Lesson 11: Mortgage Loans
Student Loans &
After the auto loan example in the previous lesson, you should now have a much better understanding of the mechanics behind debt, principal and interest (and depreciation). We will continue with similar concepts for this lesson breaking down a mortgage loan for a home. The mechanics will be similar because debt tends to behave the same no matter the type of loan. However, there is a huge difference between the types of assets being financed. Whereas vehicles are depreciating assets that decrease in value, houses are actual investments with appreciating values that help maximize your Net Worth! However, there is a huge catch that most people do not know.
Let's begin with another major difference between purchasing a vehicle and purchasing a home; the Escrow Account and prepaid expenses. As discussed in Lesson 6 Figure 7, the Escrow Account is an asset account held by homeowners to prepay Property Taxes and Homeowners Insurance. A portion of each monthly mortgage payment is directed to the Escrow Account to ensure the homeowner has enough cash to pay their recurring insurance and property taxes.
The Escrow Account is also funded on the purchase of the home. The amounts vary between lenders and jurisdictions, but the table below shows you the standard amounts that most lenders require when funding your Escrow Account upon purchase. Generally speaking you will need to deposit 10-20% of your annual homeowners insurance premium + 2 months of the annual projection for property taxes. This acts as a "head start" on these expenses that you will owe throughout the year.
And of course, there are the infamous closing costs. The phrase closing costs covers a pretty long list of various legal and financial fees necessary to complete the transfer of the title of the home (title = legal document of ownership). Investopedia has a great breakdown of them here. The long list of fees can be overwhelming but fortunately they are not necessarily your responsibility. Your lender and title company handles all of the legal, boring stuff. You handle the payment. Your lender will provide a full breakdown of all closing costs and a summary of what you owe on closing day. Therefore, you should totally be aware of the closing costs you are responsible for and ask any questions before closing.
When all said and done, the buyer is usually expected to have 3-5% of the purchase price reserved for total closing costs and expenses. Side note: The seller pays for both buyer and seller's agent fees (the amount that goes to the real estate agents).
Let's take a look at a detailed example summarizing what happens on your Balance Sheet when you purchase a home:
Example 11-1: You purchase a home that costs $200,000 with a Mortgage Loan from a competitive lender. You make a 10% down payment of $20,000 from your Savings Account and finance the other $180,000 with the following terms: 30 years, 3.5% interest.
You are also responsible for closing costs + prepaid property taxes and insurance:
Closing costs for $6,000 (3% of the purchase price)
Deposit to Escrow for Prepaid Expenses: $300 for taxes + 200 for insurance
Part 1 - The purchase
Left (Asset) side:
Savings account: The three Credit entries result in a total decrease in your Savings account of $26,500. This is comprised of the $20,000 down payment, $6,000 closing costs and $500 initial deposit to Escrow.
Home/Property account: In purchasing a home valued at $200,000, you add an Asset worth $200,000 to your personal Balance Sheet! This is a key part of the leverage that an appreciating home value provides home owners and real estate investors.
Escrow account: The $500 Credit entry in the Savings account is matched by the $500 Debit entry to fund your Escrow account. Your Escrow account is held with your lender but it is still your account, so its transactions affect your personal Balance Sheet.
These transactions result in an increase of $174,000 on your total Asset value!
Liabilities: You own the Asset value of the home but you also own the debt balance for the mortgage loan. Remember, the Debit/Credit mechanics for Liability accounts are reverse that of Asset accounts. Therefore, a Credit entry of $180,000 increases the Mortgage Loan Liability account and represents the debt you owe over the next 30 years.
Equity: The closing costs/fees are Expenses, therefore they decrease your Equity (Net Worth).
$200,500 + ($26,500) = $174,000
Assets = Liabilities + Equity
$200,000 + $500 + ($20,000) + ($6,000) + ($500) = $180,000 + ($6,000)
$174,000 = $174,000
Important Note 1:
The value recorded for the Home/Property value is a primary difference between purchasing a home (potential investment) vs purchasing a vehicle. Remember in the previous lesson, the vehicle was added to the books at $5,000 lower than you paid; you lost $5,000 of the Asset value immediately upon purchasing it. Likewise, a $5,000 Expense was recorded to match the decrease in Asset value. No such thing happened here with the home. The full value you paid was added to your books and the only Expense incurred was to process the transaction; not to devalue the Asset. PS - There are also "closing costs" and fees associating with purchasing and registering a vehicle, but I didn't cover them since they are generally not as significant as that of a home.
