Category Archives: Mortgage

Mortgage myths

Mortgage myths

Following a good discussion on the topic of mortgage, I would like to share a few myths:

The first year the payment is almost all interest. Your friends and your brokers keep telling you that the first year you will be paying a high portion of interest on your loan. What does that mean? Actually nothing! Many people interpret this in the wrong way. They don’t want to refinance again because the payments for the first few years contain higher percentage of interests. Once you passed the first few years, your payment include more principle and less interests. If you refinanced again, your payment will contain higher portion of interests again, thus disadvantage.  Their reason is that they are paying a lot of interest payments, so it seems a waste to refinance again because they think all the interest payments they made did not count anything.

Well let me explain to you, there is no disadvantage for the first year. Why? The US government regulates the mortgage industry with clear disclosure, they can not cheat on you. If your APR is stated as 5%, then it is 5%. As long as you borrowed x amount money from your lender, you pay 5% on the x amount interests. You don’t pay more, you don’t pay less either, it is very fair. If you think you are paying a higher percent than this 5% for the first year, then you are wrong. It is against the law to charge more. So don’t explain to people that the first few years’ payments contain high interests, it does not help anyone, instead explain to people this: when you have x amount of borrowed money in your procession for one day, you need to pay interests on the x amount for that day based on APR, no more and no less.

Mortgage interest is tax deductible thus there is a higher equivalent return. The question asked is this: if you have x amount of money, would you pay down the mortgage with y percent interest or would you invest in a mutual fund with z percent gain? A lot of people would answer the question saying that mortgage interest is tax deductible, making complicated mathematical formulas. It is true that because the mortgage tax is deductible, even you pay y percent interests to mortgage company, you would will get some money back from IRS at the tax time. Thus people believe that if they invest their money instead, they should target a tax equivalent gain much higher than the mortgage interests rate so that it is fair comparison. Below we will demonstrate the tax equivalent gain theory is wrong in this situation. If we ignore the situation that the capital gain may put you to a higher tax bracket, then we should only compare whether y is greater or smaller than z without considering the tax factor.  That is: if z is greater than y, then you should invest in the mutual fund even if you have to pay the capital gains  tax on it.

Here is the math.

option 1: pay down x amount to your mortgage. The result is zero: result=0.

option 2: not pay down x amount at interest rate of y, invest the x amount to yield z percent.

result=-x*y+x*y*T1+x*z-x*z*T2

we explain each term below:

-x*y  =this is the interests you pay. It is negative because it is going out of your pocket

+x*y*T1=this is at the end of the year, you are getting the money from IRS. “T1” is ordinary income tax rate.

+x*z=this is the investment yield

-x*z*T2=this is the capital gain you have to pay IRS. T2 is either interests income or capital gain income tax rate.

Thus if y=z, and if T1=T2, then the result =0. If T1>T2, then result > 0.  This means when the y=z, it is always better to invest your money.

In summary:

1. if you mortgage rate is y, don’t think about tax equivalent issue when you are making your decision.

2. instead, simply compare the mortgage rate y with the investment gain z directly, if z is equal or greater than y, then don’t pay down your mortgage, invest the money to something else for z percent.

 

 

Money saving tips on home mortgage refinancing.

The steady downward trend in mortgage interest rates in recent years have undoubtedly presented many opportunities to lock in historically low rates. With the downward trend anticipated to continue for the foreseeable near future, there are bound to be more opportunities to refinance into a lower interest rate loan. This article offers a lesser known tip on how to profit from every drop in interest rate.

As any savvy borrower would know, refinancing into a like-kind mortgage product with lower interest rate can lower the monthly payment, but does not always translate into money saved over the lifetime of the new loan. The main reason is that the new loan will usually carry a longer term than the number of payments remaining on the original loan. This reset of payment schedule is what can drive the total cost for the new loan to be higher than the total payments remaining on the original loan!

If the objective is to reduce the monthly expense, then by all means, refinance into the new loan. However do so knowing that the monthly savings come at the expense of higher total cost.

If the monthly amount on the original loan is affordable, then there will always be money saved by refinancing into a lower interest rate loan and continue paying the same monthly amount as in the original loan. This strategy works if the new loan has no pre-payment penalties, no points, and no fees. By paying the same monthly as on the original loan, the additional amount is applied to the principle every month to effectively shorten the length of the new loan. There will always be money saved on this new loan when compared to the original loan. As an additional benefit, the new loan offers the option of paying the new lower monthly payment should the need ever arise. This would not be possible by staying with the original loan.

In conclusion, whenever the interest rate drops, refinancing to take advantage of the lower rate is always recommended as long as the new loan does not impose pre-payment penalties and has no points and no fees. The only downside may be the hassle involved during the loan application process. Whether it is to satisfy a need to reduce monthly expense or to save money over the lifetime of the loan, the benefit of refinancing to a lower interest rate will outweigh every bit of hassle.