Podcast Episode 122: Basics of Debt, Part 2: Dealing With Mortgages

Paul Adams: The difference we’re getting at here is that the path by which to get there, to be as safe as possible, is to not give the bank lots of extra money, not to make extra mortgage payments every single month, because every time you make an extra mortgage payment you’re not lowering your own payment next month, number one. Number two, they’re giving you no credit if you hit bad times for having made the extra payment. And the only thing you’re absolutely doing is making the bank safer. Having a paid off home can be great, but let’s do it by writing a check once, not by making the bank safer, and safer, and safer over time.

Announcer: Welcome to Sound Financial Bites, where we help you with bite sized pieces of financial and life knowledge, to help you design and build a good life. The knowledge that has been shared from stages at conferences, pages of national business magazines, and clients living across America, our host, Paul Adams, now brings directly to you.

Paul Adams: Hello and welcome to Sound Financial Bites, I’m so glad you could join us today. My name is Paul Adams, I am the founder and CEO of Sound Financial Group, and the man who’s incredibly happy to know that you’re listening right now. I can see you. I know where you are, in your car, driving to work. I see you in the gym, you need to keep your chin up, or you’re going to ruin your form on the squat rack and injure yourself. And for those of you out for a beautiful winter run, we first acknowledge you for dealing with the cold, icy air going in and out of your lungs while you continue to try to stave off Thanksgiving and Christmas pounds.

Paul Adams: With me is Cory Shepherd, the nicest guy you’ve ever met. And a guy that I am proud to have as co-host, and with me at Sound Financial Group. Cory, you are going to lead us on an incredible journey in conversation today, as I understand it.

Cory Shepherd: I am indeed, and I just want to be clear that that shout out to everyone running through the icy air is to no one in Seattle right now. Now that I am in Chicago, going for daily runs, and it was 25 degrees today, no weather love for all y’all.

Paul Adams: I just keep telling Cory, be happy that it’s 20 above zero.

Cory Shepherd: Not below, yes, we’ll get there. We will … yeah. So we are going through a series on debt. We did an episode on car financing, and leasing, and now we’re taking a step deeper into mortgages.

Paul Adams: And this is one of those conversations where you could feel like, “Oh, you know, I don’t know if I need to listen to this podcast, because mortgages, I’ve already got a mortgage, I know how they work.” These apply to

other types of debt, and it applies to those of you who have already maybe had five or six mortgages over your lifetime that you can take something away, I’m sure, from the conversation Cory’s going to lead us through today.

And today we’re going to have a special giveaway, so for those of you listening to the podcast, we’ve got some visuals that are going to be up on YouTube, but if you’d like to download the visuals, you’re going to be able to get all of this at mortgage.sfgwa.com, that’s mortgage.sfgwa.com.

Cory Shepherd: So you can see that we’re calling this A Tale of Two Mortgages today, but really think about it as a philosophy around how to regard debt on your balance sheet, and how to have it be a part of your overall results, not just a one point in time decision. So we’re using mortgages as a model.

So 15 year mortgages and 30 year mortgages are the two most common alternatives, or as we’ve seen it, the most common discussion around mortgages is, “Should I do a 15 year or a 30?” There’s many other variations and kinds, we’re not going to deal with them today. We’re just going to take a look at these, the differences between these two, I would think, most popular. Now, there’s probably a mortgage broker listening that’s going to say, “Those aren’t the two most popular,” they just happen to be the ones that we see the most with our clients.

Paul Adams: Feel free to address any of your complaints to Cory Shepherd.

You can email at [email protected].

Cory Shepherd: Yes, wonderful. Make sure in the subject line to put, “Dear Paul,” and then it’ll get to the right place. Yeah. So a 15 year mortgage has a higher monthly payment than a 30 year mortgage, and all things being equal, usually has a lower interest rate. Now that’s going to be important as we …

well, Paul, I’ll ask you, would you tell everyone why in general they might suspect that a 15 year mortgage has a lower interest rate than a 30 in most cases?

Paul Adams: Well, why most people think, or why it actually does?

Cory Shepherd: Well, maybe start with the latter and go with the former, yeah.

Do both.

Paul Adams: So what a lot of people are told is, “Hey listen, you’re going to pay less in interest over 15 years.” Which is true, if you don’t hold the debt as long the actual interest payments made to the bank are less. Couple with that is the bank actually charges you less interest rate on the 15 year mortgage per year than on the 30 year mortgage.

