Your Mortgage—A Hidden Source of Savings
A long time ago a famous business leader said: "...An organization or an individual will spend all the money he or she thinks he has..." He then continued, "therefore in order to have any savings you need to disguise savings as necessary expenses".
His observation of human nature is that since one is going to spend ALL the money he thinks he has (not even what he actually has, but what he THINKS he has—even worse) then, let's figure out a way to disguise savings as necessary expenses.
The end result would be the same. Meaning all money is spent, nothing is left, but the difference when we apply his system, is that some of it converts to savings.
This may not be your case. It may be that you are in total control of your finances and don't have any problems saving, however for most people, it is a constant give and take.
How can a mortgage fulfill the above and be a source of savings?
First, a mortgage is a necessary expense that once you assume, it is very hard to get rid off. You need to either sell the property or pay it off. Both take time, effort and money (closing costs, commissions, etc...)
Second, a mortgage generates three sources of savings for you:
With every payment, a portion of the debt is reduced. Every time the amount of money you owe goes down, you own more of your home and therefore the amount of "equity" which means the money left to you if you sold, increases.
The mortgage generates a tax deduction. I will provide an example below.
The mortgage is a big percentage of an asset. For example, if you buy an $850,000 home with 10% down, it means your mortgage would have a starting balance of $765,000.
This means someone else (your Mortgage Lender) is lending you $765,000 that you did not have to come up with, and now you control an asset worth $850,000.
In the long run, home values tend to at least keep pace with inflation.
If inflation is 3%, this means you are likely to have a home which went up in value by 3%:
$850,000 x 0.03 = $25,500
Notice that you got the 3% on the WHOLE $850,000 including the Loan Amount!
In practice, as of this writing, homes have increased in value a lot more.
This is an example; this example covers the first 15 years of a loan amounting to $750,000 at 6.250% which is more less today's rate.
Take Year 1:
Your principal went down by $8,788 and your tax deduction was about $11,190 for the year.
This mortgage example represents a payment of $4,618 per month.
But economically, you are getting:
$732 back in principal reduction ($8,788 / 12)
$932 in tax deductions ($11,190 / 12)
a total of $1,664 per month
That means that in economic terms your mortgage is costing you:
$4,618 - $1,664 = $2,953 per month.
Question to you, are you already saving $732 every month?
Maybe you are, but most people are not.
So in essence, all your money is gone, but you managed to save $732 dollars.
This is when I get attacked by Financial Planners that would say (and they would be correct):
"But Alejandro, the client had to spend $46,626 dollars in interest just to save $8,788? that's a bad deal!"
Yes, it is "bad" deal from a purely numbers point of view, but it is human nature.
What I have seen, over and over, is that most people who have a home or a property, on the whole, tend to be better off than people who rent.
One more observation, food for though: is your rent about $3,000 per month? Rent buys you 30 days—that's it. You don't save anything, you don't control an asset, you don't get inflation protection and in most cases you don't get a tax deduction either.
The gist of it is, rule of thumb: if you are paying in rent about $3,000/m you might consider buying a $850,000 property—I'll help you get there.
Take Year 10:
Principal went down by $15,401 and you still have your tax deduction of $9,603.
You might say, "but Alejandro, by year 10 the money would be worth a lot less!" and my reply would be:
Yes and that is why making a payment of $4,618 per month would feel a lot lighter and your home would then be worth:
$850,000 + 3% over 10 years = $1,142,329.
I am being conservative, homes today have increased a lot more than that.
Summary:
As time goes by, your fixed payment would be less and less significant to you. The amount would be the same but inflation will erode its value.
You are still saving all along even though you have no money left at the end of the month.
Your asset, the property, continues to go up in value even though you are not necessarily working at it besides taking care that your home does not deteriorate.
Is this a perfect model to save money? No, there are other models that are better but as far as effectiveness is concerned, I have yet to find a better model that takes into account real life human nature.
