The Housing Market
The housing market has been insane since 2020, and everyone seems to have an opinion about what the future holds. No matter what your opinion on it is, there’s no denying that things are really out of whack and that this is an anomalous situation.
Houses are even more unaffordable now than they were prior to the housing market crisis in 2008. The median home price is now over 80% higher than at the peak in 2007, despite cumulative inflation being only about 42% and real median income up less than 10% since then.
Meanwhile, rent prices have increased, but not nearly to the extent of home prices in most areas, really throwing off the rent/buy ratios. The only thing holding up housing prices right now is the lack of housing inventory for sale.
If not for people being locked into low interest rate 30 year mortgages, there’s no doubt that a significant housing market decline would be imminent. This is a very tough time to be in the market to buy a new home, and many are struggling with deciding if they should buy now or wait for lower prices. The answer largely comes down to personal situation and time horizon, but from a historical standpoint, waiting seems like a good idea if possible.
Paying Cash for Our House in 2020
It’s been about three years now since I wrote an article about paying cash for our townhouse instead of getting a mortgage. Interestingly, that article got some of the most criticism on social media of any I’ve ever written. People were very surprised that I wasn’t taking advantage of low mortgage rates at the time. In fact, I still get messages and emails about that article sometimes now. I believe that the reasoning in that article was sound though, and most of the criticism seemed to come from people who were just reacting to the title and didn’t even read the article.
Something interesting has occurred since I wrote that article though. First, mortgage rates dropped to all time lows over the next year, but then suddenly they exploded higher starting at the end of 2021 and have stayed elevated since then. The 30 year mortgage rate chart is pretty crazy to look at. 40 years of steady decline in rates, and then suddenly a break in the trend.
Now that rates are much higher than I could have gotten back in 2020, I recently had someone ask if I regretted paying cash now in hindsight. The answer is still no.
All of the factors in the last article still apply, but an even bigger reason why I don’t regret it is mortgage amortization, which is often not well understood.
What is a Loan Amortization Schedule?
Mortgages are a special type of loan that tend to favor the lender in normal markets. This article explains amortization pretty well. The reason the mortgage loan amortization schedule favors lenders is because most of the interest on the loan is front loaded. That means that for the first half of the loan term, more of your payment is going toward interest on the loan, whereas in the second half of the loan term, more of your payment is going toward the principle. This calculator and graph does a good job of illustrating this.
Why would this favor the lender? Because most people are not staying in their homes for the full term of their mortgage, meaning they never get to the point where the amortization schedule starts to work in their favor. In fact, the average homeowner has a 30 year mortgage but only stays in their home for 13 years. For someone who is only staying in a home for 13 years, the true cost of interest on their mortgage is actually much higher than the rate they thought they signed up for. With higher rates, longer mortgage terms, and shorter durations of staying in the home, the true interest rates are actually significantly worse.
Here’s an example so we can see how this works:
- Let’s say that I buy a house for $400,000 with 20% down and take on a 30 year mortgage at a 6% interest rate.
- This gives me a mortgage payment of just under $2,000/month, not factoring in taxes and insurance.
- I buy the house expecting to stay there forever, but 4 years later I get an amazing job offer in a different state that I can’t turn down.
- Over the course of the 4 years on my $320,000 mortgage, I pay about $92,000 in payments.
Most people would assume that my payments built me a significant amount of equity in the house, but that isn’t actually true. Amazingly, due to the mortgage loan amortization schedule, the vast majority of those payments went toward interest on the loan.
In fact, of the $92,000 in payments I made over the four years, just over $17,000 of that went toward the principle of the loan. That means that I paid almost $75,000 in interest! If the housing market stayed flat for those 4 years or increased at only a couple percent per year like normal, then after property taxes, realtor fees, and closing costs, I would end up with less money than I started with despite paying $2,000/month!
So what is the true percentage of my payment that went toward interest on my 6% mortgage for those 4 years? Over 81%! After accounting for the transaction costs, I would have been much better off renting.
Now let’s do the same example, but for someone staying in their home for 13 years, which is the average based on the data.
- In 13 years with the loan above, I’d make just under $300,000 in payments on my mortgage.
- How much of that goes toward principle? Only $75,000, leaving the other nearly $225,000 going toward interest on the loan.
- So what was the real percentage of my payment going toward interest during those 13 years? 75%!
- It actually wouldn’t be until year 19 that more than 50% of my payments would be going toward principle on the loan.
Many people signup for a 30 year mortgage thinking they’re actually only paying 6% interest, when in reality the majority of homeowners (who stay less than 30 years) are paying upwards of 50% of their payment toward interest during the life of their loan, before selling the house and starting over with the same terrible amortization schedule on a new home.
Homeownership isn’t a scam, but for people that move houses often, it sure can feel like it is.
My Situation
So why am I glad I didn’t get a 3.5% interest mortgage on our townhouse when I had the chance? Because I wouldn’t have been actually paying anywhere close to 3.5% in interest. We have no intention of living in our townhouse for more than another year or two maximum, which would put us at being there for 4-5 years.
In my situation, over the course of 4 years, my effective interest paid on the loan would have been about 63%. I would have also had higher transaction costs, less negotiating power, and a much slower closing.
Based on my prior article, I calculated that by paying cash for the house, I saved about 2% of the purchase price in closing costs and saved about 3% on the purchase price (both on the conservative end) due to negotiating a lower price due to a quick closing and low hassle for the seller. If I add those costs as effective additional “interest” on going the mortgage route, that would have made my effective interest rate paid on the mortgage almost 90%. That is truly insane!
Be Aware of Your Actual Mortgage Interest Rate
I think most people understand that the mortgage loan amortization schedule means they pay more of the interest up front on the loan, but I don’t think most people understand just how big the impact is, or how moving often and getting new mortgages, along with the associated fees, can mean that you’re essentially paying 100% interest in some cases.
If my true effective rate of getting a 3.5% interest rate mortgage was close to 90% over 4 years, imagine what it would look like for someone staying in an expensive house for only 2 years with a higher mortgage interest rate. That would be a major torpedo to your net worth and future financial goals.
Before taking on a mortgage, it’s extremely important to think long and hard about how long you will truly be likely to live in that home. If it’s 5 years or less, then there’s a very good likelihood that you’d be better off renting instead, even if the mortgage rates are back to 3-4% at that time. Even if it’s 10 years, there’s a good chance you’d be better off renting at current mortgage interest rates and inflation adjusted home prices higher than the housing crisis of 2008. The higher mortgage rates go, the more this favors renting instead.
Were these numbers surprising to you? I was certainly shocked when I was doing the calculations for this one! We’ll most likely pay cash for any future houses we buy as well based on these numbers.
Disclaimer: I recognize that paying cash for a house is not realistic in many people’s situations, which is why I said that in many cases if getting a mortgage doesn’t make sense mathematically for you based on the amortization schedule, you may consider renting instead. But, in my situation, I had saved up and had cash on hand to be able to buy a house outright rather than get a mortgage or rent. Many people criticized my choice by saying I should take advantage of the low mortgage rates and instead invest that cash I had saved up. However, I still stand by my decision to use the cash to pay for the house due to the reasons outlined above, and I will likely make the same decision for future housing purchases assuming that I have enough cash to buy the next house.
Fifth Wheel Physical Therapist 