Now, here’s where we want people to just think, I don’t mean just think like in a pejorative way, but just pause long enough to ask yourself … everybody listening to this call is in business, lots of you are executives and

business owners, would you ever go out to your customer base and say, “Hey, what you should do is take this other strategy where you pay us half as much money?” That’s pretty rare. That’s not something you’re going to run out and do, and certainly not something you make a business practice of, even if you made a periodic exception to it.

But that’s exactly what banks are doing any time they offer a 15 year mortgage. In the banker’s talk, you’ll pay a lot less interest and they teach that to you. Now the question becomes, why would they do that? And the reason why they would do it is they want to have that interest paid back more quickly, because the faster your principal is paid back, the faster they can lend it out at whatever the new and current interest rates are. So it works really well for them to have it paid down more quickly, because it makes their investment safer, which I think Cory’s going to talk about, not to mention it gives them the chance to lend it back out at what they hope to be higher rates, based upon whatever the prevailing interest rates are as time goes on.

Cory Shepherd: So that is the bank’s strategy. Paul, that was a perfect segue, because our question is what is your goal? What is your strategy? Do you want to have zero debt as soon as possible? If that’s your most important goal, then maybe you want to choose the 15 year, although that’s not a definite either, and we’ll get to that. You want to manage cash flow constraints? Well, a 30 year has a much lower payment, and if you want to create the most value over the course of your life, well, this podcast is not going to answer every one of those questions for you, but we’re going to look at a sample situation to say how that might work.

But as we’ve already discussed, the bank’s goal is to get the money back and lend it out again, because that’s how they make money on lending money. So the important distinction here is what’s the bank’s goal, what’s their strategy? And what is yours?

So we’re going to look at A Tale of Two Sisters. One has a 15 year mortgage, one has a 30, and aside from their hair color if you can see this online, everything else is exactly the same. So the only difference, color of their hair, and a 15 year versus a 30 year mortgage. Now, I took some interest rates,

I think this was a couple of weeks ago when I was playing around with this, so if you look up interest rates today you’re probably not going to see exactly the same, but these are real comparative interest rates from online for a 15 year versus a 30 year mortgage.

Paul Adams: And it’s 3.93 for the 15 year mortgage, 4.58 for the 30 year.

Cory Shepherd: And it’s the same exact size mortgage, $500,000.00. I hope that’s right, I forgot exactly which one I used. We’re going to see in a second. So monthly payment is $3,680.00 for the 15 year versus $2,557.00 for the 30.

Paul Adams: Huge difference in payment, $1100.00 a month, almost a … it’s like a 40% increase in payment.

Cory Shepherd: Mm-hmm (affirmative). So here is an example of what the first 13 months look like of the payment. Now I did this screenshot, it’s a little bit of an eye chart to see, and I did that so we didn’t have to look at all 360 months of this in a row. They’re both starting at the same balance, it was $500,000.00, I’m glad I remembered that correctly. And they’re inching down over time. So this is just about the first year.

So now we’re going to zoom out and check in a little bit more periodically. So let’s take a look at who’s done paying faster. We’ve got $3600.00 a month sister, and $2500.00 a month sister. Now we already gave it away. The 15 year gets done sooner in 15 years, because it’s a 15 year mortgage.

Paul Adams: So weird how that works.

Cory Shepherd: So weird how it works. Sister 2, stairsteps down over twice as long of a period. So she gets down to zero over 30 years. So obviously Sister 1 is done faster. So if your primary and only goal with no other concern for any other elements was to get done with that mortgage as soon as possible, then yeah, maybe it might make sense to do a 15.

But is this the whole story? I mean, we’re doing this podcast, so no, it’s not. Here’s the rest of the story. Sister 2 has that lower payment, so if we’re really going to compare apples to apples, we have to say, well, if $3680.00 was the total amount that they both had available, Sister 1 with a 15 year mortgage is putting it all to the mortgage, what does Sister 2 do with that $1123.00 a month? Well, she can save it. She can put it somewhere in her balance sheet, or in some kind of rate of return, and grow a balance over time.

So for this example I gave her a 6% annual rate of return, kind of moderate, middle of the road, pretty good portfolio, but nothing crazy. And what does that do for her? Well, that means that in the background not only is she inching down the balance of a mortgage, she’s also compounding some growth in an investment account at the same time.

Paul Adams: Which is so key, because no matter how you slice a mortgage, or how efficient it is, it’s always simple interest. And when you’re investing and growing money, it’s compound interest.

Cory Shepherd: So Sister 1, with the 15 year mortgage, gets to do that as well with all the money that she saved from her mortgage payments starting in year

15, so she’s saving twice as … not twice as much, but that higher amount, the full amount, $3680.00, that she finished with her mortgage to her investment account from year 15 and onward, as you can see on the top, but if anyone has shown you a power of starting early example, it’s a powerful force to be compounding money 15 years earlier. So let’s see where that leaves both of them.

