Mortgages 101: What You Need to Know

THIS POST MAY CONTAIN AFFILIATE LINKS. PLEASE READ MY DISCLOSURE FOR MORE INFO.

 

mortgageThe 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.

 

Interest-Only Mortgage

mortgageI 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)

paper millionaire mortgageThis 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.

 

Comparison Example

interest ratesLet’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.

 

Alternative Strategies

sp500 mortgageSome 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?

 

Tax Deductions

tenant mortgageI’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?

 

My Case

portfolio mortgageYou 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.

 

Working Hard

roller coaster mortgageWhile 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

mortgageWhen 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.

 

Does this make you reconsider paying down your mortgage early?  What is your opinion on maintaining a mortgage while diligently investing a set amount every year?

Mustard Seed Money

Welcome to the website. A mustard seed is a very small seed but astonishingly grows very large over time. My hope is that through your financial journey that your small investment in time, money and faith will grow beyond anything that you could ever imagine.



72 Comments

  1. I’m always fascinated by your mortgage payoff story since it’s exactly what Mr. FAF and I are trying to do.

    Your post is so timely since it’s the home buying season. It will be a while before we will buy our second house, but we’ll try to stay away from PMI and probably ARM as well. Fixed mortgage is the way to go for us! 😀

    • Thanks for stopping by Ms. FAF!!! I’m glad that you enjoyed the article. Each week I’m unsure what I’m going to write about so it’s always up in the air if other people will find it interesting or not 🙂 I honestly didn’t even think of mortgage season although I probably shouldn’t admit that!!!

    • Thanks for sharing Brad!!! That would definitely be a tough pill to swallow bringing cash to the table in order to sell my home. Like you I hope to not have a mortgage again 🙂

    • Thanks for sharing Matt!!! I believe today that I heard San Fran was currently slowing down and that it didn’t bode well for the rest of the country. I’m not sure the exact correlation but I am definitely a little scared of the market.

    • Surprisingly, I’m not super against these as the financial Realtor. I’m finding in my market younger families and/or first-time home buyers just simply can’t afford a home. It’s sad because by having the mortgage their monthly “rent” WITH escrow would be $200-400 cheaper per month. But they have to continue to rent because of no down payment. 1% down and these equity sharing programs are allowing more buyers into the market who, if not for outrageous rental prices, could afford a home.
      Cash Flow Celt recently posted…How Tulips Broke the Market: A Case StudyMy Profile

      • Thanks for sharing Cash Flow Celt!!! That’s crazy how expensive some of these rental markets are becoming compared to those that buy. Seems like there may be a correction in the rental market coming. I know I read it’s happening in SF.

  2. We bounce back and forth on paying off our mortgage. Since we have 15 year mortgage we have kind of decided that is a decent compromise. I really like the 15 year especially for first time home buyers because they are probably going to move in a few years. With a 15 year you end up with about 3 times the equity in the home when it is time to sell.

    Are you planning to pay cash for your next house?
    Grant @ Life Prep Couple recently posted…Never Finance: Always Pay Cash For CarsMy Profile

  3. The 25% rule is such a great guideline, not matter what path you choose it will help prevent from going in over your head on your biggest payment each month.
    Brian recently posted…Time of Your LifeMy Profile

    • Thanks for sharing Brian!!! I definitely agree 25% is the way to go. I’ve found when you go too much above that, that’s when you start to get in trouble.

  4. Interest-only and ARM mortgages always bothered me because of the uncertainty. Yes, its a great way to pay very little and invest the difference, but the market isn’t a sure thing either, so I never had much confidence in that strategy.

    I love the fixed rate mortgages because I am locking in futures expenses at today’s rate; while my income will continue to rise. I passed on a 15-year because it was just more expensive on a monthly basis for me, so I signed up for bi-weekly mortgage payments.

    With the bi-weekly, my cash flow was better aligned with my company’s payroll cycle and wasn’t wiping out one paycheck on the 1st of the month, leaving me to starve until the next payroll. The extra payment per year helps reduce the loan faster causing you to pay less interest. I never really felt the pain of the additional mortgage payment.
    Church recently posted…Death & Finances: Managing Both Duty and EmotionMy Profile

  5. Having seen and heard the horror stories, we never even considered another mortgage other than the 30-year when we bought our first home in 2011. We scrimped and saved for the down payment, I paid off my student loans, and my wife’s ring.

    With our current home, we really want to pay off the mortgage. Sometimes we go back and forth though because we don’t love the HOA where we are. So, we may end up moving again at some point. That said, we spoke with some agents and an appraiser — and the home already went up in value. Awesome!

