Thinking Mortgages in 2021? Think Twice

2021 has started with many norms being pushed to unexpected levels, one of which is the Homeownership Rate. Not only are millennials flooding into Tesla, Bitcoin, and all other momentum assets, but many find Real Estate to be the next necessity! As people dive into this dynamic industry, have they taken time to understand the different types of mortgages available?

With 30-year fixed rates hoovering below 3.00% who wouldn’t want to finance their next home? Plus, did anyone mention the tax benefit of a mortgage? Check out the graph below!

As expected, homeowners are flooding the market at an astounding rate, which seems counterintuitive as the narrative usually highlights the inept financial literacy of majority of Americans. However, homeownership rates are rebounding near ’04 levels due to a variety of reasons. According to a report presented by Housing Wire, “Zillow predicts 6.8 million existing home sales in 2021, the most recorded in a single calendar year since 2005 and a 21.1% increase from 2020.”[1]

With that in mind, logic would say that one should put 20% down on a home and pay off the rest of the mortgage with a 30 year, fixed-rate mortgage. With current rates at 3.00%, people can put the rest of their money into the stock market and earn so much more, right? Not quite.

Before you begin, check out the Most Affordable Housing Markets of 2020, HERE!

Think about this for a second: are mortgage lenders operating in their best interest or yours?

The answer is clear: NOT YOURS.

Mortgage Calculator at Face Value

A simple search of “Mortgage Calculators” yields, a simple, all-encompassing mortgage calculating tool. Based on Bank Rate’s default mortgage variables, one can assume their, and many others’, perception of the financial profile for a typical American searching in the real estate market, as highlighted below.

Bank Rate assumes the “typical” American will put seek a 30 year, fixed-rate mortgage with 20% down. For those unfamiliar, if a buyer is unable to provide 20% upfront, they will incur a Private Mortgage Insurance (PMI) fee. Therefore, if Bank Rate assumes the potential buyer will put 20% down, their estimated monthly payment will be less, and, ultimately, the size of the mortgage they provide will be smaller.

Also, it is interesting that mortgage lenders assume the typical American will put 20% down on a house when only 41% of Americans would be able to cover a $1,000 emergency with savings.[2] With that being said, there are unlimited government programs to support individuals seeking homeownership whether they can put 20% down or 0%.

Lastly, Bank Rate uses an effective property tax rate of 1.86%. There is nothing wrong with this assumption, but the effective property taxes differs SIGNIFICANTLY across states and counties. For example, in Hawaii, the average property taxes rate is 0.3% of the home value, where as in New Jersey the average property taxes rate is 2.21%.[3] Although it may seem small, manipulating a variable by 2% on an asset worth $312,000 will increase the monthly payment by $495!

So, how do these mortgage variables manipulate one’s perception of the size of mortgage they can incur?

The simulators that mortgage lenders create maximize the cost of real estate an individual can buy and, ultimately the size of the loan they will incur from the lender. Mortgage lenders will not make as much money on small interest loans, i.e. 3.00%, as they would on a loan with a rate over 10.00%. Instead, lenders maximize their profit buy issuing a large quantity of loans.

How do mortgage lenders issue a large quantity of loans?

By creating the illusion that anyone can enter the real estate market in a healthy way.

Understanding Amortization Schedules

For those who have never taken the time to analyze an amortization spreadsheet that depicts the breakdown of each monthly payment by principal and interest, it is astonishing how much interest is paid versus principal in the early payments of a 30 year loan.

Using the same assumptions in the mortgage calculator above, 30 year fixed-rate of 2.86%, here is a breakdown of the payments during the first three years:

Note, the interest payment exceeds the principal payment for the first five years of the mortgage! The Lendee is paying the lender more in interest than they are paying themselves in equity…

Additionally at the end of the mortgage, the total interest paid is $122,485.73! The commas are not incorrectly placed…

The total interest paid over the term of the loan is nearly half the loan amount!

The Power of the 15 Year Mortgage

Now, using the same mortgage amount, $249,600, with a 15 year fixed-rate mortgage of, 2.36% (Market rate on 02/01/2021), the difference between principal payments and interest payments are drastic.

In the first month, look at how much money is going to the equity of your property over interest to the bank! Granted, the monthly payments are $614.34 more, there is a much more efficient use of one’s capital. As expected, the total interest payments over the life of the mortgage are significantly less using the 15 year structure.

With a 30 year mortgage, the lendee will pay 2.6x more in interest over the life of the loan! The majority of the payments are not going to your equity,. To whom is all of the interest going? TO THE BANK.

Incase the above charts are not illustrative enough, take a look at the graph below:

Difference in Interest Payments

The interest payments over the life of a 30 year, fixed-rate mortgage starts with a much larger sum and tapers off at a significantly slower rate than the 15 year mortgage. Americans have been convinced that the opportunity cost is greater with interest rates so low to opt for a 30 year mortgage. However, a 15 year, fixed-rate mortgage has a lower rate than a 30 year and saves a huge portion of money from going to the lenders.

If you think Bank Rate is the only resource utilizing these manipulating practices, here’s what a simple search on Ally Bank yields:

Again, notice the same variables are manipulated to create the perception that anyone can enter the housing market for property that is most likely too expensive for the potential buyers.

Opportunity Cost

For the vast majority of Americans, the opportunity cost of incurring a 30 year, fixed-rate mortgage so the remaining money can be invested into the market is not a prudent decision. The risk-reward does not make sense to assume a brokerage account will grow at a rate greater than the potential equity build up from a 15 year, fixed-rate mortgage.

Additionally, CNBC suggests Americans utilize a 30 year, fixed-rate structure and make additional payments every month. However, if you’re ever in such a bind where you need to revert from your monthly payments on a 15 year, fixed rate structure, you’ve bought too expensive of a house.[4]

As Americans continue to pour into the real estate market, hopefully they take into the implications of a 30 year, fixed-rate mortgage versus a 15 year and, ultimately, who benefits most from the monthly payments (hint: it’s not the hard-working American).

In fact, starting in 1Q2021, The Federal Reserve has allowed some of the largest banks to resume stock buybacks. So, what are they doing with the revenue they’re generating from the mortgages, conducting stock buyback programs!

Note: For those interested in determining how much they should be spending on their house payments each month, check out our budget HERE!

Article Sources

  1. Housing Wire “Zillow: Expect Another Record Year for Home Sales
  2. CNBC “41% of Americans Would be Able to Cover a $1,000 Emergency with Savings
  3. USA Today “How much are Property Taxes Across the US? Differences can be in the Thousands of Dollars
  4. CNBC “‘Forget 15-Year Mortgages. Do 30, ‘Says Self-Made Millionaire- Here’s Why