A Concept & Facts for creating wealth using your mortgage as a tool, instead of an obstacle, for creating wealth.

Excerpt from "Ordinary People, Extraordinary Wealth"

 What secrets do the top 1% of financially successful people do?    

 Secret 1 
They Carry a Mortgage on Their Homes Even Though They Can Afford to Pay it Off. 
If you had enough money to pay off your mortgage right now, would you?

Many people would. In fact, “The American Dream” is to own your home—and to own it outright, with no mortgage. Imagine owning your home without having to send a check to a mortgage company or bank every month! Being so fortunate must evoke such a sense of security, satisfaction, and well-being that you could only dream of it! Imagine the feeling you’ll enjoy when, after 30 long years—360 monthly payments—you finally make your last payment, and the house is yours forever!  If The American Dream is so wonderful, how can you explain the fact that thousands of financially successful people—people who have more than enough money to pay off their mortgage right now—refuse to do so? Consider these facts derived from my survey research. Of the respondents:
 1. The average home value is $255,700; the average mortgage balance is $142,000. Even though 100% have the ability to own their home without a mortgage, 83% carry a mortgage anyway. 
2. 100% have the ability to send in extra money along with their monthly payments, to eliminate the mortgage ahead of schedule—but 90% choose not to. Instead, 85% of the respondents have a 30-year loan and no one in this group sends in extra principal payments or participates in bi-weekly mortgage plans. 

Clearly, these successful Americans are not bothered by carrying a big, long mortgage. Compare yourself to them. If you have a mortgage and are struggling to pay it off, or if you’re dreaming of the day when you make your final payment, you’re trying to do something that financially successful people do not do.  What do they know that you don’t? It’s vital that you understand what’s happening here. And we begin with the fact that talking about mortgages is not a conversation about economics or finance. It’s about emotions. You “love” the idea of owning your own home. You “hate” your mortgage. If you’re like many, you may even “fear” it. All of these are emotional words; none of them are financial. Yet, a mortgage is a financial tool—not an emotional state of mind. Why, then, do you feel the way you do about your mortgage?

Blame it on your parents.
Just about everything you’ve learned about money, you’ve learned from your parents. Even though Mom and Dad never said a word to you about money, they had lots to say about mortgages—especially when you announced you were planning to buy your first house. “Make a big down payment,” they told you, “and keep the mortgage payment low.” “Pay it off early, child. You don’t want that mortgage hanging over your head.” 

Indeed, your parents and grandparents made it very clear to you that mortgages are bad, something to minimize, or to avoid whenever possible. A necessary evil at best. But what they never told you was why they felt this way about mortgages. It’s important you understand their perspective or you’ll fail to understand why their advice is bad for you. So let’s look at mortgages from your parents’ and grandparents’ point of view.

 Why People Fear Mortgages—and Why You Shouldn’t
Our story begins in the 1920s. Back then, houses typically cost $5,000. Sure doesn’t sound like much, until you consider that the average annual income in the U.S. was $1,434 in 1925. Consequently, few people could afford to pay cash for their homes—just like today. So, people borrowed the money from banks—again, just like today. But the loans were structured differently back then. A common clause in the loan agreement gave banks the right to demand full repayment of the loan at any time; if you failed to repay your loan when asked, the bank had the right to take your house from you and sell it to recoup its money.  So although the terms called for you to send $24 to the bank every month2 to pay off that $4,500 balance over 30 years, you knew you suddenly might be required to repay the remaining balance in full at any time. You didn’t worry about that clause, because you knew that having the bank ask you for $4,500 in cash, well, they might as well ask for the moon.  Then came October 29, 1929.

