The world of real estate was a strange place in July of 2007. I think at this point, mortgage lenders had an idea of what was about to go down, but still kept writing as many toxic loans as possible before their inevitable doom. Our first home purchase was one of these loans!
As college students with no jobs and $300 in total savings, our friendly mortgage assistant recommended 100% financing with two mortgages: an 80% and a 20%. He also recommended interest only ARMs for these mortgages, because it would help lower our monthly rate. Sounded great to us! The 80% had a 6.5% interest rate, and the 20% had a 12.5% interest rate. For those of you who know real estate, you can see how dangerous these loans were.
But we were only kids, with no actual money, surprised that someone would give us a house. I remember walking away from the closing with house keys, an $8K incentive check from the builder, and a grin on my face. Looking back, this was probably the perfect example of predatory lending, but I can’t blame them entirely. I could have done more homework. Or at least rented for a year or two to learn the area and save up a down payment.
After the closing, we went to the store and purchased some paper plates, plastic cutlery, a $3K HDTV, and a PlayStation 3. Like I said before: we were still kids. We ordered pizzas and spent 2 nights on an air mattress in the new house, then drove 3 hours back to campus to finish our final semester of school. We then drove back and forth every other weekend to check the mail. If there was ever an anti-mustachian way to do real estate, this was it.
A Cash Flow Killer
What did our mortgage breakdown look like?
Each month, we would pay $1,614.96, of which $1,220.96 went to interest, $246 went to taxes and insurance (T&I), $148 went to our homeowners association (HOA), and exactly $0 went to principal. We assumed we would start paying more principal eventually, but years later, we still owed the same $170K on a house that was now only worth about $70K. The house had dropped a full $100K in value after the financial crash. This was not good.
We were paying ~$20K a year into this house, and not a drop of it was principal. This is crazy! Let's do some math and run our numbers through an amortization calculator. Our total mortgage principal was $168,990.00. But if we actually paid this loan off over the course of 30 years, we need to add $270,555.60 in interest payments, for a total cost of $439,545.60. It's like purchasing three houses, but you only get to keep one!
An Exit Strategy
Buying more house than you can afford and paying interest on it for 30 years eats up cash flow that could otherwise be used for paying down debt or investing. That $270K in interest payments over 30 years could be sitting in my investment account instead! That's why I have a hard time swallowing the traditional advice that mortgage debt is ‘good debt'. To me, debt is debt and interest is interest. We decided we were done being on the wrong side of the interest equation. But how could we get out?
We couldn't sell it- the property value was too low compared to the mortgage, and we still needed somewhere to live. Refinancing wasn't an option- our loan to value ratio (LTV) was so high (over 240%) we didn't qualify for the various HARP (Home Affordability Refinance) programs of the time. We are not the type of people to walk away from financial obligations, either: we signed our names on the dotted line, so it was our responsibility. We decided we needed to buckle down and pay it off aggressively.
Around the bottom of the real estate market, an opportunity arose for us to move in with a family member. The situation wasn't ideal: it was located in an older part of town, the neighborhood seemed a bit sketchy, and sharing a house with parents is a true test of patience. But we took the opportunity and rented out our house for additional income. The rental income was still $700/mo short of covering the mortgage, but it was better than nothing! We added it to our snowball and began quickly paying down the loan.
Think Before Buying
What did I learn from our mortgage crisis?
- Don't buy ‘more house' just because you can
- Buy with cash, or put a large down payment
- Pay it off fast- like you would any other debt
- If you live in a high cost of living area, rent instead!
But what if you were lucky enough to lock in a low 3% interest mortgage for 30 years? Should you invest your cash flow instead of paying off your mortgage? This is a tricky subject, and there are so many discussions on this. The traditional advice is that you could invest your money and make more than you could paying off the mortgage.
Personally, I would still choose to pay off the mortgage instead. You enjoy a guaranteed rate of return, and if you pay it quickly, you'll then have a much larger cash flow to invest following your payoff. To me, having a paid off house in FI is the safer solution, but I am somewhat risk averse and this is just my personal preference.
Millennial Revolution blogs about how mortgages destroy wealth and are the primary reason most people never become millionaires. They are adamant about renting instead of owning, and for the most part, their argument makes sense when you run the math.
There are exceptions, however. In certain low cost of living areas, owning can save you money over renting. Some back of the napkin math: Following the 4% rule, you need $300,000.00 invested to support a $1000.00 monthly rent payment passively forever. If you can find a house whose total cost (including interest, taxes, insurance, HOA, and maintenance allowance) is less than that, it can be a better deal. But these properties are usually the exception, not the rule.
Wrapping It Up
I happen to live in one of the areas where owning can save money over renting, but it requires buying the right property at the right time. Rental real estate can also make you good passive income, if the property is chosen carefully and the math works out. Our property was unfortunately not one of those.
So we paid it down aggressively. Adding the rental income to our savings snowball, we now had over $3000 a month to douse the mortgage fire. But even at this rate it still felt like we were moving in slow motion. We wanted to have the house paid off in under two years, and to do so, we needed to find an additional $2000 a month. We were motivated and ready to make more drastic cuts to our spending… on the next Financial 180!