Residential real estate has reached an all-time high in 2017. In times like these, it seems everyone you meet is invested in real estate and is telling you to do the same. While that could be a sound move, in a market with strong job and population growth and reasonable expenses like property taxes and insurance, how should you structure the funding for this investment? To answer this, you must first decide if your goal is to have your properties paid off as soon as possible, or to maximize leverage.
We have all heard that your goal with your primary residence should be to pay it off as soon as possible; we’re taught to believe that puts us in a safer position. However, in most cases it does not. Ask yourself “Who is advertising for and incentivizing me to pay off this loan?” The answer: your lender. The reason for this is because doing so puts them in a better position, not you.
As an example, you take out a $200,000 loan on your $400,000 primary residence (it would work the same for your rental property). You had planned to take a $320,000 loan, but the payments were above your limit, so rather than purchasing a less expensive home, you took your savings and put it in the house. Then, you attend a course, sponsored by your bank, where the Financial Advisor demonstrates to you that making an extra payment each month saves thousands in interest over the period of the loan and pays it off considerably faster. This is all true, but it does not mean you will grow wealth faster; quite the opposite. It is only half the story, a slight of hand – please reach out to us here at Paradigm Life if you’d like to talk through the full story with a Wealth Strategist.
Now, let’s fast forward ten years. Your house is worth $550,000 and you have paid off $150,000 of the original $200,000 loan. Your loan principal is $50,000. You have contributed $350,000 including the initial down payment, and you have ‘equity’ of $500,000 (the current market value minus the loan amount). In short, you’re feeling confident and are close to your goal of owning your home outright. When you get to this goal, is the house truly yours? No, all you have done is removed one of the interested parties, the bank. You still have the third party you will never get rid of in the U.S. – the local government. This ‘partner’ expects routine property tax payments or they will take the property that you were under the impression was yours, ‘free and clear.’ Here is just one of hundreds of examples of this occurring each year Widow Loses House Over $6.30 Tax Bill (Forbes). The point I’m making is that paying off the loan does not insulate you from losing the property, it just removes one of the threats.
Unfortunately, in this example you don’t reach the goal because in this 10th year, tragedy strikes. Your spouse becomes critically ill and requires an expensive organ transplant operation not covered by your insurance. Remaining at their bedside for weeks at the hospital also costs you your job. You go to the bank to pull back out the money you so diligently put towards that goal of paying down the mortgage. This will require an expensive refinance, but far worse, the bank will not consider it. They inform you they are not in the business of lending money to unemployed individuals, and that they hope you are still able to continue your current payments…actually they may be hoping you don’t because your failure would turn their $50,000 investment (your current debt to them) into a $550,000 asset when they foreclose on the home.
If you had instead put only 5% down, $20,000, and made minimum payments over the years, instead contributing the additional ~$300,000 to a safe, liquid account where it is growing at over 4% free of taxes and fees, would you be better off? Would you have options? Thankfully we don’t all face a tragedy like this, but if you choose to hold the money in an account like this, a Wealth Maximization Account that we set up for clients at Paradigm Life, you have an emergency fund and an opportunity fund, and the ability to pay off the home loan any day you choose, which means you have options. Please reach out to a Wealth Strategist if you would like to learn more.