Wednesday, May 11, 2005


All Things Financial - A Personal Finance Blog

My friend, JLP, at All Things Financial has raised the important issue about the best financing for ones home. Financing a home is one of the most important financial decisions the average American makes. Unfortunately, many consumers miss the most important consideration.

Anyone who has run a business knows that profits are not critical to survival but cash flow is. The typical family needs to think in terms of cash flow, not in terms of profits or cost. A home is an illiquid investment. The transaction costs to sell a home are more than 6% and the transaction costs to refinance a home average more than 2%. During tough times, selling a home or refinancing a home can be a challenge. Those who pay off early are all the more likely to incur extra financing costs in the long-run.

Buying a home has been and will continue to be one of the better investments most Americans will make. If one borrows money to buy a home at 5.5% interest, the after tax costs to own the home are probably less than the long term-appreciation. Homeowners often discover that they have lived in a house "rent free". The equity in ones home is often a significant part of ones net worth. My recommendation is that most folks should buy all the house they can afford when they are young.

My wife and I bought a 3 bedroom house the year after we graduated from college, three years before the birth of our first daughter. We bought all we could buy and the payments were very steep. That monthly payment of $300.90 was a bear. When we sold the house for a $135,000 profit, the last payment of $300.90 was peanuts. The rent on the house the last year would have been $1,200 per month. The last year we lived in the house, we saved about $800 per month plus the capital appreciation.

Many financial advisors recommend 15 year mortgages or they suggest one should make extra payments whenever possible. This is short sighted and risky. I can best illustrate with an example.

Buyer A borrows $200,000 to buy a house. The mortgage lender, who earns a fee every time someone refinances or takes out a new mortgage, tells the buyer to take a 15 year loan to save .25% interest. The buyer agrees. His payment is $1,607.97 per month and in 15 years he owns the home free and clear. He has reached his prime earnings years and has no interest expense to deduct.

Buyer B borrows $200,000 at 5.5% interest for thirty years. His monthly payments are $1,135.74 per month. Most of this payment is tax deductible. After paying fifteen years, he still owes a balance of $138,991.51. However, he takes the difference between the payments, $472.23 per month and invest it the average big stock. At the end of 15 years, he has $214,694.65 in his investment account. The account is growing at the average rate of $1,968 (tax advantaged and tax deferred) and his house payment is still $1,135.74 per month much of which is tax deductible.

Suddenly, Buyer A and Buyer B both lose their jobs. Buyer A has no job and no money but he owns his house free and clear. The reason these guys lost their jobs is because the economy is in a deep recession. Buyer A can sell his house to raise money for his family but the market is lousy. Buyer B has no job and still owes $138,991.51 against his house and has a $1,135.74 payment to make. However, he has an investment account of $214,694.65. Buyer B decides his family should stay put until work can be found. Buyer B has many options. He might start a business or simply hunker down and live off unemployment insurance and savings until the worst is over.

Heaven forbid that things get worse and Buyer A and B have to file bankruptcy. Buyer A gets to keep his house as does buyer B. However, if Buyer B's account is invested in an IRA or other retirement account, he gets to keep that too!

The layoff, could have come at anytime earlier and, in every case, buyer B would have been in the best shape to withstand tough times. Along the way, either buyer might have had a reason to refinance. Hopefully not because refinancing costs money. At the end of 15 years, assuming 4% price appreciation, each house that had an original value of $240,000 is now worth $440,000. Which buyer would have a higher credit score, the one with $214,694.65 in investments or the one without liquid assets?


credit report said...

thanks for the info