I thought I would take a brief moment to share a few interesting tips and tricks I recommend when considering real estate. I have compiled these in my limited years of investment and my brief time in school.
Tip #1: Use your mortgage like a bank account. One interesting phenomena in real estate (residential especially) that is surprisingly irrational is the treatment of mortgage. If you have a residential mortgage at 6.5% and your bank account nets a 2.5% saving rate, there is really no reason to put any money in your savings account (you lose 4% on every dollar you deposit!). Outside of cash needed to operate day to day, all of your savings should go to paying off your highest interest debt. A lot of people either don’t think about this or just do not know the true implications of this. Luckily, our newest writer, James Hsu has saved me some time by providing a quick analysis on the value of paying off mortgages early. Not only do you save yourself a tremendous amount of interest by paying off your mortgage early at no additional cost, but you also free yourself of future debt. My recommendation is to set a maximum emergency cash flow you need to live and funnel everything else to your loan.
Tip #2: Pay your mortgage more often. Interest is calculated monthly on most loans (based on principal balance at that time); therefore, paying bi-weekly essentially allows you to pay slightly less interest. While it may only save you several hundred dollars of interest payments a year, this money adds up. If you get paid bi-weekly, send in half your mortgage payment early. This can shave several years off your mortgage.
Tip #3: Consider a second loan to avoid paying PMI. This can be tricky because you want to make sure the second loan cost you less than the mortgage insurance (obvious, but it has to be said). Optimally this will be a second loan that you can repay early, avoiding most of the interest payments. Check with your mortgage broker or banker to see if this option may be right for you.
Tip #4: Consider offering seller financing. Many people avoid doing this, simply because they don’t understand it. Seller financing can be a great way to earn 7% to 9% interest over a fairly short period of time. With rates still relatively low, seller financing can be a great future investment. Of course you should consult a lawyer, who can draw up the paper work and suggest a reasonable interest rate. Additionally, this flexibility makes your properties more marketable (and perhaps more valuable).
Tip #5: Get to know your banker. Many people look at banks as faceless corporations, they are far from it. The better you know the person(s) in charge of your loan the better off you will be. From discounts on refinancing to lower rates on future loans, a great banking relationship is imperative in the real estate business. I know I have said this before, but it will always remain true. People that know you personally will bend over backwards to make you happy.
To some these tips may not be eye opening and to others they may change the way they view financing. Which ever the case, remember financing is a great tool to make (or save) money. Go beyond the standard mortgage or canned advice and get into the details. You will be surprised where you can find savings. As always, please feel free to add any additional tips you have in the comments area.
Chris says:
I say insted of paying off the mortgage, why not take your money and try to get a better return? I shoot for a 10% CAP rate in any building I buy, the ROI is usualy much, much better. So insted of taking say $20k and paying down the 6% mortgage on your house, why not go and try to get a much better then said 6% return on that money?
Food for thought…
Good post!
March 1, 2007 — 7:04 pm
Michael Cook says:
Chris,
You are fast, I didnt even get the post approved before your email popped up. Great suggestion, unfortunately not everyone is in a position to reinvest their additional income (students like me for example). Its better to put the money in a mortgage and then get a home equity loan for the next investment than to put it in a savings account or cd.
Regardless of the alternative, savings accounts and cds should really be the last resort. There are just too many better options out there. Thanks for the addition.
Mike
March 1, 2007 — 7:11 pm
David G from Zillow says:
Excellent post, Michael! You inspired me to add a “recommended blog posts” category to our wiki pages with links to GREAT posts like these — just linked to this post from our “Mortgage” page on the wiki: http://www.zillow.com/wikipages/Mortgage
March 1, 2007 — 8:56 pm
Brian Brady says:
Michael:
I will ask the obvious question; why would anybody pay off money with a 4.0% after-tax cost-of-funds ? I see the benefit of directly deposting money to a HELOC (because you can re-access it) but to a first lien?
That might be the most dangerous thing someone can do. It worked for our parents and grandparents but we have so many other challenges (and opportunities) they don’t have.
March 1, 2007 — 9:18 pm
Dan Green says:
Brian, I have your back on points #1 and #2. Principal has no return on equity and fails all four investment objectives of a rationale investor. See http://www.themortgagereports.com/2005/03/want_to_be_cons.html for more math on that.
Points #4 and #5 are winners. Well done, Michael.