When the stock market crashed, millions of investors lost huge sums of money. Problem was, it wasn’t their money they had lost. You see, most investors back then had bought stocks with borrowed money—money lent to them by their stockbrokers, called a “margin account.”3 Under rules then in effect, you were allowed to buy $100 worth of stock by giving your broker just ten bucks; your broker would loan you the other $90. So when the Crash hit, knocking 30% off the value of everyone’s stock portfolios, a typical brokerage account that previously was worth $100 now contained stocks worth only $70. But the investor had borrowed $90 to buy them! This led to a “margin call,” where the broker would tell the investor that because his account had exceeded the “margin limits, ” he had to come up with more cash. If the investor failed to do so, the broker would begin to sell some of the investor’s stocks, and the broker would continue selling until enough cash was raised to meet the margin call.  Selling off the portfolio was the last thing the investor wanted his broker to do. The stocks were already down 30%—this was the worst time to sell. So, to avoid the margin call, the investor went to his bank and withdrew enough cash to meet his broker’s margin call. The investor had to act quickly, because under stock exchange rules, margin calls must be fulfilled within 24 hours. Therefore, in the days following the Crash of ’29, a lot of investors went to their banks and made withdrawals. 

It didn’t take long for the banks to run out of cash. When they did, word quickly spread. Bank depositors stampeded the banks, demanding their money. To get more, the banks started calling their loans due. They sent telegrams to their borrowers, demanding they pay off their loans immediately and in full. Because these homeowners didn’t have the cash—you might as well ask for the moon—the banks foreclosed and put the houses up for sale in a desperate attempt to raise capital. It didn’t work.                                                     With no one willing or able to buy the houses, banks found themselves owning virtually worthless real estate. Unable to satisfy depositors who were demanding their cash, the banks closed their doors, many of them never to reopen. With investors unable to get their cash from their banks, they were unable to meet their margin calls—so their brokers started selling out their holdings. But everyone was in this dilemma, so the brokers couldn’t find buyers for the stocks. With no one willing to buy, the brokers had to continually drop the stocks’ prices.  Ultimately, the Great Depression saw the stock market fall more than 75% from its 1929 highs. More than half of the nation’s banks failed. Tens of millions of Americans lost their jobs as companies went bankrupt. And millions of homeowners, unable to raise the cash they needed to pay off their loans, lost their homes. The American Dream had become a national nightmare.  But not for those who owned their homes outright. These lucky few were immune to the banks’ collapse. With no loans to repay, they got no telegram demanding full payment. As their neighbors went broke and lost their homes, with thousands committing suicide, those who owned their homes outright succeeded in keeping them. They might not have found work, or had much to eat, but they kept a roof over their children’s heads. And thus was born America’s mantra: Always own your home outright. Never carry a mortgage.                     And yet, despite all this, a small group of Americans insist on carrying a mortgage even when they can afford not to. Why would they place themselves at such risk? Don’t they know what they’re doing? 

Actually, they know exactly what they’re doing. They are among America’s elite: the wealthiest 1% of the population. Not only do they know what they’re doing, they know why they’re doing it. It’s you who fails to understand. What you and your parents have failed to realize is that our nation has learned from the harsh lessons of the 1930s. A ’30s-like depression has not been repeated, and indeed cannot occur again, because of the safeguards that have long since been put into place.
 Among them:  
1)  Banks are no longer able to cancel your mortgage. This means that if you have a mortgage, there is no risk that you suddenly might be required to pay off the loan. Instead, provided you make each month’s payment on time, no bank can force you to pay off the entire remaining balance. 

2)  Customers are no longer permitted to buy stocks with only 10% down. The maximum margin limit is 50%; for some securities it’s 20%—and zero for speculative investments (such as internet stocks). This dramatically reduces (or even eliminates) the risk that an investor will get a margin call, which in turn reduces the risk that investors will need to make simultaneous and massive withdrawal demands on their banks due to cash flow problems in the stock market.

 3) By similar action, the Glass-Steagall Act of 1933 kicked banks out of the stock underwriting business. By building a “Chinese Wall” between Wall Street and the banking business, the government insured that brokerage failures wouldn’t harm the banking business. 

4)  Congress created the Federal Deposit Insurance Corporation in 1933 to protect consumers from future bank failures. Before FDIC, consumers were unprotected in the event their bank went broke because of bad lending practices. Today, however, consumer accounts up to $100,000 are protected, giving citizens a level of confidence in banks that didn’t exist in the 1920s and early 1930s. Congress also created similar programs for savings & loans (FSLIC, now part of FDIC), credit unions (NCUSIF) and pension funds (Pension Benefits Guaranty Corporation). Though rare, bank failures still occur, but no depositor has ever lost his or her life savings as a result of one, thanks to these programs.

