Home Mortgages and Personal Liquidity

October 22, 2012 — 1 Comment

During the recent and ongoing financial crisis, home values fell precipitously. In many cases the drop was 30-40%. For a home that had been worth a half-million dollars, $150,000 to $200,000 of its value was erased. This was especially painful for people who had accelerated their payments by following a 20- or 15-year mortgage schedule. For them most, if not all, of their principal evaporated with the economy’s collapse.

When you prepay a mortgage, you are in essence making a decision about where to park discretionary money. For a $500,000 loan at 4% , the difference between a 15-year mortgage and a 30-year mortgage is about $16,000 per year. In other words, by choosing a 15-year mortgage over a 30-year mortgage, you are opting to park an additional $16,000 per year “in your home.”

The question is, what is the advantage to you of doing that? For a financial decision to be advantageous, it has to do at least one of the following:

• Improve the Growth of your money.
• Improve the Income from your money.
• Improve the Liquidity of your money.
• Improve the Tax treatment of your money.
• Improve the Security of your money.

Briefly, let’s address each of these with respect to the possibility of accelerating the amortization on a home.

1. The Growth in value of a home is independent of the equity in it. A home worth $500,000 will appreciate at the same rate whether it is fully leveraged or free and clear.
2. In our case, “Income” really refers to the interest rate of our home loan compared with what we could earn on the money in investments. In order for mortgage prepayment to give an income advantage, our investments would need to yield less than 4% on average for the duration of the loan, in this case 15 years.
3. In order to access home equity, which is what we mean by Liquidity, we have to either sell the asset or borrow against it. Clearly, there are “parking places” with more attractive liquidity features.
4. The Tax deductions of a 30-year mortgage are greater than those of a 15-year.
5. Knowing that home values can deteriorate quickly, and that equity is devoured if they do, do you have more Security if the discretionary principal is in a liquid account you control, or in the hands of the bank you borrowed from?

If nothing else, these considerations should give us ample reason to question the advisability of shortening our mortgage term.