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The rule of thumb is you should not spend more than 25% of your take home pay on your mortgage. Spending more than this would most likely cause you to be house poor and unable to pay off other debts or invest for the future.
Of course, some bank might be willing to lend you way more than they should. But I’d recommend that you don’t take them up on their offer. During the last housing crisis, too many people took out overly burdensome mortgages.
So which type of mortgage is best?
There are three type of main mortgages available these days.
I dislike this one the most. This mortgage acts just like it sounds. The first 5-10 years of the mortgage (depending on the specific mortgage) only pays for the interest on the loan. In that time, you do not pay down the mortgage principal at all.
I knew someone who chose an interest-only mortgage. It was a 40-year mortgage. The first 10 years were interest-only, and the remaining 30 years were fixed. This was during the height of the housing bubble.
It was as though he was renting his home, while getting the tax benefits. But his hope was that the house’s value wouldn’t go down. That’s because if the home’s value dropped, he would owe more on the house if he chose to sell it in the future.
On top of that, after the 10 years, he would need to refinance the home because he wasn’t able to initially cover the principal payment, hence why he selected an interest-only mortgage.
This is akin to gambling, and that’s why I advise people to steer clear.
Adjustable Rate Mortgage (ARM)
This one acts just like it sounds as well. Over the period of the loan, the interest rate that you pay on the house fluctuates based on the market interest rates. Typically, there is a lock-in period of a few of years, usually 3, 5 or 10 years. These mortgages are also normally lower initially than a 30-year fixed, but there is a chance that the market will rise. If you read the fine print, most of the time, rates are capped at 1% increase initially, but they can increase each year by 1% after that.
In a falling interest rate environment, such as that of the late 2000s, this is a great mortgage. The problem is the market’s future is unknown. There is always the risk of rising interest rates, like those of the early to mid 2000s. At that point, interest rates rose and people were unable to pay for their homes.
Right now, the difference between a 30-year fixed and a 5/1 ARM (a fixed 5-year rate and then adjustable rates every year after that) is 0.25%. This hardly seems worth it, unless you know that you will be moving out of your house before the adjustable rates occur, or if you anticipate lower market interest rates.
Fixed-Rate Mortgages (FRM)
Finally, this is the most favorable mortgage, in my opinion. The most popular options for this type of mortgage are either the 15-year fixed or the 30-year fixed mortgages. The difference in interest rate payment is 0.75%. That may not seem very large, but over the life of the loan, it makes a huge difference.
Let’s say that you took out a mortgage for $300,000 with a 30-year mortgage at a 4% interest rate. Over the duration of the loan, you would end up paying over $515,000. That means that you would pay almost $215,000 in interest alone. That first year alone, since it’s amortized, you would pay almost $12,000 in interest but only $5,000 in principal.
In contrast, that same $300,000 mortgage over 15 years at 3.25% would result in paying a total of $380,000 on the loan. That is almost 1/3 less in interest than that of the 30-year mortgage. On top of that, you would pay down almost $16,000 in principal and $9,000 in interest in the first year of the loan.
These numbers may seem like they don’t add up. In the 30-year mortgage scenario, you would only pay $17,000 the first year, while in the 15-year mortgage scenario, you would pay $25,000. Yes, the 15-year mortgage is more expensive.
But in the long run, think about how much money you could potentially save. In the case above, you would save almost $135,000 by choosing the 15-year mortgage.
Some financial gurus advocate for the 30-year mortgage over the 15-year because you could invest the $8,000 (savings from the first year) into the stock market each year.
If you are a disciplined investor, yes this could be beneficial, as the $8,000 that you save each year could grow over the 30 years into almost $1,000,000. In contrast, with a 15-year mortgage, you wouldn’t have excess funds to invest during those 15 years. But then afterwards, you could invest almost $25,000 each year for the following 15 years to yield almost $700,000. The difference is $300,000. When you factor in the extra interest paid on the 30-year mortgage, the difference drops down to $165,000, that you would come out ahead with a 30-year.
Here is the most important question: Are you disciplined enough to invest the difference in order to maximize the benefits?
I’d be remiss if I didn’t talk about the tax deduction available with mortgage interest paid on your schedule A. Each year, you are able to deduct the mortgage interest up $1,000,000. So depending on your tax rate, you could utilize tax deductions to further come out ahead.
Some of my readers may be slightly confused at this point. I just basically proved why a 30-year mortgage could actually be beneficial. So why did I ignore this math and pay off my mortgage early anyway?
You may think I would have been able to achieve FIRE sooner if I hadn’t paid off my mortgage so quickly. I actually conducted the analysis and found that if I had invested the money into the S&P 500 instead of paying off the mortgage, that the difference would have only been 0.1%. The 2000s were a lost decade for the stock market, so I was fortunate that paying off my mortgage didn’t hurt me more from an investment standpoint.
So while I was fortunate to pay off the mortgage during a down period in the stock market, I’m still grateful for the flexibility that my wife and I received by paying off our mortgage.
Because we were able to pay off our mortgage early, my wife’s income wasn’t essential in order to pay our bills. She is able to serve as caregiver to her special needs sister full-time, as we experience greater financial freedom without a mortgage.
While my peers were having fun, I spent most of my 20s working hard and trying to get ahead. It was a grind. But I believe hard work pays off. I would take hard assignments at work in hopes that all my work would translate into a bigger paycheck.
But, while I was working harder, I was not working smarter. The assignments were terrible, and I was miserable. I had no time to take vacations and was running ragged.
When I finally paid off the mortgage, my wife and I planned a trip to Europe. I had always dreamed of visiting Norway, the birthplace of my great grandparents. It was definitely one of the most memorable trips that I had ever taken. Afterwards, I thought to myself, why didn’t I do this before now?
Changing Things Up
When I returned, I purposed to seek out jobs that aligned with my passions and to focus less on climbing the ladder.
You know what the crazy part was? I have received more promotions post-mortgage and that I did while I was working my tail off to pay off my mortgage. Being able to follow my passions has increased my productivity and value at work to the point where I am now managing multiple teams within my organization.
While I may have been able to accumulate a bit more wealth if I hadn’t eradicated my mortgage, I know I would not be as happy. Paying off my mortgage granted me an invaluable peace of mind. And at the end of the day, I value my happiness over the amount of money in my bank account.