Three Keys to Paying Off Your Home the Quickest and Safest Way
We recently had the personal experience of buying a house. #alltheemotions is an understatement, as I’m sure you can attest to! We were rushed because it was a hot market and houses were selling in sometimes less than a day, overwhelmed with options, fearful of not finding the right one, hurried before someone else makes an offer, slowly making purposeful decisions, waiting to make sure it’s the perfect one, accepting that there’s no perfect one, envisioning this as your future home, disappointed that another offer was accepted, scrutinizing the flaws in the inspection process, satisfied that it was good enough, relieved to have made it through, again overwhelmed at conquering the mountain of moving.
It really is a funny story how we came to the point of making that purchase. We’d decided early on in our marriage that our primary financial goals were to increase cash flow and control of our resources. We’d seen the catastrophe of the housing market in ’08 and wanted to ensure we wouldn’t be in a position to lose our wealth if the housing market fell again. We weren’t ones to buy a home purely out of sentiment to fulfill the American dream. To us, home ownership was an expense, not an investment.
But as we worked with clients, we began to see tremendous value in locking in an annual housing cost with a mortgage. In an inflationary environment, costs of everything, including annually renewable rental agreements, go up. The benefit to having a contractually guaranteed fixed payment into the future is like having inflation insurance. And, with as many other tools that we saw as more valuable places to store our money, we couldn’t deny the side benefit of building equity to be able to use later, whereas paying rent was purely an expense.
We were coming up on the 8th anniversary of our “temporary” move to Virginia, and our transient-ness that we thought would have us moving again had morphed into roots and relationships. Interest rates were maintaining an unsustainable low, the local real estate market was maintaining and had been slowly and steadily increasing.
We quickly made the decision to purchase a home that initiated a whirlwind 2 months from the conception of the idea to the date we took possession of the keys to our property.
From the vantage point of my own personal experience and the work that we do with clients to optimize their whole financial system, I want to distill the three key lessons that will help you purchase and pay for a house in a way that propels your financial objectives to keep more money, increase your cash flow, and pay off the mortgage.
1) Know the difference between “having debt” and being “in debt”
Here’s how to find out where you stand. Grab a blank paper. Anything, even a napkin, will be fine. Draw a line down the middle. On the left, write Assets. On the right, Liabilities.
This is your basic balance sheet.
Assets are what you own that has value. This may include property, bank accounts, cash, retirement accounts, businesses, cars, the cash value of life insurance, precious metals, etc.
Jot down your assets by name and approximate value. Total your assets.
On the other side, liabilities are what you owe. These are obligations you have to pay someone else. They are your mortgage, the balance of your credit cards, student loans, car loans, etc.
List your liabilities and their approximate value. Total your liabilities.
Now, here’s the calculation to find your net worth:
Assets – Liabilities = Net Worth
If you get a positive number, you are in an equity position.
If you get a negative number, you are in a debt position.
Having negative net worth means you are “in debt.” Having a liability simply means you “have debt.” They are two completely different things.
If you have positive equity with some liabilities – the position most people find themselves – then, contrary to what you may have been led to believe, you are not “in debt.” You simply “have debt.”
While “being in debt” is a legitimate concern that you should take every reasonable precaution to avoid, “having debt” is just a method of payment.
The alternative position is to have paid cash, where you now owe no payments, but you’ve also given up your reserves and shut down the opportunity to use that money for anything else.
Financing allows you to make the same purchase, but if you follow the money, it keeps the control of your capital in your own hands.
2) Know what your money could be earning for you
Imagine you’d developed your savvy as a real estate investor, stock trader, or business owner, and knew that you personally had the ability to earn double-digit returns on your investments.
Any time you put your money to task to earn a lower return, or to avoid a loss, you’re forfeiting the gain you could have had. This is called opportunity cost.
People commonly rack up a huge opportunity cost by putting their money into their house, building equity, believing that their primary residence is a good investment.
But is it?
With investments, you’re expecting a rate of return. Since your home isn’t giving you a monthly cash flow, the rate of return is measured purely by the valuation of the house as an asset.
Real estate values do generally tend to uptick over time. On a macro level, because land is a limited resource, with continually increasing demand, prices rise.
On a micro level, you’ve heard, no doubt, that real estate depends on 3 things: location, location, location. Property values rise and fall subject to surrounding community factors, adjacent developments, etc.
If something were a good investment, you’d be earning a return on dollars you put into that investment. Using that logic, we’d expect to put dollars into our house, expanding our equity, and reaping the returns.
But there are two problems with this:
#1: The appreciation of your home has nothing to do with equity.
First, let’s look at the mechanics of appreciation: If you and I both bought neighboring houses at $500,000, and 10 years later, your property value grew to $1 Million because of a new strip mall being developed next door, my house would also be worth $1 Million.
If you had paid cash, and I had financed to the hilt, the appreciation didn’t discriminate between our payment methods. Our gains are equal, in spite of our disparate equity.
Even though your home’s real estate value may rise and fall, it is not your equity that’s driving it. Equity and appreciation are completely independent of each other. Since the house appreciates whether or not you have equity, dollars added to home equity earn nothing.
#2: Just because you have equity, doesn’t mean you have the ability to USE it.
