home Equity & Net Worth Comparison

In this illustration, you have a higher net worth if you buy your home than if you rent the same home. However, your net worth is much higher if you rent the smaller apartment than if you buy your home.

Rent vs. Own – More Realistic Illustration

In the simple illustration, I ignored risk.  All four of mortgage rates, inflation, home appreciation and stock market returns vary widely from year to year.  In the more realistic illustrations, I use the actual values of these economic variables for each period starting in 1987 and ending in 2019 to introduce volatility.  I’ve looked at this time period because 1987 is the oldest year for which I could find home appreciation values.  Had I used even older time periods, mortgage interest rates would have been outside the range of what is shown here, so the probabilities should not be considered representative of all possible results.

I show four sets of comparisons to increase the likelihood that one of them is close to your situation.  In the first comparison, I use the same assumptions as in the simple illustration other than the economic variables.  I increase your down payment from 15% to 50% and 100% of the purchase price in the second and third comparisons.  In the fourth comparison, I retain the 15% down payment assumption but change only the time period you own the home from ten years to two years.

10 Years; 15% Down

The box and whisker plot (described in this post in case you aren’t familiar with reading one) below compares the simulated values of your net worth (i.e., your home equity) after you sell your home if, under the Buy Home strategy, you own it for ten years and put 15% down.

Home Equity & Net Worth Comparison - 10 Years

Because I used ten years of inflation and stock market return data, the data used in the graph include 23 ten-year periods, those starting in each year from 1987 through 2009.  The boxes represent the range from the 25th percentile to the 75th percentile of your net worth under each strategy.  The line in the middle of the box is your average net worth.  The whiskers that stick out of the boxes range from the 5th to the 95th percentiles.

Using these assumptions, the range of ending net worth values from renting the apartment (gray box) are almost always higher than either of the other two strategies.  At the average (solid line in the middle of each box), you have a very slightly higher net worth if you buy your home (blue) than if you rent the same home (orange).  The range of your net worth is wider if you rent the house and has a higher upper end, due to the possibility of attaining high investment results.  Over a ten-year period, the average return on an investment in the S&P 500 is very rarely negative, so you never have a lower net worth from renting as compared to buying the same home based on this time period.

10 Years; 50% & 100% Down

The higher your down payment, and therefore the higher your equity in your home, the higher your net wroth from renting as compared to buying, as shown in the two charts below.

Home Equity & Net Worth Comparison - 10 Years

Home Equity & Net Worth Comparison - 10 Years

The higher ending net worth values when you rent in the comparisons with bigger down payments emanate from the larger amounts that you have available to invest.  That is, if you are comparing your net worth after renting to the option in which you pay for your house in one lump sum of $240,000, you have the full $240,000 available to invest for the entire ten years.  But, when your down payment was 15%, you had only $ $36,000 (15% of $240,000) to invest for the full period plus the amounts that you paid in principal each month.

2 Years; 15% Down

Another scenario in which your net worth will be higher from renting than from buying is if you plan to own your home for a very short period of time.  For illustration, the chart below compares your net worth if you own your home for only two years and put 15% down.

Home Equity & Net Worth Comparison - 2 Years

Your ending net worth is generally higher under the two rental options than the buy your home option.  However, the difference is not as clear as when you pay cash for your house.  There is much more volatility in stock market returns when looking at only two-year periods as compared to ten-year periods, so the range of results under both rental options (in which you are investing your extra cash) is much wider than in the ten-year scenarios.

Conclusion

These analysis show that, in many cases, your net worth will be higher if you rent than if you own.  However, as noted above, maximizing your net worth is not everyone’s priority when it comes to their residence.  As such, you’ll want to consider your priorities and preferences along with these findings in making your decision to buy or rent.

Flex or Fix in Buy vs. Rent

Flex or Fix in Buy vs. Rent

Your residence is likely one of your biggest expenses.  The most common options for residences are renting and purchasing.  There are costs and benefits to both approaches, some of which depend on your lifestyle and goals and some of which depend on your finances.  In