    • It’s always a positive sign when homes are going up. It always makes me feel better about my purchase 🙂 Even though we’d like to move, we still tried to pay off our mortgage. We wanted that flexibility in the future and it definitely is something that we’d do again 🙂

  6. We have only had fixed mortgages. I don’t like to gamble on the variable rates. We did refinance once which didn’t work out so great since we moved a year later. However I did work for the institution that the loan came from so I saved some fees. Softened the blow somewhat. I do envision paying down the principal more aggressively in there near future here.
    Mr Defined Sight recently posted…The Importance Of Financial TeamworkMy Profile

    • Thanks for sharing Mr. Defined Sight!!! That stinks that you had to move but sounds like it wasn’t as bad as it could have been. Those refinancing fees are definitely expensive 🙂

  7. Good article; the best part about a 30 year mortgage is you can pay it off in 15 years if you just pay extra principal every month! I understand 15 years might give you lower rates, but I think the flexibility is worth the <.50% difference in interest rates.

    • Thanks for sharing Bailey!!! I can definitely understand wanting the flexibility 🙂 . Having the 15 for me was advantageous b/c I know I would have slacked but if you have the discipline it can definitely work.

  8. A nice compromise between a 30-year and 15-year mortgage is to use a 30-year mortgage, but make extra payments. We used this strategy and were able to pay ours off in 8 years.

    As you said, one needs discipline when the payments are not automatically deducted. But it’s comforting to have the flexibility of falling back to the lower, minimum 30-year payment if money becomes tight in a given month.
    Dr. Curious recently posted…Enter the Void: A Sensory Deprivation ExperienceMy Profile

  9. During the housing crash, adjustable rate mortgages got a bad rap. For .25% difference it’s not worth it but at one point it was about 1%. I would have gone with an adjustable rate mortgage if I could go back in time. Being that I knew we would likely have to move to a bigger place at some point with a growing family (we’re in a 850 sq ft co-op which we converted to a 2 bedroom and the 2nd room is tiny), we could have gotten a 5 or 7 year fixed rate. Even when it adjusts I think it has to go up incrementally, it’s not like it’ll shoot up to 10% or something crazy like that. Plus with the economic environment, I don’t see that happening anyway.

    • Thanks for sharing Andrew!!! It’s definitely not nearly as big as it once was. Personally I like knowing my payment will always be the same but can understand especially in the past why an ARM was advantageous 🙂

  10. We paid off our mortgage in 30 months (Jan 2010 to June 2012). Not sure how we did it but we are glad our condo is paid off. Now we focus on savings and funding 2 college kids’ tuition.

  11. I elected to go with the ARM because it saved us 1.25%. I’ve been investing the difference plus some and if the mortgage interest ever gets out of hand, I’ll just pay the thing off. We’ll see how the strategy plays out in a few years.
    Tom @ HIP
    High Income Parents recently posted…What Financial Health Means to MeMy Profile

    • Thanks for sharing Tom!!! That’s quite the savings of 1.25%. Much better than the current rates. Sounds like you got a great deal. I’ll definitely be following along to see how it works for you 🙂

  12. Interesting that you did better professionally after you paid off the mortgage.

    Like you, I’ve paid it off (finally, in early 2016) and I’m enjoying the lower stress level of being entirely debt free. Because of that, I can focus on financial independence in 3 years. Yeah!

    We ended up doing a “stepped” pay off strategy (not as a plan, but it just worked out that way). We started with a 30 year mortgage in 1993, moved to a 20 in 1999, then a 15 (after paying for remodeling) in 2006, then a 10 in 2009 (after rates really dropped). We paid the last of it off early in 2016 and we’re done!

    If I had to make a recommendation, I’d go with a 30 year, and work to pay it off early. I would also follow the “Millionaire Next Door” 2X rule (2 times my pay is the maximum mortgage) as this allows funds for other things. Note that the bank will typically give you 4X to 5X your pay.

    Kevin@39months

  13. Woah, that interest-only mortgage sounds scary.

    I think the banks like adjustable-rate mortgage because it protects themselves from changes in interest rates in the market.

    However, the fixed rate is good for borrowers because they get to lock in a rate regardless of how interest rates change in the market.

    I would definitely check out a fixed rate mortgage if I need to go for one.