 5)  The Federal Reserve, which controls the nation’s money supply, now understands that the best way to prevent a “run on the bank” is to provide banks with all the cash they need, rather than withhold currency like the government did in 1929. Back then, the government feared that flooding the banks with cash would result in inflation. Instead, the government created the worst depression in history. But we’ve learned our lesson, as shown by two modern examples: a) Within hours of the Crash of 1987 (the first 1929- like crash since, well, 1929), Fed Chairman Alan Greenspan announced that the Federal Reserve would supply as much cash to the nation’s banks as they needed—reassuring all Americans (and the world) that there would be no repeat of 1929. Greenspan’s comments are widely credited with calming much of the panic on that October 19th, and many argue that his actions, more than any other, helped America avoid another depression.  b) Responding to concerns that computer problems would lead to bank failures in the year 2000, the government said it would it print and distribute $200 billion in extra currency, so that banks would have more than enough cash on hand to meet any withdrawal request—even if the computers stopped working.  

6) Competition in the mortgage industry has dramatically increased. If one lender won’t provide you the loan you seek, odds are better than ever that another will. And new, innovative loan programs make mortgages more affordable than ever—reducing the likelihood that you’ll default.
 The point? Those who tell you to pay off your mortgage are basing their advice on their fear—fear that having a mortgage might cause you to lose your home. But as you now understand, your risks of losing your home are negligible compared to homeowners of the 1920s. And that means these fears are largely unfounded.  Largely, but not completely. Because there are still two aspects of mortgages that I haven’t yet dispelled for you: the challenge of affording the monthly payment and the interest you’ll save by not having to make that payment. Let’s start with the first one. Do you fear that you might not be able to make the payment every month? This is a problem, because, as I pointed out, the bank can foreclose on your home if you fail to make your monthly payment on time. Therefore, you fear, what if you suddenly lose your job? With no income, you won’t be able to make the payments—and you’ll lose your house. Isn’t this enough of a reason to eliminate your mortgage? No.          
The Truth is that the less money you have, and the more worried you are that you might lose your job, the more important it is that you keep a big mortgage. This might seem counterintuitive (as I warned you in the introduction), but it’s the truth. And it’s critical that you understand this point. Bill Gates can choose to have or not have a mortgage; it won’t make much difference in his life either way. But if you have little money and even less job security, having a mortgage is the safest way to handle your home. Why? Because there’s more to life than having a home. Like putting food on the table.  Let me give you an example, The New Rules of Money 

7)  Karen and Janet each earn $35,000 a year. Both are in the 28% tax bracket. Both have $12,000 in savings. Each buys a $120,000 house.                                                  
Janet wants to minimize her mortgage, so she uses her $12,000 in savings as a down payment, and opts for a 15-year loan at 6.5%. Her monthly payment is $941, but only 57% of that payment is tax-deductible interest; the rest is principal. Therefore, Janet’s net after-tax cost for her mortgage is $790. And to pay off her mortgage even quicker, Janet sends in an extra $50 with every payment. Of course, these payments are devoted entirely to principal, and therefore provide no tax deduction. Karen, on the other hand, obtains a 30-year mortgage at 7%, putting down just $6,000 and financing the rest. Even though her mortgage balance is bigger than Janet’s ($114,000 compared to $108,000), her monthly payment is just $758. That’s not all: Because 81% of the payment is interest, Karen’s after-tax cost is just $586 a month—$204 less than what Janet pays! Karen invests these savings each month for five years, earning 8% after taxes per year. And where Janet sends to her lender an extra $50 each month, Karen adds $50 to her savings. Result: Over five years, Karen accumulates a total of $12,675. Suddenly, both women find themselves out of work. Because Janet used all her money as a down payment, she has no savings to rely on. True, she’s got $43,285 worth of equity in her house (because she started with a big down payment and has been making monthly payments ever since), but that won’t help her buy groceries. Being unemployed, she can’t refinance, and news of her being out of work caused her bank to reject her application for a home equity line of credit. If she wants to get a hold of her equity, there’s only one way for her to do it: She must sell her house. This would force her to lose her home—the one thing she wanted to avoid! Indeed, Janet has discovered the biggest secret about homeownership: 

