Forget White or Blue. How About a Green Christmas?

Hello again!  For those who may have missed the inaugural post to this blog, one of the primary reasons I’m taking the time to write about various finance related topics is because people ask me financial questions all the time (which I love, by the way) so it occurred to me it may be beneficial if I start typing out responses to the questions I get most, or the areas I see people struggle in most.

I mention this because there may be some topics I cover that you find less interesting or you’re already quite knowledgeable in.  Either way, please consider forwarding this blog to other friends or family as there is a good chance there may be some resources they may benefit from.  The web address to send them (or to bookmark for yourself) is www.thelowdownreport.blogspot.com.  Please also consider “following” my blog.  I still don’t know what that means, but I suspect it means you’ll be aware of new posts as I put them up??  Also, the first person to read this post will be my 300th visitor!  

Alright, now back to business.  Part 2 of The Great Debt Debate will focus on what is called (excuse the jargon) deductible debt.  This means, for a majority of us, the interest we pay on this debt is deductible when we file our yearly taxes.  In short, if you qualify for the deduction you’ll receive back about $0.15 for every $1 you pay in interest.  Not a bad deal!  Deductible debt consists primarily of mortgage loans on your primary or secondary home, government sponsored student loans, and home equity lines of credit (HELOC).

My goal here is not to tell you how mortgages work, or where best to get a mortgage, or even how much of a mortgage you should consider taking (relative to your income, etc., which I will likely cover another time), but instead to focus on how best to manage the largest debt you’ll probably ever have, some pitfalls to watch for, and to challenge some conventional wisdom by suggesting that it rarely ever makes sense to have a 30 yr fixed mortgage.  I’ll also look at student loans and some best practices in managing them.

One thing everyone can agree on is that lower mortgage rates are better than higher mortgage rates.  For some, lower rates allow them to buy a bigger home than they would normally consider.  For others, lower rates simply mean they will have extra cash to put into savings each month.  Guess which view I take?  Lower rates mean lower monthly payments.  BUT, there are some other important things to consider when financing, or re-financing, your home. 

Interest-Only vs. Principal and Interest

The decision to pay down principal on your home is an important decision.  Should you pay principal?  Well, it depends.  Part of the decision is whether or not you are a disciplined saver.  Having an interest-only mortgage ONLY makes sense if you save the principal you would other wise be paying to the mortgage company.  Interest-only mortgages should not be used just to buy a bigger house.  This can be very dangerous.  I have paid $0 toward the principal of our home(s) in the last 10 years.  If you’re like most, your house value has decreased in the last few years.  By paying down principal, you are putting money into an investment that is decreasing in value.  Your $100 principal payment two years ago may only be worth $80 now.  By only paying the interest and putting the would-be principal payment into a savings account, your $100 savings deposit two years ago would be worth around $104 today.  This can be a big difference over time. 

Even in a more “normal” environment where home prices are increasing, there is still a tremendous benefit to only paying the interest.  Being disciplined by saving your would-be principal payment can mean thousands of dollars built up in a savings account over time.  If you ever move, and as you’ll read in a bit, you will several times in your life, you will have that extra cash in your hand ready for a down payment instead of locked up in your home and unusable until your home sells. 

I cannot stress enough – doing this requires discipline.  It would be VERY easy to just spend the money you should put into savings.  This will be a challenge for most.

The 30 Year Mortgage Myth

It’s what your parents did.  It’s what your friends do.  It’s the rate most quoted in ads, commercials, by banks, etc.  It might be one of the worst financial decisions you can make.  The 30 year fixed rate mortgage is the most widely used product in the lending community, therefore, it’s the most widely held mortgage among consumers.  On some levels, it makes sense.  It’s the easiest to understand, it provides an affordable payment, and it’s nice knowing that after 30 years of payments your house is paid off.  The reality is much different. 

The studies I’ve read, many by the Federal Reserve, suggest that the average person moves to a different home every 6-8 years.  There are very few people who stay in the same home for 30 years or more.  I, for example, have lived in 5 different homes in the last 10 years.  It would make more sense, then, to look at financing your home closer to the amount of time you’re likely to live in it.  The reasons are many.  The average 30 year mortgage rate today is around 5.10% (check local listings).  The average 5/1 ARM rate is 3.15%.  (What’s a 5/1 ARM you say?  It’s simply a 30 year loan, amortized over 30 years, that offers a fixed rate for the first 5 years.  After 5 years it becomes a variable rate.)

The savings are significant.  On a $200,000 home, you’ll pay about $4,000 less in interest each year (or $333 per month).  That’s $20,000 less interest over the 5 year period.  More importantly, that can be $20,000 in your savings account.  Plus, if you’re average, you may not live in your home more than 5 years.  There are also 7/1 ARMs available. 

The savings are so significant that Alan Greenspan, the prior Fed president, commissioned a study to research whether 30 year mortgages should be discontinued because they can be so financially disadvantageous to consumers.  My research also shows that interest rates tend to run in 5-7 year cycles, so if you found yourself staying in your home longer than 5-7 years, you’ll likely have a good opportunity to re-finance before your 5/1 ARM would change to a variable rate. 

This won’t be the best choice for everyone.  Like most financial things, one size does not fit all.  Some may still benefit from a traditional 30 year mortgage, but if you spend the time and do that math in context of what your future living plans might be, you may be surprised at what you find.  There are other considerations to make that I won’t discuss here (future income potential, credit scores, age, etc.)

Wow, I feel like there is a lot I didn’t cover, but this post is getting lengthy.  What are your thoughts?  I know I have a couple of Loan Officers who read this blog.  Am I crazy?  Disagree with me?  Please share.  I’ve got a lot of material and spreadsheets to help analyze the best way to manage your mortgage, so if you have questions, please feel free to ask me privately or publicly.  These are just my thoughts and opinions, so take them as such!  Next time.....CAR LOANS.

Until we meet again…