So at year 15, let’s do a progress check first. So Sister 1 with the 15 year mortgage has a house and has a mortgage balance of zero. Sister 2 with the 30 year mortgage has a house, same house, same exact value of those houses, she has a mortgage with a balance of $332,000.00, but she also has investment assets of $328,000.00.

Paul Adams: And if I could take one step back for a moment here, Cory, the thing that I think is so easy to dust over is one sister has paid off her house altogether, meaning in simple terms, one sister has a $332,000.00 mortgage left, the other one has $332,000.00 more in equity. It doesn’t matter what the value of the home is. But the bottom line is that if that home went from being worth half a million and now it’s worth … we’ll just be conservative, call it 750 15 years later. If it’s worth 750 15 years later, there was zero rate of return on the extra money that’s locked up in home equity for Sister 2, because the home appreciates at exactly the same rate, regardless of the level of equity.

So extra equity in your property, it may avoid an interest cost, that’s true. But it absolutely does not produce any additional return in the tool called the home.

Cory Shepherd: Very good distinction, and I think people miss that a lot. And it’s the … the financial industry as a whole does try to focus us on the one thing in front of us, so a lot of conversation happens around the mortgage. But never like all of the other parts of that, including the reason why you’re doing it in the first place which is the home that the mortgage is tied to.

So to make the story even more intriguing, think about this from the perspective of Sister 2 with a 30 year mortgage. Now, the numbers aren’t exactly even. She has a $332,000.00 balance and $328,000.00 of investment. But she’s a couple thousand dollars off, for all intents and purposes, she has a pot of money equal to the mortgage. She also could choose at that time to match her sister.

Paul Adams: Yeah, she could just be paid off.

Cory Shepherd: Pay it off. So just because what the bank gives you says 30 year mortgage doesn’t mean you don’t get to pick a shorter timeline in the meantime.

Paul Adams: In this have we … which by the way I’m fine that we didn’t do it, I think it just speaks to the conservation, or the conservativeness of your strategy. But the sister that’s paying off over 30 years, did you give her any credit for the extra tax deductibility she had over that 15 years?

Cory Shepherd: No.

Paul Adams: Which is perfect. Meaning the whole thing about well, you get to write off extra … which really can be worth a lot of money potentially, that’s not even counted here.

Cory Shepherd: Right. So it’s probably better than this. It is probably better than this, depending on how mortgage laws and taxes laws change. So, here’s our recurring theme. Know what the bank strategy is, but pick a strategy that lets you chart your own course, and maybe even change your path midway. See, if we look at the two sisters and ask, “What is your strategy?” Sister 1 with the 15 year mortgage has created a strategy that’s really a one way street. The same goes for paying extra payments on your mortgage every single month.

So whatever kind of mortgage you get, if you’re month over month paying more to the bank than you have to as a minimum, then you’re locking yourself into a one way street, because no matter how many early payments you make, if you have one month that you can’t make the normal mortgage payment, the bank’s not going to be sympathetic, they’re not going to give you credit for the early payments that you made. They’re going to want their one on time payment that month. So just know that.

Paul Adams: The more equity you have, the likelihood goes up that you will have your home foreclosed on. Think about that for a moment. The reason they give you a lower interest rate on the 15 year mortgage is also in part because their safety net is happening more quickly. You see, your home, which many people unfortunately count as an asset of theirs, which it’s not, it’s just a

… something you own to hopefully minimize the cost of shelter over your lifetime. But it’s not your asset. Even when it’s owned outright, it doesn’t meet our definition of an asset. A definition of an asset being will it put money in your pocket now or in the future without changing your lifestyle? The answer is no, unless, which we need to talk about at another time, all the things you could do to make your house be a potential reverse mortgage candidate later on. But you have to position you entire financial life properly to do that.

So in this case, those two people, imagine in year 10 how much lower the debt is for our 15 year mortgage sister versus the 30 year mortgage sister. And if there’s a significant financial calamity, ala 2008, there are people, and you probably as a listener know somebody who managed to stay in their home, or know someone who knows someone who managed to stay in their

home for months, and months, and months, and months without making payments because the bank did not want to own it. I’ve talked to people in the foreclosure departments of banks, and there is a term they have, the red pile and the green pile. If you have a lot of home equity, you’re in the green pile. Meaning they can go take your home, they can put it on the auction block and sell it for $1.00 more than what you owe, and they’ll give you the dollar. But if you have a lot owed on the house, they don’t want to come and get the house, they want to work with you to begin making your mortgage a performing mortgage again. But they don’t want to own the home.