    Thanks for sharing!
    Cory @ Growing Dollars from Cents recently posted…How To Customize A WordPress Website For BeginnersMy Profile

    • Thanks for sharing Cory!!! I can definitely see why banks would entice you to get an ARM. It definitely works out to their advantage in a rising interest environment.

  14. I’d much rather pay off the mortgage. Done is done. You don’t have to think about it, check in on it, worry about it, etc. it’s gone. Less stress and more “peace of mind.” I’m all for that!

    • Paying off the mortgage was definitely one of the best things that I ever did. Definitely have a huge peace of mind knowing that I don’t have to make that payment anymore 🙂

  15. I suppose in keeping up with the accounting tradition of maintaining a “Balance”, I have both a mortgage and investment plan to contribute to on a regular basis. I don’t want to miss out on investing opportunities at this age by paying off early. I think that would probably stress me out. However, I do plan to pay my mortgage off early, but not anytime soon. I say do whatever decreases stress and increases peace of mind 🙂
    SMM recently posted…Rich & Famous People with Smart & Dumb Money HabitsMy Profile

    • Thanks for stopping by SMM!!! Like I always say that’s the great thing about finance, it’s personal for a reason. What makes sense for one person doesn’t for another 🙂

  16. I have a 5/1 arm and I’m pretty happy I got it. Yes, it is gambling, but over the first 5 years, I will be saving about $30k vs. if I didn’t refinance into it in the first place! If I can pay down my PMI, I can get there even faster!

    Also, in 4 years, maybe I’ll have a family and will want to move or refinance into an investment property. The savings on ARMs are well worth it.
    Erik @ The Mastermind Within recently posted…My Life and The Role of AmbitionMy Profile

    • Thanks for sharing Erik!!! It definitely sounds like you have a plan in place, which obviously doesn’t surprise me 🙂 . Love reading your stuff and how it works out for you 🙂

  17. It’s funny how contentious mortgages are in the FIRE community! I’m definitively in the early payoff camp, for sure. I want to have as few bills and as few variables possible during retirement, and that includes a mortgage. I just like the added security. I know many people count a house as an asset, but I consider it a liability until we’ve paid it off and own it outright.
    Mrs. Picky Pincher recently posted…A Day Without MakeupMy Profile

    • I’m with you. I am definitely not viewing my house as an asset until I can sell it and have something else to live in that doesn’t cost me any money. Otherwise it’s a liability that I have to pay 🙂

  18. When it comes to managing your money, I truly believe that taking the route that allows you to sleep at night will serve you best. Regardless of that the optimal math model tells you. Even if the number for certain methods comes out ahead, burn if there is the added stress and unhappiness in your life, what is the price on that? Who can quantify and put a number on happiness?

    All in all, your financial success comes down to your discipline to stick to what you have planned to put yourself in a better financial situation. For me, I love good debt and I am not afraid to borrow to invest.
    Leo T. Ly @ isaved5k.com recently posted…Who’s The Real Leo T. Ly?My Profile

    • Thanks for sharing like always Leo!!! Great insight and I couldn’t agree more. Whatever helps you sleep at night is definitely the right financial decision for you 🙂

  19. Great article. We have a 30 year mortgage with a fairly low balance. We put a lot down on our house as a safety net. We wanted to make sure that if either myself or my husband stopped working for some reason, that one of our salaries alone could carry the house and the tax bill. With that being said, we are taking some of the extra income each month and investing it in high quality dividend stocks. Going forward our plan is to reduce some of the extra income going towards investing and reallocate it to paying down the mortgage.
    Courtney @ Your Average Dough recently posted…4 Reasons You Should Take a VacationMy Profile

    • Thanks for sharing Courtney!!! Sounds like you have a great plan in place and that it makes a ton of sense for you and your family. Plus getting quality dividends to pay in perpetuity is definitely a great way to spend some of your money 🙂

  20. We found our sweet spot somewhere in the middle, not extreme on either side. We pay down our mortgage aggressively when I can’t find better options for investment. Currently, we are finding less and less attractive things to do with our capital, so we pay down the mortgage. Opportunity costs for sure.

    • Thanks for stopping by Turning Point Money!!! Sounds like you found the right mix and I can’t blame you. It’s pretty frothy out there in the stock market. I don’t see a ton of stuff I like either 🙂

  21. I always feel like I come here with a question on my mind and you’ve just published a post about that specific topic. I’ll be honest, I never considered a 30-year mortgage to be a good thing because I never took into account the extra money that could be invested in the stock market.

