Updated: Mar 4, 2021
I’ve written ad nauseum about mortgages: how the payments breakdown, overview of the different kinds of mortgages, FHA, VA, conventional, ARM, etc. But what I haven’t written about is my overall take on them.
Mortgages are pretty much a necessity in the United States. It is difficult to save the chunk of cash needed to buy a home outright. According to Zillow, the average price of a home in America is over $250,000. According to Ziprecruiter, the average salary in the US is somewhere around $60,000. If a couple were each making the average salary of $60,000 ($120,000 total) and they saved 10% of their salaries towards a home purchase, they would save $12,000 per year. At that rate, it would take this couple over 20 years to save $250,000 – and do you think the average price of a home would still be $250,000 in 20 years? No.
There is a school of thought out there that having a mortgage, and thus paying interest on a home loan, is a bad thing. I am not enrolled in this school. When is having a mortgage a good idea?
You’re relatively young (could have the place paid off by retirement)
You plan on living somewhere for at least 3 years
You can buy a home for which the total payment is approximately equal to what the rent would be on the property
Here are the two main reasons people have voiced to me that they are against mortgages:
Objection 1: If I don’t own my home outright, someone can take it from me.
If you have a job, career, and/or transferrable skills, you should not be afraid of your home being foreclosed on. Combine your employability with an emergency fund, and no one will be able to take your home from you.
Objection 2: I don’t want to pay that much in mortgage interest.
There is no question that the amortization on home loans benefits the banks immensely. Since you pay most of the interest up front and most loans only last 7 years (meaning the owners move, refinance, or pay off the mortgage), the banks do very well here. As outlined above, though, being able to save up enough money to pay cash for a home or pay the mortgage off in the early years when interest is the highest is just plain difficult.
Here are the two main reasons I believe it is acceptable to have a mortgage on your home:
Home values increase about 4% per year, and with interest rates below that, you could be paying 3.5% APR on a home whose value is increasing by more than the interest rate. Increasing home values increase homeowners’ net worth. For more on home equity, read this blog.
Getting a mortgage on a home and paying the home off prior to retirement allows the homeowner to free up retirement income for other things, like healthcare.
That covers how I feel about having a loan on your primary home. For investment properties, my opinion is a bit more nuanced. Logically, if you can get a loan on a property and have tenants pay down this loan, collect enough rent to more than cover your expenses, and capture appreciation all at the same time, it makes sense to have a mortgage on a rental property. Here are the questions that leads to the nuances:
What if you weren’t able to collect rent for an extended period of time, for example, during a global pandemic? There must be hundreds of landlords out there right now who are not collecting rent, are not permitted to evict, and must pay their mortgages.
What if you can’t get favorable loan terms unless the loan is in your personal name? Even with liability and umbrella insurance, the safest thing you can do is hold rentals in an entity to protect your personal assets to the fullest, however, commercial loan terms, and even loan terms on investment properties held in the investor's name, are not nearly as favorable as conventional loans (or FHA and VA loans, for that matter).
In our experience, paying for a property outright and owning it in an LLC is the right choice. When we were unable to collect rent during the pandemic, we at least knew we didn’t have a mortgage to pay. Furthermore, if you borrow money for your primary home, your interest rate and required down payment are lower than they would be for an investment property. For example, if you were to borrow $200,000 for your primary residence and buy a $175,000 investment property with cash, then it’s almost as if that primary home loan financed your investment property. Additionally, making a cash offer on an investment property easily could be the difference between getting the deal and not getting it.
In short, it is not only acceptable, but generally a good financial move to own an affordable home prior to retirement, even if you need a mortgage to own it. Mortgages on investment properties, on the other hand, may make sense or not depending on the investor's risk tolerance.