Sunday, June 24, 2012

The Problem With a 30-Year Mortgage

The 30-year mortgage is a tacit admission that you will likely never own your home.

As I have noted in earlier posts, the 30-year mortgage is a relatively modern invention, not coming into being until after World War II.  Prior to that time, most mortgages were about as long as car loans were today, with "extended" 10- and 15-year notes coming into being only during the Great Depression.

As a result, houses were smaller, cheaper, and fewer people owned them.

Today, houses are larger, more ornate, more expensive, and still very few people actually own them.

When we were in the Real Estate business, the number bandied about by Real Estate Agents was that the average homeowner moved "every five years".   This may have been a bit of an aggressive number, but for some markets, such as Washington, DC, probably about accurate.   This link has an very excruciatingly detailed analysis that posits that the average is about 14 years, nationwide, but only 11 for first-time buyers.

What is clear from this data, however, is that very few people are staying in a home for 30 years and paying off their mortgages and then owning their homes, free and clear, in retirement.  And with the orgy of refinancing that went on in the 1990's and 2000's, many homeowners gave up entirely on the pretense of paying for a home, and just assumed mortgage debt was a permanent thing.

Is this good, bad, or value-neutral?   I think bad, for a number of reasons:
1.  Most folks end up paying more to "own" a home than they would to rent it.  Even in good markets, home prices are such that the cost to own often exceeds the cost of renting a comparable home.  Here on the Island, for example, to rent my house would cost about $1600 a month, plus utilities.   Cost to own, if financed over a 30-year mortgage, would be at least $2500 or more.

2.  The first 10 years of a mortgage are mostly interest payments.   When you sell your home at the 14 year mark, you make a banker very happy.  He collects all those mortgage payments as nearly pure profit and then gets nearly ALL the money he loaned you, back.   You paid down little, if anything, in terms of the balance.  The bankers make a lot of money, you never get ahead.

3.  When you sell your home after 10-15 years, you likely buy another house and get a new 30-year mortgage, re-setting the clock and starting all over again paying tons of interest payments.  After 30 years of owning a number of homes, you have paid a lot of interest, but not a lot of principle.  The banks have made a ton of money.  If you have any equity at all, it is from appreciation of the property.

4.  There is a temptation to refinance, particularly in the last two decades, as rates have dropped.  And each re-fi keeps resetting this 30-year clock, which is why many homeowners of our era adopted the mantra, "I'll never pay off my mortgage (hee-hee)!"

5.  Tied in with #4 is the temptation to take "money out" in a refinance to pay off other, higher-interest debts, but re-amoritze them over 30 years.  This eats up any appreciation gains the homeowner might have had.

6.  If property values decline, the entire things unwind in a hurry.  Suddenly, you are "upside-down" on a house, and it appears you will never be able to pay off the balance or be able to sell the home for the balance owed.  You are stuck "renting money" for however long it takes before you can sell the house for what is owed, or just throw in the towel to foreclosure.
Even if you don't do a cash-out re-fi or become a "serial refinancer" (as one young attorney gleefully described herself to me), you still end up paying a lot in interest, over time, if you move every five to fifteen years.   You never end up owning the home,  just renting the money to buy it, over time.

Why is this a bad thing?  Well, for starters, it means you are taking your income, and spending it in terms of cash-flow not in terms of cash.  So instead of owning anything, you are just making payments, perpetually, to be allowed to stay there.  It is like serially leasing cars - you stop paying, and you are walking.  You never end up owning anything or accumulating wealth - just dissipating it.

Why is that such a bad thing?  Well, eventually, you will stop making money - you will retire, or get laid off, or fired, or lose your job.   In this modern economy, you can count on that.  And signing up for 30-year obligations based on the idea that a "job" will pay for it, is kind of dumb, considering most "jobs" last about a decade, if that.

Again, this whole 30-year mortgage concept is not something cast in stone and handed down from Moses, but rather a modern invention, and like a lot of modern inventions (such as credit cards) we are only just now seeing what the down sides are.

To be sure, one reason so many people signed up for this deal was the dangling carrot of tax deductions.   We all felt we could lower our taxes if we borrowed money to buy a home.  But for the most part, the savings in taxes are dwarfed by the additional cost of interest.  You cannot deduct your way to wealth, period.

Does this mean you should never get a mortgage?  Don't be stupid.   For most folks, it is the only way they will be able to afford a house.   And at today's interest rates, money is cheap, if you can qualify for the loan.

But again, you need to stay in a house for five years just to break even.  If you are not planning on "settling down" for at least a decade, home ownership could be a wash.  It might be smarter to buy a smaller house, learn to live with less, and get a 15-year mortgage and end up owning your home outright.  Better to own a smaller home outright than to have paid interest for 15 years and hardly made a dent in the mini-mansion (and then lose it to foreclosure).

Not only that, but if you outgrow that house, you may be able to rent it out and have a cash-cow investment working for you, instead of a ball-and-chain around your neck.  I dunno, it worked for me - I made a ton of money renting out positive-cash-flow Real Estate (as opposed to negative-cash-flow speculation!).

I think the thing to bear in mind is that a mortgage is debt and not like a rent payment.  The goal should be to build equity over time, not merely add to the debt pile.   And stressing yourself financially, in order to be able to have fancy stuff, makes no sense at all.   When the shit hits the fan, you want to be able to survive the downturn.   Buy a less house than you can afford and only as much house as you need.  And avoid the temptation to throw money at a house in "improvements" and crap - they don't add much value to it - if any.

Taking on debt for a fancier place to live makes little sense.   On the other hand, that debt load could be put to good use on an investment property - and by that I don't mean a buy-and-flip house, but something that can be bought and rented out for more than you pay, each month.  And in the coming years, some bargains may appear on the horizon like this.   And when that happens, you want to be the guy who has cash-in-hand, or at least the ability to borrow.

And if that isn't your bag, well, use that money you would have spent on mortgage payments and granite counter-tops to fund your 401(k) and save for the future.  Accumulating wealth means not accumulating more and more debt.

When you sign the papers on a 30-year note and you think to yourself, "Gee, this seems like an onerous obligation!" you are not being "weird" but in fact, rational.   Many folks jump from house to house - going bigger and fancier as they make more money, convinced they can now "afford" a fancier house.  All they are doing is increasing their debt-load and decreasing their net worth - while at the same time, locking themselves into some high cash-flow requirements.

That is a choice, not an obligation.