    I’m actually more like you. My wife and I will probably have a child within the next couple of years, and my wife plans on being a stay at home mom. If something were to happen to me, I’d want as much of the house paid off as possible. The peace of mind that comes from that and freedom from debt is more than worth it for me.
    Matt @ Profitable Matters recently posted…Online Surveys: Lucrative Side Hustle Or Waste of Time?My Profile

    • Thanks for sharing Matt!!! I’m glad that the article was helpful and being able to have the flexibility in the future is definitely one of the best perks to paying off your mortgage early. We are definitely happy with that decision 🙂

  22. How do i know how much extra to pay toward paying down the principle with our monthly mortgage? Do we call our bank and ask them: how much extra do we pay monthly to pay off the house in the next 7 yrs. For example?

    • I use to add an extra payment to my mortgage and explicitly said this extra money is going towards principal. Make sure they don’t apply it to interest 🙂 I’m sure you can also contact them to ask as well .

  23. I like what Church said – the ARM sounds too unpredictable. When we were mortgage shopping I completely ignored ARM but now I think (especially on a smaller mortgage) ARM might not be a horrible idea. Had I do it over, I would have done what High Income Parent said since we can just pay it off. No regrets though! Our interest rate is 3.75% which is still great though! Thanks Mr. MSM!
    Lily He-Prudhomme recently posted…What Financial Health Means to Me {Contest Essay}My Profile

  24. Great post. 25% is a good limit to set on a mortgage. It is even better if you can go even lower. You made a great point about not listening to bankers about how much you can actually borrow. They are just salespeople. You also provided some great options for balancing your mortgage and funding investments.
    Dave recently posted…The Vanguard Star FundMy Profile

    • I definitely agree the lower you can make your % the better. Watching some much of my paycheck go towards the mortgage was very painful at times. Definitely glad those days are behind me 🙂

  25. I think your last line says it all. Life is unpredictable and yes paying off a mortgage is probably more emotional than rational, but I’m glad it’s done. That said, we had a variable interest loan, which is probably the most common type in Australia. Interest rates did go up to around 9% in 2007 before crashing down, but it wasn’t much of an issue as the bank used a 10% interest rate to determine how much they’d lend. That said, some or all of the loan could be fixed at any point

    • Thanks for sharing Eliza!!! I definitely can’t imagine paying 9% interest rates, especially since I have been engrained to think 5% is high. So funny to see the difference in our two countries 🙂

  26. This is a great breakdown! I’ll definitely be sharing it with my readers.

    Most people don’t realize all of the different nuances of mortgages. It gets complicated!

  27. I actually disagree with your conclusion on the ARM’s. I think for a savvy financial consumer, they make a lot of sense – especially when you start getting to $300k+ mortgages. You know what your payment is going to be – even if it’s variable.

    You have a fixed period, say five years where you’re paying usually a discounted promotional rate (sometimes just the margin). After that, you know your rate will ALWAYS be index plus margin. Nearly every ARM I’ve ever seen has had two year adjustment rates with a fixed cap of 2% per adjustment. So just calculate your payment based on a worst case scenario. Bankrate.com has all kinds of calculators for it.

    If you had gotten an ARM anytime in the last ten years, you would be thanking yourself for it. Consider the average home is only lived in for seven years, we call that a win!

    A lot of the issue with the ARM’s came into play with people being qualified for a home they couldn’t afford. They could afford the promotional rate but not the actual prevailing rate so after their fixed period, they lost the ability to pay for the home. That’s not the products fault. That’s the fault of the consumer and the lender.
    Cash Flow Celt recently posted…How Tulips Broke the Market: A Case StudyMy Profile

    • Thanks for sharing!!! I have heard of a ton of people that have utilized ARMs and gotten great benefits out of it. On the other hand I have had some people get burned by ARMs as well. For savvy investors I definitely think an ARM can be a great tool, although it’s a tool that can get you in a ton trouble with if you’re not careful. Sounds like you know how to use it correctly!!!

  28. We’re thinking through this right now, and especially the alternative strategy. I have little doubt we have the discipline to invest, but it would still be nice to have more equity built in the home simply so that we have flexibility if a job changed or we had to move. The best thing about renting is the flexibility. Selling a home would make us much more inflexible as far as huge changes. However, we’re looking at living in a market where home prices are increasing constantly and rental prices are *even* higher, which shocked me. So who knows…
    Finances with Purpose recently posted…Happy Fourth of July! (And Some Gratitude Practice!)My Profile

    • Thanks for sharing Finances with Purpose!!! It’s definitely a weird market depending on where you live. Seems like this bull market is running out of teeth so we shall see…

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