The real price of your home
February 26th, 2007 by Remon
It’s funny, people buy a house for say $150,000, they sell it ten years later for $200,000 and think they made a profit. Let me tell you, you most like didn’t make a dime! You probably even lost money on the deal.
Most people have a mortgage without IO (Interest only) option. This is fine if you want to be 100% sure you pay off the loan in 30 years, but there are other cheaper ways to pay off your home, although they come with a litte risk.
The interest on mortgages is tax deductible, I live in Holland and the average John Doe here is in the 42% income tax bracket. This basically means that 42% of the paid interest is tax deductible. In the USA the interest on your first or second home mortgage is tax deductible as well.
Let’s make a simple calculation: Let’s say you buy a house for $150,000 with a 30 year mortgage at 6%. We’ll make two calculations, the first is the regular mortgage where everyting is paid off after 30 years. The other calculation is an 80% interest only mortgage, where only 20% of your house is paid off after 30 years. Don’t worry about the other 80% though, we’ll up the $150,000 mortgage to $175,000 and use the extra $25,000 to put in mutual funds.
Example 1: Regular mortgage.
Start balance: $150,000
Monthly payment: $899.33
Payments: 360 (30 years)
Gross total loan cost: $323,757.28
Net total loan cost: $250,779.22 (42% tax bracket)
Wow, you paid around $100,000 extra for your house. It would be even more if you’re in a lower tax bracket. Let’s go to the interest only mortgage.
Example 2: Interest only mortgage
Start balance: $175,000
Interest only: 80% ($140,000)
Payments: 360 (30 years)
Gross total loan cost: $327,543.37
Net total loan cost: $204.675.15 (42% tax bracket)
Interesting, the mortgage is $25,000 more but the net cost is over $70,000 less. However, after 30 years we still have $140,000 to pay off. Let’s see what happens if we put the extra $25,000 in 1 or more mutual funds.
Mutual fund example:
Start balance: $25,000
Yearly growth: 7,2% (average over 30 years)
Management Fee: 1.4% (yearly)
Monthy deposits: zero!
End balance: $141,837.82 (30 years)
Not bad, and 7.2% yearly is very doable. I aim for 13-15% yearly and even that is not very hard to attain. Interested to see what happens at 8% or even at 10%?
At 8% a year your end balance would be $180,088.92. That’s $40,000 more then you need to pay off your mortgage. At 10% a year, your end balance would be $326,906.68, what can I say? You can buy an extra house with that!
Conclusion:
It can pay to have an interest only option on your mortgage if you know how to make good use of it and dare to take a little risk. If you are someone who needs securities in life, don’t do it. Go for a regular mortgage and overpay for your house. It’s worth it. If you’re willing to take a small risk this may be something for you. Keep in mind though that your house is not an asset as long as you live in it, it’s a liablity and should be treated like that. Have a backup plan in case your mutual funds don’t grow enough, or even loose money.
I’ve attached the excel file for you to use. The first sheet is for calculating the mortgage, the second sheet is for calculating the mutual fund growth.
If you want to link to it please link to this page instead of linking to the file directly.