Important Note 2: The Escrow deposit is not recorded as an Expense even though the funds will be used for Expenses. Again the Expenses are "prepaid" upon purchase, meaning you lose the cash now but you do not lose the Asset value until the Expenses are actually due and paid. For now, the $500 responsibility is just a transfer between your Asset accounts to ensure the funds are there when needed.
Part 2 - Monthly payments
The mechanics of the mortgage loan work just like that of the vehicle loan; the closer the debt balance gets to $0, the better for your Net Worth but the monthly interest weighs on your Net Worth.
As a reminder, here are the terms of the loan:
Principal: $180,000 (Principal = amount you borrow and owe)
Length: 30 years
I used an online mortgage scheduler and plugged in the numbers from our example. It produced a complete picture of each monthly payment over the course of the 30 year loan. Figure 11C below shows the total monthly mortgage payment, including the Escrow deposit for insurance and taxes. Then Figure 11D shows the first year (12 payments) of just the Principal and Interest portion showing the change in the Principal/Interest ratio with each payment:
You spent a total of $9,696 but only $3,451 went against the debt itself. That interest column is brutal! Just like the auto loan, the early payments are weighted mostly towards interest. However, since mortgage loans have such higher Principal balances, the interest is much higher.
In our example, the Principal:Interest ratio does not favor Principal until year 11 of the loan. Figure 11E below shows the monthly payments in year 11 so you can see exactly what I mean. The March 2031 payment is the last payment where the amount of Interest is higher than the Principal portion. In April of year 11, the tide turns and the majority of each subsequent payment is weighted towards Principal!
The figure below shows the final year of the loan, where the amount of monthly Interest continues to dwindle down (to almost $0) as the monthly Principal slowly rises and the balance decreases to $0:
Focusing on the Total column at the very bottom: A loan of $180,000 ends up costing you over $111,000 in interest!
That is a lot of money! Most people do not understand the mechanics of debt and do not realize the true cost of the debt they incur. When people say "they should teach finances in public school," this is what they are referencing. The banking world loves taking advantage of your lack of knowledge. They wave a 3.5% interest rate at you, but you end up paying them over 50% of the principal in interest! This is why it is critical that you do not over-leverage on debt. This is why it is critical that you understand what your debt truly means.
You can lighten the interest load greatly be increasing your down payment or buying a smaller, cheaper house. Remember, your principal amount is the amount that you did not cover upon purchase. If you make a down payment of 80%, then you only have to finance 20%, which would drastically decrease your interest. Most folks, however, do not have 80% to put down and absolutely need the mortgage to be able to purchase the home. That need will never go away, but if we (financial professionals) share our knowledge and experience then we can collectively decrease the amount of people being take advantage of.
Appreciation & Equity
As mentioned, a home is a potential investment and it's largely because of the appreciation potential. That is, its potential to increase in value over time (if properly maintained). As the owner, you and your Net Worth own that value! However, the interest and maintenance expenses are the hidden villains that most fail to account for.
Let's say you are in year 11 and want to sell the house to move into something smaller (to have more money to invest in stocks and maximize your Net Worth). Lucky for you, homes in your area experienced a 3% annual appreciation rate so your house is now worth $270,000! Since this is your primary residence and you did not receive rental income on it, the market value represents the total potential inflow from 11 years of ownership.
