A Tale of Two Brothers

By Ric Edelman

Ric Edelman has educated his clients for years on the benefits of integrating their mortgage into their overall financial plan. In his book, The New Rules of Money, Ric tells the story of two brothers, each of whom secures a mortgage to buy a $200,000 home. Each brother earns $70,000 a year and has $40,000 in savings. The first brother, Brother A, believes than half the nation’s banks failed and millions of homeowners, unable to raise the cash they needed to payoff their loans, lost their homes. Out of this the American Mantra was born: Always own your home outright. Never carry a mortgage. The reasoning behind America’s new mantra was really quite simple: if the economy fell to pieces, at least you still had your home and the bank couldn’t take it away from you. Maybe you couldn’t put food on the table or pay your bills, but your home was secure. Since the Great Depression laws have been introduced that make it illegal for banks to call your loan due.

The bank can no longer call you up and say, “We’re running a little short on cash and need you to pay off your loan in the next thirty days.” Additionally, the Fed is now quick to infuse money into the system if there is a run on the banks, as we saw in 1987 and Y2K. Also, the FDIC was created to insure banks. Still, it’s no wonder the fear of losing their home became instilled in the hearts and minds of the American people, and they quickly grew to fear their mortgage. In the 1950’s and 60’s families would throw mortgage burning parties to celebrate paying off their home. And so, because of this fear of their mort- gage, for nearly 75 years most people have overlooked the opportunities their mortgage provides to build financial security.

WHY PEOPLE HATE THEIR MORTGAGE AND WHY YOU SHOULDN’T

Many people hate their mortgage because they know over the life of a 30 year loan, they will spend more in interest than the house cost them in the first place. To save money it becomes very tempting to make a bigger down payment, or make extra principal payments. Unfortunately, saving in the old way of paying off a mortgage, which is as soon as possible. Brother A bites the bullet and secures a fifteen-year mortgage at 6.38% APR and shells out all $40,000 of his savings as a 20% down payment, leaving him zero dollars to invest. This leaves him with a monthly payment of $1,383. Since he has a combined federal and state income tax rate of 32%, he is left with an average monthly net after- tax cost of $1,227.

Also, in an effort to eliminate his mortgage sooner, Brother A sends an extra $100 to his lender every month. Brother B, in contrast, subscribes to the new way of mortgage planning, choosing instead to carry a big, long-term mortgage. He secures a 30-year, interest- only loan at 7.42% APR. He outlays a small 5% down payment of $10,000 and invests the remaining $30,000 in a safe, money- making side account. His monthly payment is $1,175, 100% of which is tax deductible over the first 15 years, and 64% over the life of the loan, leaving him a monthly net after-tax cost of $799. Every month he adds $100 to his investments (the same $100 Brother A sent to his lender), plus the $428 he’s saved from his lower mortgage payment. His investment account earns an 8% rate of return.

Which brother made the right decision? The answer can be found by looking into the future. After just five years Brother A has received $14,216 in tax savings, however he made zero dollars in savings and investments. Brother B, on the other hand, has received $22,557 in tax savings and his savings and investment ac- count has grown to $83,513. Now, what if both brothers suddenly lose their jobs? The story here turns rather bleak for Brother A. Without any money in savings, he has no way to get through the crisis.

Even though Common Home Equity Misconceptions Many Americans believe the following statements to be true, but in reality they are myths, or misconceptions: Your home equity is a prudent investment. FALSE Extra principal payments on your mortgage saves you money. FALSE Mortgage interest should be eliminated as soon as possible. FALSE Substantial equity in your home enhances your net worth. FALSE Home Equity has a rate of return. FALSE Page 4 How the Affluent Manage Home Equity 4 he has $74,320 of equity in his home, he can’t get a loan because he doesn’t have a job. With no job and no savings, he can’t make his monthly payments and has no choice but to sell his home in order to avoid foreclosure.

Unfortunately, at this point it’s a fire sale so he must sell at a discount, and then pay real estate commissions. Brother B, while not particularly happy at the prospects of searching for a new job, is not worried because he has $83,513 in savings to tide him over. He doesn’t need a loan and can easily make his monthly payments, even if he is unemployed for years. He has no reason to panic, as he is still in control. Remember… Cash is King! Now, let’s say neither brother lost his job. We’ll check in on them after fifteen years have passed since they purchased their homes and evaluate the results of their financing strategies. Brother A has now received $25,080 in tax savings, he has $30,421 in savings and investments (once his home was paid off he started saving the equivalent of his mortgage payment each month), and owns his home outright. Not too bad, right? Now let’s check on his Brother. Brother B has received $67,670 in tax savings and has $282,019 in savings and investments.

If he chooses to, he can pay off the remaining mortgage balance of $190,000 and still have $92,019 left over in savings, free and clear. Finally, let’s assume that rather than pay off his mortgage at fifteen years, Brother B decides to ride out the whole thirty years of the loan’s life. While Brother A has still received only $25,080 in tax savings, his savings and investments have grown to $613,858, and he still owns his home out- right. Brother B, on the other hand, has received a whopping $107,826 in tax savings, has accumulated an incredible $1,115,425 in savings and investments, and also owns his home outright. He can start over fresh and enjoy the same benefits once again. Unfortunately, the majority of Americans follow the same path as Brother A, as it’s the only path they know. Once the path of Brother B is revealed to them, a paradigm shifting epiphany often occurs as they real size Brother B’s path enables homeowners to pay their homes off sooner (if they choose to), while significantly increasing their net worth and maintaining the added benefits of liquidity and safety the entire way.