Further, let’s say that your house appreciates, and you want to use your equity to pay for an expense or an opportunity. You’re going to have to get permission from the bank first. If you get through that hurdle, your first option is selling your home and uprooting your life, or your second option is to go through major scrutiny at the bank for a cash-out refinance.
Either way, you still have to go through an invasive process no matter how you choose to access your cash.
The appreciated asset belongs to you, but you don’t have complete control and freedom of when you can use it.
So, not only is your house a poor investment, it’s a poor place to store money, because every dollar you put into equity is being put out of commission, earning nothing. And if your house happens to appreciate in value, you have to jump through hoops to access it.
And back to the idea of opportunity cost, dollars you use to pay off your house cost you money because of the opportunities you are passing up that could be earning you a rate of return.
If you had $200,000, and you could use it to either:
- Pay off your house and avoid paying 4% interest, or
- Invest for a 7% return,
then the opportunity cost of paying off your house with the $200K is the 7% you cannot earn in the investment because your money is already committed to another job.
If you instead keep your capital and put it to work earning 7% interest while continuing to pay the 4% interest, you’re ahead by the 3% spread.
3) Aim for future confidence
Having confidence for the future comes from having safety, guarantees, protection, and generally, knowing that you can count on what you have right now still being there for you tomorrow.
What creates more confidence for you in the future?
- A paid-off house with no more payments, but no cash, OR
- A house with future payments AND a fat chunk of cash in savings
If you “have debt,” you most likely have a monthly debt payment. This is the primary reason most people tell me they want to pay off their house quickly is to save interest or to get to a position where they have fewer monthly payments. Chances are, you could do a lot more if you didn’t have those payments. Maybe you’d save more, or maybe buy more stuff.
But, let’s look closer. If you’ve raced to pay off your house, what position are you in if you lose your job? It doesn’t matter if you’ve prepaid 25 years of mortgage payments, the payment is still due next month. If you have no income and no liquid cash to make a payment, you have serious ramifications when your credit score drops and you’re facing foreclosure. Even if the house was completely paid off, and you faced a few months of no income, you won’t qualify to get money out of the house to pay for gas and groceries because the bank wants proof that you’ll be able to pay them back.
That is no one’s definition of safety or confidence.
If, however, you are in a position that you still owe a mortgage, even into your 60s, but you have access to liquid capital that you can use, you would still have security, even if you lost your income. You could pay for all your living expenses, as well as make mortgage payments necessary to keep the roof over your head.
If the goal is paying off the house, you’re at risk of losing it. If the goal is future guarantees, you can build savings, security, and confidence.
The real issue here is whether to pay cash or take out a mortgage. Every consecutive decision you make about how to pay for your house stems from that core decision. Clarity here will give you clarity with how much to put down, and what loan terms will give you the most cash flow and the most control. Here’s the logic of each decision:
Pay cash vs. Mortgage
Pay cash
PRO: Increase your monthly cash flow because there are no more payments
CON: Give up your capital to the bank and forfeit the other things you could do with that money
Mortgage
PRO: You keep your capital and put it to more productive use
CON: Decreases your monthly cash flow because of having to make monthly payments
Maximum vs. Minimum Down
And when it comes to how much to put down, here’s the pros and cons of that decision too:
Maximum down payment
PRO: Lowers your total mortgage and monthly expense of paying the loan
CON: Give up more of your capital and forfeit the other things you could do with that money
Minimum down payment
PRO: Increases your total mortgage and the monthly expense of paying the loan
CON: Keep more of your capital and so you can put it to your best use
15 Year vs. 30 Year
Lastly, when it comes to deciding what type of mortgage to opt for:
Shortest duration (ie. 15 year)
PRO: Lowers your total interest expense, and speeds up the date that your loan is “off the books”
CON: Increases your monthly payment, reducing your monthly surplus available have to save or do something else with
Longest time-frame (ie. 30 year)
PRO: Decreases your monthly payment, increasing your monthly surplus to save, spend, or invest elsewhere. The bonus is that if you save that difference, you can often pay off the mortgage faster than 15 years.
CON: Increases overall interest paid (but remember, it’s tax deductible, and you save more in taxes than with a shorter loan), and lengthens the timeframe until the loan is “paid in full.”
Another bonus here: if you’re in the position with sufficient cash to pay off your loans, whether or not you’ve actually paid them off, you are out of debt!
I can’t speak for you, but I’d prefer having a pile of cash that I can use for emergencies or to invest in an opportunity. I get more peace of mind from knowing that I could sustain my monthly payments and lifestyle for 12 months or more, even if we lost our income than I would if I had my house paid off, with the possibility of a dipping housing market washing away my equity, and no cash on hand if unforeseen expenses or opportunities were to arise.
Here’s the bottom line: to maintain control of your capital, maximize your monthly cash flow, and get out of debt as quickly as possible, use the lowest down payment, the longest loan, save the difference, and be out of debt when your savings is great enough to cover the remaining due on the loan.
You also want to improve your credit so that your interest rate is as low as possible, further reducing your monthly expense, and save your surplus where it’s liquid, getting a better rate of return than your house, and available to be used for emergencies or opportunities. Both of those objectives are so personalized that the best strategy for you will depend on a thorough assessment of your objective and financial picture.
In this way, you have the greatest control and security, no matter what the future may hold.
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