Which, in our one way street versus retaining control, in year 10 our sister with the 30 year mortgage has a lot of money elsewhere on her balance sheet, she probably never has a problem making the mortgage payment, because she had a lot of surplus capital now set to the side giving her the right to pay off the mortgage any time she wants after 15 years, but it also gives her a right to make mortgage payments for a really long time if things in life get dicey.

Cory Shepherd: And if that all … if you’re listening to that and it sounds wacky, like you’re saying, “Wait, if I’m more underwater in my home, the bank doesn’t want to sell my house, they’re not going to take it away from me?” Yes, it sounds wacky, and it’s exactly what happened over and over again in 2008 in the mortgage crisis.

So the 30 year check in is Sister 1 with the 15 year mortgage who after she paid hers off was saving the whole 3,000 in her account, has just over a million dollars, a million and 75 thousand. Where Sister 2 has 1.1 million. And that’s without the added benefits of tax deductions, certain things like that that would actually increase the value that Sister 2 was getting, but just the simple math of the mortgages and putting some money into an investment account, everything being the same, 30 year mortgage is leaving the sister with more money.

So this is not telling you be a 30 year mortgage person, or be a 15 year mortgage person, but think about what’s going to give you the most flexibility to have a strategy play out that benefits your life. If you want to be a 15 year mortgage person, consider that you might want a 30 year mortgage, but don’t tell the bank until the end of your 15 that you’d like it to be a 15 year mortgage. Because then you get to make that decision with all of the information about your life and options that has played out over 15 years, and do it all in one fell swoop, or change your mind and, I don’t know, go buy a business that you have the opportunity to buy, go buy another property, do whatever would make more sense at that point in your life with all of the information that you have.

Paul Adams: For clarity, we love that when people have a paid off home … having a paid off home is a great deal of security, mental clarity, frees up cash flow, no question. The difference we’re getting at here is that the path by which to get there, to be as safe as possible, is to not give the bank lots of extra money, not to make extra mortgage payments every single month. Because every time you make an extra mortgage payment, you’re not lowering your own payment next month, number one. Number two, they’re giving you no credit if you hit bad times for having made the extra payment. And the only thing you’re absolutely doing is making the bank safer. To make you more safe, it needs to be on your balance sheet until such time that you pay the bank off. And there is an old joke that goes something to the effect of even if you own your house outright, and pay off your mortgage, if you want to know who the real owner is, stop making your property tax payments, eventually the real owner will knock on the door and introduce themselves.

That’s not the ideal path we want to be on, but I do want everybody listening to realize that having a paid off home can be great, but let’s do it by writing a check once, not by making the bank safer, and safer, and safer over time. Let’s control our cash flow, control our assets, be responsible for it, and watch what happens in the way you’re able to navigate and move with your balance sheet over that period of time.

With that, Cory, would it be okay if we jumped on to give a couple of the featured reviews we’ve had this last week on the podcast?

Cory Shepherd: Yes, that’s great, let’s do it.

Paul Adams: Okay, so the first one I have is Start Listening, a five star rating, so thank you for that, by Terrible@Finance. “I usually glaze over as soon as someone starts discussing financial planning, or anything remotely related to the topic. This podcast break things down into reliable, interesting topics that help …” sorry, “relatable,” I would also like to think we’re reliable. Relatable.

Cory Shepherd: Reliably interesting. Yeah.

Paul Adams: Yeah. “Relatable, interesting topics that help frame financial conversations. Listening has started a lot of great conversations with my spouse, and helped me actually start to take ownership of our money and where it’s going.” So to you, Terrible@Finance, if you have not done so, please take a moment, be sure to send us a screenshot of that with your address and we will send you a copy of Michael Michalowicz’s Clockwork,which is the book we’re giving away right now, cannot say enough good about what we’re hearing from people, both on the podcast reviews, but also what people are getting from this book, and being able to think about their lives and finances differently.

And as a reminder, if you want to get the PowerPoint that Cory put together to give you some visuals, maybe look at the PowerPoint while listening to the podcast, maybe while you’re sitting with your spouse to have these conversations, I cannot encourage you enough, you can go to mortgage.sfgwa.com, mortgage.sfgwa.com. You’re going to be able to download that Power Point, it will have it all flattened for you in PDF. And also write us a review, give us an honest review on iTunes or wherever you consume your podcast. We’re going to send you a copy of that book along with a big thank you, and we’re going to be taking those featured podcast reviews and putting them right here on the podcast.

Cory, great job with this today. And to all of you, we hope that this conversation has been a contribution to you being able to design and build a good life.

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