March 1, 2007 — 9:40 pm
Brian Brady says:
I stipulate, Dan.
#3 is what #3 is; a simple math problem.
March 1, 2007 — 9:53 pm
Bonnie Erickson says:
Chris, A savvy investor would take your suggestion and take the money elsewhere for a better return. However, there are others that cannot emotionally handle rental property or higher risk investments. Emotion plays a big part in how money is handled (hence, it’s one of the top causes for divorce) and how it is invested. For many Michael’s advice is the safest route.
March 1, 2007 — 10:05 pm
Michael Cook says:
This is why I love this forum. Brian writes, “why would anybody pay off money with a 4.0% after-tax cost-of-funds ? I see the benefit of directly deposting money to a HELOC (because you can re-access it) but to a first lien?”
My response is that if your alternative is a 2.5% (taxable) savings account, you are still better off. I will add an additional caveat here. This advice is obviously not for an investor, who should be able to earn well over a mortgage rate in any investment. It is strictly relative. If you have an after tax opportunity to earn more interest than your mortgage, take it.
Looking strictly at a typical homeowner, who probably only has the option of a cd, savings account, or maybe the stock market (riskier than their home for sure), based on the analysis you presented I still think they are better off paying off their home. Please notice I made no mention of apprecation because as you mentioned in your article above, it comes with or without paying down the loan.
Furthermore, your analysis assumes that investors have constant projects going. What about the lag time between investments? If you have six months to a year between investments, where does the rental income go? Probably the highest interest second if they are available, but with some commercial loans in the range of 8 to 10% right now, there could be some scenarios where the money should go to those loans.
I will concede that my analysis did neglect the cost of borrowing the money back. This was not done out of ignorance, but simply for ease of reading. Adding the cost of borrowing makes the decision tougher because in some cases it will still be worth it, and in other cases it may not. For example, if I pay down my 8% mortgage over a 15 year period saving $x in after tax interest payments, the cost of borrowing everything back in year 15 will probably not effect the potential savings depending on the size of the loan. Conversely, if its six months, it would certainly make this method ineffecient.
Additionally factoring in things like PMI also muddy the waters. I am afraid by striving for simplicity, I may have opened this door. And since it is now open, keep the feedback coming. I could talk about this stuff for hours.
March 1, 2007 — 10:16 pm
Michael Cook says:
Dan mentions “Principal has no return on equity and fails all four investment objectives of a rationale investor.”
I agree that there is no return on equity, however, I dont think it fails a test of rationality (not sure what your four are, but I am just assuming wealth maximization). Looking at the example mentioned on Jason’s site, Assume the following:
“- $230k loan amount
– 6.125% interest rate
– 5 year time period in which you will pay the loan off
On a 30-year fixed loan, at the end of 5 years, I will have paid $69,356 in interest. I found that by adding $3000 extra per month, I’d have the loan paid off by the end of 5 years which in turn means I’ll “only” have paid $38,272 in interest.”
In this example, if you had invest the $3000 per month in a savings account yielding 2.5% you would be short $7,143. Adding tax consequences bridges that gap somewhat, depending on the rate you use (and depending on your ability to capture all of the tax savings). As interest rates creep up, this gap will widen and it becomes an opportunity cost problem vs. an ROI/ROE problem. From an investors perspective you are clearly correct because they have better options, but for the laymen homeowner with a savings account and a home I think my math checks out.
Again, if the investor has investment options equal to or better than their mortgage, they should take them. This only applies to people who do not have (or want the headache of per Bonnie above) better options.
March 1, 2007 — 10:55 pm
Brian Brady says:
>I could talk about this stuff for hours
to a willing audience. Good work, Mike. Your advice is sound for a single property homeowner…maybe.
A few posts from a mortgage guy on Active Rain:
http://activerain.com/blogsview/Fed-Releases-New-Study-on-Paying-Off-Your-Mortgage?12405
http://activerain.com/blogsview/14953/Become-a-Banker-Well
and my favorite:
http://activerain.com/blogsview/14618/A-Tale-of-Two
March 1, 2007 — 11:08 pm
Michael Cook says:
Interesting… Your favorite reads like an ad for the mortgage specialist industry, but raises good points. The point that I think people gloss over the most, however, is the availability of investment vehicles yielding the same mortgage rate or only slightly worse.
