Home Mortgages - Getting the house you want without the debt you don't

My wife and I bought our first house straight out of college. We did plenty of research and felt we were ready for our first mortgage. Looking back, we did a lot of things right. We also missed some information that would have helped us save money. Hopefully this will provide some of this missed information in time for you to use it.

Finding the right house and mortgage can be a true balancing act.  Not everyone has your best interests in mind.
Finding the right house and mortgage can be a true balancing act. Not everyone has your best interests in mind.

Bias Information:

One of the best pieces of advice I received, while looking for a home, came from my father. He told me to, "remember, the goal of all lenders and realtors is to take your money."  While this may be a little pessimistic, it is basically true.  This explains why the lender (bank) pre-approved us for a loan of $280K on a single $50K per year income.  Sure, it may have been possible, but sure sounded a little over-reaching to our budget.  The realtor, throughout the process, kept telling us the market was good so buy as much house as we could afford.  This was to take advantage of the rapidly rising market values in the newer homes.  If some of this is sounding familiar, pay attention.  These are biased lines designed to make them the most money.  After all, the lender makes money on the interest and origination fees and the realtor is looking at their 3-5% cut as well.

The Healthy Debt Myth:

I expect all of us have heard this at one point or another. We were informed of this several times while looking for our first house. It goes something like this. "A home mortgage is healthy debt and it is a great way to lower your tax burden." In actuality, this is a myth; although it may be better termed a half-truth. A mortgage is a healthy debt only in that it is tied to an asset. Typically, one can pay off the debt by selling the asset. There are the exceptions to this, such as a depreciating market, but generally this is true. This differs from a loan for a car, for example, since the car is continually losing value as soon as you buy it. You will almost never be able to sell a car for more than you owe unless it is almost paid off.

The second part of this myth deals with taxes. Yes, the interest paid on a home mortgage is deductible on federal taxes. This is very nice for those of us who have decided to enter home ownership. However, taking out a larger loan, or buying a larger house for the tax break is never a good idea. Why? Simple, you never save more than you spend in interest. Lets look at a quick calculation:

  • Interest payments: $5,000
  • Tax Bracket: 25%
  • Tax Savings: 25% x $5,000 = $1,250
  • Net Loss: $3,750

So, according to the numbers above, you gave the bank $5,000 and save $1,250 on your taxes. That is a net loss of $3,750. This does not sound like a great deal to me. It is nice if you were going to spend the $5K anyway, but not strictly for the savings. This simply means that you should not let the amount of the tax deduction influence what you spend on a new home. As common sense would tell us, a larger home mortgage is not helpful.

By limiting the mortgage term to 10 years you minimize the compounding effect of the interest.  You pay the bank less and get more house.
By limiting the mortgage term to 10 years you minimize the compounding effect of the interest. You pay the bank less and get more house.

Compounding Against You:

You may have heard how compounding interest works for you in the stock market or even life insurance. Most banks and advisers are quick to point out how it can help you make money. Most are not as honest on how it makes THEM money. The truth is that compounding works against you when buying a house. Unfortunately, most of us do not pay attention to this and the effect it has. Lets look at an example:

  • Loan Amount: $150K
  • Interest Rate: 6%
  • Loan Term: 30 year
  • Interest Paid: $174K
  • Total Amount Paid: $324K

In effect, you are paying more than twice the value of the house! Wouldn't it be nice if there was a way to buy the more expensive house without paying the premium caused by compounding? Well, there is. It just takes some patience and possibly a little sacrifice. This is how it works.

Patience Pays:

As with your high school physics class, there have been a few assumptions here to simplify things. They don't change the concept, they just mean the numbers are not 100% correct. The major assumption is that the rate of inflation will equal the rate of appreciation. We won't worry about adjusting for inflation or the change in market value. The second is a steady income. In real life I would hope you are earning more in 20 years then you are now. Again, for simplicity we will not be changing the total house payment. It is also important to note that these values are principle and interest only. If you are doing your own calculations be sure to add in your escrow to your monthly amount. With that out of the way, lets look at the numbers. Jim and Susan are looking at a house with the following mortgage:

  • Loan Amount: $250K
  • Interest Rate: 6%
  • Loan Term: 30 years
  • Monthly Payment: $1,500
  • Total Interest: $290K
  • Total Amount Paid: $540K

When all is said and done, Jim and Susan will have paid a total of $540K for their house over the 30 years. This is exactly what most individual do. The idea of a "starter home" has all but left our vocabulary. We tend to expect to graduate from college, get a job and buy the perfect house. Lets look at what happens when Susan wises up and explains how a three step purchase (three successive mortgages) can get them more for less.

Sequential Mortgage Approach

First House and Mortgage
Second House and Mortgage
Third House and Mortgage
House Value: $135K
House Value: $270K
House Value: $405K
Loan Amount: $135K
Loan Amount: $135K
Loan Amount: $135K
Interest Rate: 6%
Interest Rate: 6%
Interest Rate: 6%
Loan Term: 10 years
Loan Term: 10 years
Loan Term: 10 years
Monthly Payment: $1,500
Monthly Payment: $1,500
Monthly Payment: $1,500
Total Interest: $45K
Total Interest: $90K (both loans)
Total Interest: $135K (all loans)
Total Amount Paid: $180K
Total Amount Paid: $360K
Total Amount Paid: $540K
Your first house does not have to be your dream home.  Taking some time will allow you to buy your dream home much cheaper.
Your first house does not have to be your dream home. Taking some time will allow you to buy your dream home much cheaper.

In this scenario, Jim and Susan could have had the same $250K (or $270K) house paid for in 20 years and only spent a total of $360K. That is a savings of 180 thousand dollars! Had they decided they needed a larger house, at year 20 they could have moved to a $405K house and at the end of 30 years still would not have paid more than the $540K. That is $155K more house for the exact same price over the same period of time. There are a lot of what-ifs that can be brought up here such as interest rates changing between loans, increased income which would allow for a higher payment, and the above mentioned inflation and change in market value. Most of these what-ifs will actually improve the value of the tiered mortgage approach. In general, you will always be ahead with sequential mortgages; taking some time to buy that perfect house.

You may be saying that this is all fine and good, but you are well into your 30 year loan and don't feel like starting over. In that case I would say you are doing no worse then most of us. However, you could always pass this on to your children or friends and family to help them understand how to get the house they want without the debt they don't.

Comments 1 comment

prasetio30 profile image

prasetio30 7 years ago from malang-indonesia

thanks for sharing with us. I get a lot of tips and information from this hub. I think all of us have to read this. It useful for us who getting new house without the debt.

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