ONE

DO NOT GAMBLE YOUR PRIMARY RESIDENCE

The first tip about buying a home is do not gamble your primary residence. Do not look at it as a way to make money, and do not do things that risk you losing it. Curiously, not gambling is one of the best ways to make money on your home, but that will become apparent as the process unfolds. Making money on your primary residence is distinctly not your primary goal. Your primary goal is to live in your home on your way to ownership.

If you are an investor, then you may invest in houses, or art, or cars, or whatever. But a home is not just a "house"—it is your primary residence. So we separate investments geared solely to make money, from the investment in your home as your primary residence. If you want to make money in real estate, then go into real estate. But "real estate" is not your home; your home is more dear to you.

TWO STEPS ARE BETTER THAN ONE

We are going to develop a plan on how to pay a mortgage the right way. And once we've done that, we'll see just how much periphery such as interest-only loans, adjustable rate mortgages (ARMs), second mortgages, and home equity loans (when used for anything other than home equity), are a gamble on your primary residence.

Let's compare three families. We are going to walk through 30 years of home ownership in a few paragraphs. We will first lay the ground work without inflation, appreciation, points, PMI (private mortgage insurance), and so forth, and only later bring these into play.

JACK AND JILL

Jack and Jill want to buy a house. They buy the biggest house they can afford, which means a commute, and a house on a hill in the idyllic country. The logic is that even if things are tight at the beginning, they will "grow into the payments (and the house)." Their earning potential is likely to increase over the coming years and so will their ability to comfortably service the loan. And if their family grows, they will have a house to match. Jack and Jill buy a $400,000 house on a 30 year loan at 6%.

DICK AND JANE

Dick and Jane also buy a home. They buy the smallest pad they can live in, in the richest neighborhood they can afford. Dick and Jane buy a $400,000 home on a 30 year loan at 6% in a grand neighborhood.


Both Jack and Jill and Dick and Jane have monthly payments of $2,398.20 (So how much do I pay each month?).

MILES AND HOLIDAY

Miles and Holiday buy a house. They buy a house that they can comfortably live in, in a modest neighborhood. Miles and Holiday buy a $200,000 house on a 15 year loan at 6%.

Miles and Holiday have monthly payments of $1,687.71.

The difference between Miles and Holiday's monthly payment and that of Jack and Jill, and Dick and Jane, is $710.49.

Obviously, Miles and Holiday have taken on the least debt—but there is no free lunch, after all, they've got the smaller size of Dick and Jane's place, in a neighborhood comparable to Jack and Jill's, for a payment that is "only" about 30% less.

SECOND STEP

After 15 years, Jack and Jill, and Dick and Jane, have each paid $315,871.76 in interest, plus $115,804.62 in principle. So half way through their loans they each still owe:

$400,000.00
original price
($115,804.62)
principal paid
$284,195.38
amount still owed

on their $400,000 houses. By year 15, Jack and Jill, and Dick and Jane, have paid nearly 80% of the original purchase price in interest alone, and still owe 71% as unpaid balance.

Miles and Holiday have, of course, paid off their house. They paid a total of $103,788.46 in interest (about 52% of the purchase price of $200,000). But they lived in a more modest house.

So after 15 years Miles and Holiday sell their house and buy a $500,000 house in an even swankier neighborhood. Miles and Holiday know that having the most expensive house in a neighborhood makes it harder to sell—so their first house is easier to sell than the house that Jack and Jill bought. For Miles and Holiday's second house they buy at a little less than the median price in a new neighborhood.

Miles and Holiday take the $200,000 equity from the house they own, minus about 8% for realtor and transaction fees ($16,000) and use the remaining $184,000 as a down payment. They then finance the remaining $316,000 ($500K - $184K = $316K) over 15 years at 6%. (Non-inflation-adjusted, that requires monthly payments of $2,666.59. But that's fifteen years down the road, and is equivalent to their current monthly payment assuming annual inflation of 3.1%; see Inflation and appreciation).

At the end of another 15 years, Jack and Jill, and Dick and Jane, and Miles and Holiday each own their own homes.

Jack and Jill paid $463,352.76 in interest for a $400,000 house for a total of $863,352.76. Dick and Jane paid the same amount. That's a lot of money to pay for a $400,000 house which is now at least 30 years old.

Miles and Holiday paid $163,985.76 in interest on their second loan of $316,000 for a total of $479,985.76. They now own a half-million dollar home. In all, Miles and Holiday paid $303,788.46 for their first house plus $479,985.76 for their second house for a total of $783,774.22. That's almost $80,000 less than J&J and D&J for a house that's worth $100,000 more, and possibly 15 years newer. Plus, in the 30 years that all families had mortgages, Miles and Holiday had many more stress-free years of having substantial home equity. Clearly, Miles and Holiday's decision to buy small, and finance multiple shorter loans, left them much better off in the long run. And for the first 15 years—when money is tight—even their monthly payment was lower.

Miles and Holiday used financial levers to avoid voluntary indentured servitude.

Everyone paid the same interest rate (6%). Interest was calculated the same "fair" way for everyone—simply pay interest each month on what you owe. No funny stuff. Everyone made mortgage payments for the same 30 years. But Miles and Holiday got a lot more for a lot less via a safer route (more home equity, acquired quicker, for longer periods of time).

The key is in observing that the less you pay each month, the more you approach the interest-only state of indentured servitude. Unfortunately, this is exactly what minimum payments on a 30 year loan does to you.

When buying a house, it is common to figure the largest amount we can afford each month (thereby immediately jeopardizing Tip Number One), on the biggest house we can get on that monthly payment. By stretching out the number of payments, we can borrow more. So quickly people agree to 30 year mortgages—and of course the lenders are all too happy to oblige. Since folks are max-ed out, they cannot make extra payments and have little wriggle room if something happens such as losing a job or incurring high medical expenses.

FIGURE ON THE SHORTEST TERM

What is closer to our better long term interest is to figure our budget based on the shortest loan term that still allows us to afford the house we need.

If we took a $200,000 loan at 6% interest for a hypothetical one year loan, the total interest for the entire year would be $6,559.43. That's quite reasonable for access to $200,000—nearly a quarter million dollars. Six percent of $200K is $12,000—but you would not pay that; you would pay just over half that because on a one-year loan you are paying down the principal very rapidly each month. Indeed, the monthly payments are $17,213.29. Of course, for a mortgage that's crazy—so obviously a one year mortgage is not going to work.

But the point is clear: 6% is cheap if you can keep the period short. Extend the period close to eternity, and you pay an infinite amount, no matter how low the interest rate.

So let's go to the other extreme. The longest mortgage you can get is about 40 years. To borrow $200,000 over 40 years at 6% you will pay $1,100.43 per month—only about $99 less per month than a 30 year mortgage. But you will pay $328,205.09 in interest alone (about 164% of the purchase price of the house); or about $96,528 more than a 30 year loan. Inflation may substantially dampen the real effect on your pocket book, but make no mistake, long term mortgages, even at historically low interest rates, are expensive.

Long term loans are so "long" that they are almost interest-only at the beginning. That is not good for you.

There are many ways to optimize the ideal length of a loan based on many criteria. There is no one magic formula. But there are a few good rules of thumb that are easy to implement.


Next: Two