Appreciation doesn't matter

Roger Schlesinger
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Posted: Dec 04, 2006 12:00 AM

Not too many years ago, a half-century or so, housing wasn't anything else but a place where people lived. Those who could afford it purchased a house, those who couldn't or didn't see any reason to buy a house, rented their homes. It really didn't matter because prices were pretty stable and people weren't really thinking “investment” when it came to houses. This all changed with the end of World War II when the G.I.'s came home and wanted to begin their lives. Housing tracts developed and buying was more affordable with better lending practices. Fast forward four or five decades and look what has happened to housing. It has become the investment of choice for the middle class, and has worked very well for a large percentage of the population in this country.

Well, I am here to tell you that appreciation doesn't matter, and you will still see housing as the investment choice for millions because it works. The reason: amortization. Amortization is the paying down of the mortgage loan, and how you do it will dictate your investment success in the short run and in the long run. Then, appreciation is simply the best icing on the cake anyone could ever imagine. So let's jump right in and see what I am talking about.

Before I get down to brass tacks, I would like you to know that there are more ways to accomplish what I am going to show you than just what you will see in this column. Mine is not the only, or even the best, solution to maximizing your mortgage dollars. It is simply the easiest and most understandable solution.

The best vehicle I know, for the majority of the people in this country, is the 15-year fully amortized loan. Following this loan very closely is the 20-year and the 10-year fully adjustable loan. That is it! In case you haven't noticed, I did not mention the most popular loan in the world – the 30-year fixed. I believe it will have its day when the average life expectancy goes over 90 years. Then you have three equal life parts: the first 30 years to enjoy and not take anything too seriously, the second 30 years to put in the effort to build a nest egg, and the last 30 years to enjoy the fruits of your labor. Until people live well into their 90's, a 30-year fixed will have to cut into the first or last 30 year period, and unfortunately generally falls into the last 30 year period. Who needs that aggravation in their "golden years"? Those years, as I have stated above, are for the rewards, not the efforts.

So what is the answer? If you are just starting out, the answer is very easy. Do not follow the advice I was given, which was "buy as much house as you can afford with a 30-year loan". The new advice is: Buy as much house as you can with a 15-year loan, or worst case, a 20-year loan. The reality is that your first house will not be everything you want or even need, but every home after that will be. Why? Because you will have the equity from your first house to use to purchase a bigger house, or better house, and the discipline to continue using a 15 or 20 year loan. Let's look at the examples:

30-year loan

$300,000 house; $270,000 loan = $1600/month

5 year balance: $251,000

Amortization $ 19,000

15-year loan

$222,000 house; $200,000 loan= $1635

5 year balance: $151,500

Amortization $ 48,500

At this point I assume both buyers will move up. Neither house has appreciated, and the 30-year loan buyer will have $49,000 to use ($30,000 down payment on the first house plus the amortization), while the 15-year loan buyer will have $70,500 to use from the down payment and amortization. The gap would be closer in the first five years if there were some appreciation, as the $300,000 would have greater value than the $222,000 house. This would begin to reverse by the sixth or seventh year, as the amortization value would really start widening. Example:

30-year loan ($270,000)

7 year balance $241,000

10 year balance $225,000

15 year balance $191,000

15-year loan ($200,000)

7 year balance $128,000

10 year balance $ 87,000

15 year balance $ 0

At the end of 15 years, the 30-year buyer would have a value (without any appreciation of the house) of $109,000, which again is made up of his amortization and down payment. The 15-year buyer would have $222,000, which was the purchase price, as he will not have any loan.

Let's add in some appreciation to the value of the house, 2% annually, and the buyer with the 30-year loan will have an additional $90,000 in value for a total of $199,000 while the buyer with the 15 year loan will have an additional $66,000 for a total of $288,000.

I wish to emphasize that both buyers had the same approximate payment of principal and interest for the entire 15 years. It is pretty simple to see that starting out with the right loan and the discipline to “under buy” the house (take a house that you can afford on a shorter amortizing loan) for the sake of the loan is the way to go. But unfortunately most of us didn't get that message when we began, so what should we do now?

Those who have a 30-year loan or an arm that is amortized over 30 or more years and have debt can do what I have been proposing all year. You can roll all your debt into a new mortgage as long as you can either save money on a monthly basis (not the primary goal) or lower your amortization to a 20,15 or 10 year fixed and have a lower payment, or be able to do both and have the best of both worlds. If you study the ramifications of this you will see how much it makes sense and the hundreds of thousands of dollars you will not pay in mortgage payments (save).

Should you have a 30-year or longer mortgage and not have debt then it takes willpower or a burning desire to free up your life in the future to make the change. I usually will tell this type of borrower to cut back on the weekend spending and you will save enough to slip right into a 15-year or 20-year mortgage.

For those who are investment minded, take the difference between your current 30-year payment and a proposed 15-year payment and consider the difference an investment. Calculate the yield by figuring out your balance on your current loan in 15 years if you don't make the change, and now you have the cost (the difference between the two payments times 15 years) and the dollars you will not pay (save) which is the balance you determined you would have in 15 years. This should turn out to be pretty dramatic and make you want to move forward.

If this column does anything at all, it should show you what you are currently missing and what you can do about it. Depending on the numbers that you come up with, your motivation should be staring you in the face. Then, if you would like, add some appreciation and start looking for sacks to store the gold for the golden years.