Your mortgage is a loan against your income; it is not a loan against the value of the house. With no income, you cannot borrow against your equity. Janet better get a job—and quick! Not only can’t she afford to buy food, she’s about to lose her house!  Karen, by contrast, has little to worry about. With $12,675 in savings, she’s easily able to make her payments each month, even without a job. In fact, she’s got enough money to make her monthly mortgage payment for nearly two years! How ironic: Janet didn’t want a big mortgage and did everything she could to pay it off quickly. Now, she’s discovering that this strategy—rather than safeguarding her home—might cause her to lose it! Clearly, then, you should not give the bank or builder a large down payment, nor should you be in a hurry to pay off your mortgage. And the less money you have, and the less stable your income, the more important the idea of carrying a big, long mortgage is for you.

But still, there must be something more to this notion of carrying a big, long mortgage. While it’s true that fear might lead some people to avoid mortgages, lack of fear is not enough to explain why people carry mortgages. No, there must be some other motivator. And there is. It’s called a desire to accumulate wealth. Here’s an important lesson all wealth-wanna-bes must understand: No one ever got rich by saving money. Or, put another way, paying off debt is not the same as accumulating assets. I stress this because many people think they will be better off financially if they eliminate their mortgage. But this is not true.

“Not true?!” you say. “Of course it is! If I don’t have to make a monthly mortgage payment, I’m in far better shape than the guy who has a mortgage!” I’m sorry, but despite the fact that millions of Americans believe this to be true, such thinking is misguided. You need to know why.

There are two kinds of people who hate mortgages: those who fear them and those who believe that mortgages cost you huge amounts of money in interest charges. We’ve already resolved the former issue—that fear thing—so let me dispel the myths surrounding the latter ...  Why People Hate Mortgages - and Why You Shouldn't

Carrying a mortgage doesn't cause you to lose any money at all. In fact, just the opposite is true: carrying a mortgage is actually quite profitable. It's eliminating the mortgage that forces you to give up profitable opportunities. You see, this second group of people ~ the ones who hate rather than fear mortgages ~feel that way because they know that over the life of a 30 year loan, they will spend more in interest than the house cost in the first place. 

Take Karen for example. By going with a 30 year loan, she'll spend more than $159,000 in interest, on a house that only cost her $120,000! This fact drives homeowners nuts. And I mean sincerely: in order to avoid spending do much in interest charges, people will do certifiably crazy things. Things like making bigger down payments, choosing 15 year loans, making extra principal payments, and signing up for bi-weekly loan programs. All these things are crazy. 

( * And I mean literally. We'll introduce you to the word Psychologists use to describe the illness in a moment, but for now, we'll just call people who think this way "wacko". )

Yet you do these things because you want to save money in interest. For some reason you have equated saving money with making money. Yet the two are not synonymous, and you need to lean this right now. The sooner the better. You see, what you've done is something that psychologist call, "compartmentalization" (* There's that word!)  It's found in the science of heuristics, used in the new field of behavioral finance. ( the study of why people do with their money what they do) Through compartmentalization, or what I call "Farming VS Foresting" you fail to examine the big picture when you make financial decisions. Instead you focus on a single issue, resolve it, then move on to the next issue. As a result, you make a series of bad financial decisions instead of one good one. 

This psychological phenomenon manifests itself clearly in the mortgage decision. You want to save money in interest, so  to minimize your costs, you do all the things I described two paragraphs up. With that issue resolved, you then start to focus on saving for retirement, and you do your best to save regularly.  As a result, you fail to accumulate wealth, and you can't figure out why.

The reason is simple but not often clear by any means. By tackling the mortgage goals first and the savings goals second, you fail to consider the role that  a mortgage plays in your savings efforts. Your battle to reduce interest expenses is won, but the wealth accumulation war is lost.

