Conventional wisdom says that weshould buy a house, take a 30-yearfully amortized loan and retire in a paid-for-home. Conventional wisdom also saysthat you should amass a separate, availablereserve of 6 months of income forthe unexpected. There might be anotherway to think about these personalmoney matters and in combination.Welcome to the new wisdom.
Real estate has been soaring withowners sitting on grander equity andbuyers having to stretch even further indebt to purchase a home. Because ofrecord low interest rates, which ironicallyderive from low inflation in non-realestate areas of the economy, a newapproach to real estate has been renderedpossible, even desirable.
To accommodate the mass urge toown a home in a period of record pricesand record low interest rates, which areinversely and directly related, the mortgageindustry has come up with creativenew lending products. Not coincidentallydriving their profits to record levels, too.Capitalism hates a vacuum. Some ofthese products include the adjustablerate mortgage (ARM), the previouslythought-too-risky interest-only loan.
Conventional wisdom says that interestrates are at record lows so we shouldbuy or refinance a home at a locked-inmaximum term. That's okay, but new wisdomsays stop and think for a minute. Aninterest-only loan is 100% deductible upto $1 million, not like the partially deductibleamortized loan where you paydown the principle. And know that wepay down very little of the principle in thefirst years of a standard loan and thatonly a minority of people keep their originalloans even 10 years. Refinances,deaths, changing needs, business moves,and all manner of "it happens" may dictateearly mortgage pay-offs, invalidatingour long lock-in plan.
Though no one can predict when theywill happen or their magnitude, as certainlyis seen now, real estate and interestrates do go through a cycle. So if youplan to be in the same house for 5 to 10years, you should be okay eventually,even if rates rise and home values flattenin the short term. Don't panic. Particularlywhen you realize that 10 yearsfrom now you will be paying down debtwith inflated dollars, even if that is just2% to 3% per year. And the generaltrend for incomes is that they will alsorise, HMOs notwithstanding.
And for those who have the discipline,investing the money you would paytoward mortgage principle reduction in awell-diversified portfolio of say 60%stocks and 40% bonds will, over time,yield the historical average of an 8%gain. Compare this with the 4% or 5%you would constructively make payingdown an amortized mortgage.
Now then, if you are a homeownerstruggling with saving that 6 months ofincome for emergencies that financialplanners often recommend, while alsowrestling with educational debt, savingfor college and retirement, and, heavenforfend, a shiny new car, consider this:Many people have accumulated a growingequity in their home that is untouchedand earning them nothing.Establishing a currently popular equityline of credit might be a solution. I said"might;" don't fly off the handle yet.
On the one hand, payments of intereston a home equity loan are deductible upto $100,000. On the other, you can consolidateyour overall debt to a lowerinterest rate and have money availablefor an emergency without saving separatelyin a tax exposed way. These loansare easily available, cost at a varying butlow prime interest rate, and require onlya minimal payment once tapped.
The key is having enough equity and aclear idea of what's going on so that youcan maintain discipline to only use theequity line if one of the above conditionspertains. Be careful and discuss the ramifications fully with your financial team, ifit seems like these ideas might be useful.Crunch the numbers and assess the risk.
At first, these inversions of conventionalwisdom about mortgage debtmight seem more like Aesop's grasshopperthan the ant–imprudent and notpreparing for a financial winter. But foran increasing number of us, the interestonly and home equity loans, used withcare, are the new conventional wisdom.
Jeff Brown, MD, CPE, a practicingphysician who is a partner onthe Stanford University GraduateSchool of Business Alumni ConsultingTeam, teaches in the StanfordSchool of Medicine FamilyPractice Program. He welcomes questions orcomments at email@example.com.