That is the easy part; the part that everybody understands and easily accounts for. The part the just about everybody fails to account for is the total outflow from the many years of ownership and "closing costs." For this example, I used the following numbers & assumptions:
approx. $135,000 mortgage loan balance at year 11 from Figure 11E
approx. $61,000 total interest at year 11 from Figure 11E
$6,100 in maintenance like lawn care & appliance repairs
$2,000 annual homeowners insurance
Annual property taxes at 1% of property value
Realtor commission fee upon sale at 6% of sales price
Figure 11G below shows the actual profit due at sale based on all these assumptions:
Most homeowners do not perform the necessary bookkeeping duties to have the benefit of seeing the their 11 year net home Equity. Therefore, most homeowners would think, "Well I'm selling for $270,000 and owe $135,000 to the lender plus $16,200 to the realtors, so I should profit $118,800." As you see, that is not the case at all. When you factor all of the expenses from 11 years of ownership, you only stand to profit about $4,000. Or in other words, owning the home for 11 years resulted in a $4,000 increase to your Net Worth. That is probably less than you expected, especially with the $70,000 rise in value, but your opinion should change when you compare it to the Net Worth affects of renting for 11 years.
It is key to understand that housing is an unavoidable cost (also known as sunk costs) since we all have to live somewhere and incur some kind of housing expense. When you rent, you are paying somebody else to provide and maintain the housing for you, but when you own a home you are essentially paying yourself to maintain your own housing.
Let's say you replaced the Principal/Interest portion, $800, of your monthly mortgage for the last 11 years with a monthly Rent expense of the same amount. Here is the Net Profit/Loss, or Net Worth affect, from 11 years of renting:
Since rent is an expense; your Checking or Cash Account decreases and your Rent Expense Account increases each month, resulting in a loss of $105,000 over the course of 11 years. A huge loss that is drastically worst than a gain of "only" $4,000; a Net Worth delta of $109,000. This is why home ownership helps people/families build wealth. Homes serve as primary residences that provides shelter and protection for families while simultaneously benefiting personal Balance Sheets (in most cases).
Based on this, it seems as if renting is a terrible idea and automatically sets you up for financial failure. That assumption, however, would be false. First and foremost, renting provides a roof over peoples' heads. Spending money and losing Net Worth to avoid sleeping outside on the hot or cold street is well worth the expense. However, renting does not build equity and does not provide the asset value/leverage that home ownership does. Therefore, the common public thought is "there is no financial advantage to renting." However, that assumption is also false.
Deeper Analysis - ROI
ROI = Return on Investment = ratio used to measure the performance of an investment. If an investment's ROI is 100%, then it doubled your money, ie spend $100 to make $100 ie buy something for $100 and sell for $200. If you spend $100 to make $50, then your ROI is 50%, and so on.
The ROI for the sale of the house can be calculated just the same. For this analysis, we need to calculate the cost basis of 11 years of ownership. Lucky for us, I am an accountant and already took care of the bulk of the cost basis analysis in Figure 11G. If we simply copy Figure 11G and replace the remaining mortgage loan balance amount with the cumulative amount of Principal paid (from Figure 11E), we are left with the cost basis (for cost basis, we need to know how much principal we have paid, not how much we owe):
A large cost basis for a modest ROI. Again though, a home is not necessarily meant to be a huge financial investment since its primary utility is shelter and security. All things considered, 2.32% is not a bad ROI. However, when you compare the cost basis of renting vs owning, you will see a large discrepancy between the two; renting is $70,000 cheaper over the same time span (about $175k cost basis for the home from Figure 11-i vs. $105,000 for renting from figure 11H).
At 11 years, that amounts to savings of about $5,800 per year. If you invested those funds each year into a fund that returned about 8% annually, the $70,000 total savings would grow to about $120,000 over 11 years. If renting for 11 years cost you $105,000 but you have a savings/investments value of $120,000 because you chose to rent, then you experienced a Net Worth gain of $15,000 and ROI of about 8.5% by your decision to rent and invest vs. buy a home. Both Net Worth and ROI are higher on the same cost basis as home ownership.
Does this mean renting is better than home ownership? No. There is no one size fits all solution when it comes to finances and investments. It more so shows you that understanding finances and investing is a very important part to strategically maximizing your Net Worth. It also highlights the importance of understanding opportunity cost analysis.
My goal is not to tell you specific paths to take, I just want to teach you about the paths you can take. The analysis covered in this lesson is knowledge that most do not know. Not you though! Now you have the entire financial picture of a mortgage loan and home ownership! Continue to the next lesson to see the mechanics of student loans and credit cards.