Sadly, not everyone has the same passion for real estate as many of us here, so their options are either lower rates of return on Cds and savings accounts or higher returns with higher risk in the stock market. It would have been interesting if your investor b had taken all of his available investment income and invested in an IRA in 2000-2001. I feel that is fair since investor a ends up jobless :). Would he have been better off then?
Introducing riskier investments into the equations is not really a fair comparision. A mortgage is a definite savings, while even tax deferred IRAs might not be unless their are invested in a money market account. Of course the yield on these is far less than a mortgage (2.5-4%), probably leaning the story a little bit more toward the mortgage payment side. Thanks for the additional links. Great food for thought.
March 2, 2007 — 6:49 am
Russ says:
Mike:
Several studies have been done on this recently(point #1) and most say that younger buyers are better off investing instead of prepaying the mortgage. One done by some top tier b-school professors showed that the average person would earn an additional 17 cents on the dollar if they invested in their 401k (they also assumed really safe investment vehicles, not higher risk alternatives) instead of prepaying their mortgage.
As you get closer to retirement it probably makes sense to start eliminating the mortgage, but when you are in your prime earning years, you could do much better things with those funds that would better prepare you for old age.
See Business week: http://www.businessweek.com/magazine/content/07_06/b4020112.htm?chan=investing_investing+funds
Everyone’s situation is unique, so I guess it is a matter of what makes you most comfortable and what your goals are for the future.
March 2, 2007 — 8:37 am
Brian Brady says:
Michael, I’m impressed!
When you first started writing here, I was excited. I thought you’d write things that were theoretically sound but somewhat impractical for the everyday consumer. As it turns out, I am guilty of this infraction.
The last two articles I’ve read (this and the contest entry), were a perfect marriage of the two; good theoretical advice DIRECTED at the everyday consumer. I completely prejudged you. You have the gift of translating Wall St. ideas into practical advice.
I hope Jeff Brown weighs in with his opinion.
March 2, 2007 — 8:48 am
Michael Cook says:
Brian,
Thanks, that means a lot. This is really an outlet for me. You would be surprised at how much time we spend learning things that are untrue or just simply impractical. Its nice be around practioneers who speak their mind freely and intelligently. I think the diversity of this site is really what makes it great.
Mike
March 4, 2007 — 9:25 am
Dan Melson says:
Actually, paying your mortgage twice per month saves almost nothing. Run up TILA’s in Calyx Point on a basic thirty year mortgage, then on the same amount at half the rate but with twice the period (which mimics the relevant math very well).
In Biweekly mortgages, what makes 99%+ of the difference is the fact that you end up making one extra mortgage payment per year, which essentially goes straight to principal reduction. The fact that you’re paying twice as often makes almost zero difference.
I did one example here
http://www.searchlightcrusade.net/posts/1127484044.shtml
But you can choose any examples you like.
March 4, 2007 — 4:37 pm
Cooper says:
mike,
i think it is interesting, all of your responses. Logically speaking i think that yes in some situations that paying down your mortgage is a smart move. You have to ask yourself what is my intentions with this investment? do i actually want to pay this one off or am i in for a short to mid term gain? i have not done the math but since market value, which translates into mortgage payments, is a function of rents, what is the advantage of having a free and clear property? well just off the rip, i would say to fuel another investment. would you agree or disagree?
March 23, 2007 — 8:37 pm
Michael Cook says:
Cooper,
You have to also consider the tax advantages of having a mortgage and the opportunity cost of the funds invested in the mortgage. For example, if rent would be 1000 per month and the mortgage is 1000 per month, its better to have a mortgage. Consider Rent = Mortgage x (1- the owners tax rate). Additionally, if the money is not in a mortgage, what rate can you invest it at? Again, here consider the mortgage as an investment yielding its interest rate x (1- the owners tax rate). Since the interest is tax deductable it must be factored in here. Typically, this rate is just above the rate you would get on a cd, which is why I suggest paying it down if you dont have any other real investments.
March 24, 2007 — 4:43 am
Sue says:
Hey Michael, I’m arriving late as I bounced here from one of your more recent posts. I have very mixed feelings about paying off my mortgage as its been pounded into my head to keep as much of my money as possible. I can, however, see both sides. Seller financing is an interesting concept and you’re right I am sure that most don’t fully understand it, including me!
June 18, 2008 — 8:32 pm