Home Mortgage Advice

A Mortgage is a pledge of real property as security for the payment of a debt. To manage it properly lets analyze it using our 3 basic Financial Therapy tools; your Life Plan, your Budget and your Balance Sheet. When you want to buy a home you do not have the money to buy it cash or you would not be reading this article.

You borrow it. In return for the loan you sign an agreement to pay the lender back their money plus interest on a set schedule. You also agree that whoever lends you the money has the right to take owner ship of the property and can sell it to settle the debt should you not meet your payment obligations. This tool has been around for thousands of years so it does work well if managed properly.

Life Plan Table

The amortization period for most mortgages is 25 years. That means that buying a house and taking on a mortgage will be an entry in your Financial Goals row in the long term goals column. Leading up to this you will have the medium and short term goals of saving up for a down payment and to cover purchasing and moving costs. By paying these up front you compound your savings by not paying interest on these costs for 25 years.

Your Budget

In a standard planning budget, 30% to 33% of your income is allocated to paying for housing. You can figure out what that works out to in dollars per month and then figure out how much total value of a mortgage you can afford. You add that to the amount saved for a down payment and that is what you can afford to pay for a house. If you cannot buy a house with that amount do not be panicked into buying one. If you are making an average family income and it takes more than 33% of your budget to buy a house, then don’t. There is something wrong with the housing market. Similarly, the sub prime scandal has taught us that if it takes some financial magic to make it affordable to your budget you are buying a financial time bomb, not a house and a mortgage.

In the long term, the one thing that is constant is the price that you paid for your house. Interest rates can change and the cash draw to service your mortgage each month can change if you do not peg the interest rate that you are paying. Be very careful of the potential that interest rates can raise. If you start your mortgage at 5% interest but it is variable or may be changed in 3, 5 or 10 years, you need to know that interest rates could be in the double digits at that time (10% or more). This would result in your mortgage payment doubling or tripling just like the sub prime mortgages. In 5 or 10 years hopefully your career will take off and you will be making more money. You may be able to afford this. If you are careful and your payments stay the same, you will have more money for the other elements of your life plan. It makes them more affordable because the draw on your cash flow may be much lower than 33% of your income. This leaves more money for living or savings.

Your Balance Sheet

A mortgage is a liability. On your balance sheet it is offset on the Asset side by your ownership of your house and the value of that house. Home equity is what you have after you subtract the total debt left on the mortgage from what you would realize after all the bills are paid should you sell your house. Home equity adds to your net worth.

Typically when you first buy a house you have very low home equity. The long term plan is that you pay off the debt one payment at a time. At the beginning most of the payment goes to interest and you chip away at the principal a few dollars at a time. Every time you make a payment you pay a little less interest and a little more on the principal. It can be very tedious but that is why you review your Life Plan Table regularly. The financial power in a mortgage is like reverse compound interest. Like compound interest, the power in this tool is delivered to you in an ever increasing amount over time. You must give it time and lots of time to work. It is not fancy and its magic takes time. Recent follies like the sub prime mess are illustrations that to stray from this plodding pace on a mortgage does not work. Stick with the program.

Through your life transitions you build your equity in your home by paying off the balance of the mortgage. When you get 15 and 20 years into a mortgage you are paying more off of the balance than you are paying in interest each month. That money becomes increased equity in your home and you add a substantial amount to your net worth each and every month. In most markets, property values increase over time. When they say the price of home went up by 3% this year that is 3% more than last year. So property values compound. This means that while you are building equity by paying down your mortgage, your equity is building because the value of your property is increasing. And this is at a compounded rate. This increases your net worth directly every time property values increase. If property values decrease, your net worth drops by that amount. However, drops tend to be short term and anomalies. If you used wise judgment when you bought the house and had a long term plan and mortgage you should be able to weather such a financial storm. Stick with the program.

Conclusion

When you see your mortgage through to the last payment you own your house. You own this asset outright!!! The housing market can go up or down and it does not matter to you. Should you wish to trade your house for a similar house you can trade a house for a house. It is trading apples for apples. The numbers on your balance sheet may go up or down but there is only an asset on your balance sheet. There is no liability on your balance sheet and there is no cash draw on your budget for housing. That frees up 30% of your income.

This sets you up for retirement. If your house is paid for, you need to make only 70% or what you are making before it is paid for to retire. You save 30% of monthly costs just by retiring. You pay less taxes, less for gas, less for insurance, less for lunches and it all ads up. Contrary to what most Financial planners will tell you, you only need 40% of your income to survive in retirement. If you have this set up, your home equity is a great safety net for other expenses or for creating new income. You can downsize your house. In retirement you don’t need a big family house. You take the equity and buy a smaller house. You have cash left over which you can invest in income producing investments. You still have the equity in your smaller home that you can use later by using a reverse mortgage or a secured line of credit.

Managing your mortgage is one of the most important tools in the toolbox for building long term financial security. KISS…”Keep it Simple Stupid. Pay off your mortgage over time. Use it to protect your cash flow and build equity that you can use later to make your retirement comfortable.