Many first time home buyers unknowingly commit themselves to excessive interest expenses by starting with their dream house. Starting with your dream house holds a lot of appeal: you get to enjoy the house now rather than later and you save on real estate agent fees on the purchase and sale of your first home. Additionally, one skirts all of the stressful unpleasantness that comes with moving and selling your home.
Unfortunately, many home owners trade thousands of dollars for this convenience. Understanding the behavior of interest on large balances will help you weigh the benefits of starting with a modest home.
Your worst enemy, or your best friend
Interest is a powerful force. Interest’s impact is determined by three things: time, rate, and balance. Unfortunately, at least two factors are usually against the home buyer. The amount borrowed usually is substantial, so the borrower has to stretch the loan out over many years. Often, the rate is high as well, so the borrower may need to reduce the amount borrowed or shorten the length of the loan.
Sadly, an understanding of this process is often lacking or just forgotten due to the excitement of buying a house. To make matters worse, house shoppers often increase the amount they’re willing to borrow as they encounter houses priced just above their price range. That decision will cost them dearly over the long haul.
When discussing large amounts over long periods, interest’s effects become correspondingly large. Consider the purchase of a four hundred thousand dollar home—not an uncommon occurrence along the coasts. There are three strategies a home buyer could employ to finance the purchase amount. (The example below ignores the impact of taxes and inflation.)
Three financing strategies
First, finance the entire amount. Second, purchase and pay off a starter home over fifteen years before buying the dream house. Third, purchase a starter home but make payments equal to the first option before buying the dream house.
The first option will burden the new home owners with a $2,528 mortgage payment (@ 6.5%) to the bank—totaling more than half a million dollars in interest over the life of the loan! While some buyers may be able to handle the payment, the $400,000 house will cost over $900,000 by the end of a 30 year mortgage.
Most people find these numbers truly disturbing. Fortunately, starting with a more affordable house can cut interest expenses in half.
The second option involves two changes: the amount financed and the length of the loan. When a $200,000 house is repaid over fifteen years, the payment drops by $786. After fifteen years, the more expensive house only requires another $200,000 loan. Borrowing smaller amounts has a big impact on the total interest costs—$227,000—less than half of the interest and at a lower monthly payment to boot.
Mortgage-free with hundreds of thousands to spare
For the home buyer who can handle a twenty-five hundred dollar payment, the more expensive house might still be a mistake. If a starter house is purchased, but paid off at the higher $2,528 payment, the house will be paid off in eight years and nine months, resulting in just under $62,000 paid to the bank. If the more expensive house is then bought and paid off at the same rate, the home buyer will be mortgage free after 17 1/2 years and $123,698 in interest.
This leaves the savvy homeowner in an enviable position with an extra $2,528 a month to invest. Placed in a savings account earning just 1.5% more than inflation, the balance will grow to $417,315 at the end of thirty years—just as the first home buyer is paying off his $400,000 house.
Photo by Jordan