** Here's why:  you know that by reducing the mortgage payment, or even paying off the mortgage completely, you save lots of money in interest charges.                              
 While that is correct you are ignoring another equally critical fact: Every dollar you give the bank is a dollar you did not invest.                                                                                                                             

 THIS IS A VITAL POINT. Mortgages today cost about 6.5% to 7.5%. Over the next 30 years , on an average annual basis, will your investments earn at least that much? Absolutely. Even long term government bonds pay nearly that amount, and stocks have been averaging 11.2 % since 1926. But giving your money to the bank to avoid 7% interest charges denies yourself the opportunity to invest that money where it might earn 10%. Thus, rather than saving you money, getting rid of a mortgage actually costs you 3% per year!  Thus by looking at the individual trees,  you fail to see the forest.

The irony is that some people feel they are making a good "investment" by paying off their home loan.  In fact all they're doing is burying money under a mattress; they aren't investing it at all. Why? Because your home will grow in value over the next 30 years whether you have a mortgage or not. Think about it. When you sell your house does any buyer care what your mortgage balance is? Of course not.  Neither does the IRS when you calculate your taxable gain or loss. The simple truth is that mortgages do not affect home values.

Therefore you have a choice. You can pay cash top buy a $200,000 house, enabling  you to own it outright, or you can buy that house with 20% down. Lets explore each one of these scenarios in detail and see which is a better at helping you achieve your true goal ~ Accumulating wealth.

Julia just received $200,000 from the sale of her prior house. Or maybe she exercised some stock options, or got an inheritance, or received an insurance settlement. it doesn't matter where the money came from. the point is, she's loaded and wants to buy a new home which costs $200,000. Julia pays cash for her house. This takes all her cash but it lets her avoid mortgage payments. In 30 years her house will be worth $600,000, assuming it grows at a rate of  3.5 %  per year. Pretty smart she figures.

But jean takes a different approach. Jean too has $200,000 in cash. Like Julia, Jean wants to buy a $200,000 house. But Jean puts down only 20% or $40,000 obtaining a $160,000 mortgage. The monthly payment is $1064, but it really costs less than that because the mortgage interest is tax-deductible, (something Julia failed to consider), and the after tax savings reduce her monthly bill by $240, making her net payment just $824 per month. To help her make those monthly payments, Jean invests the $160,000she didn't give the bank, and earns 10% per year on her money. She's got to pay taxes on those profits, and she does so ~ but at the 20% long term capital gains rate, not the ordinary 28% ordinary income tax rate. The Jean earns a monthly after tax return of $1067. After paying for the loan, she's got $243 per month left over, which she reinvests. After 30 years, Jean (like Julia) has a house worth $600,000 (and like Julia, it's fully paid for by then). And that's not all. Jean also has her $160,000 ~ as well as another $550,000 from investing $243 per month over 30 years.

Julia wanted to avoid the expenses of a mortgage.  Jean wanted to accumulate wealth ~ and if doing so meant carrying a mortgage, Jean was willing  to do it. The result?  Jean's net worth is $1,310,000 ~ more than twice as much as Julia's.

So don't fret about the interest the loan is costing you. Focus instead on all the money you're able to save as a result of not giving all your money to the bank in the first place.

But if this monthly  payment is still bothering you, lets do some time traveling. You'll see  how much fun it is to carry a mortgage. Thirty years ago, in 1970, homes cost an average of $23,400 and 30-year fixed rate mortgages were 6%. The monthly payment , assuming no money down: $140. That's probably less than your current car payment!

Before you long for the good 'ole days, remember that the average monthly income in America back then was $646. In other words, that $140 mortgage was as challenging to people then as your $1000 payment is to you. And in 20 years, you'll be teasing your kids about the low payment because income and housing prices will  be much higher in the future, just as today's wages and prices are much higher than those of 1970!

Indeed, it's important to remember that mortgage payments get cheaper over time, even though they never actually change, because the payments are fixed as your income grows. So don't fret about having to make that big mortgage payment. It won't seem big forever.

For all these reasons the 30 year mortgage is better than one you'll pay off in 15 years.  It also explains why bi-weekly mortgage plans are not Great ideas. You see, both those programs cause you to pay more in principal each year than you do with a 30 year loan. And the more you pay in principal, the quicker you pay off your loan. But as we've seen, giving the bank any more principal than necessary is the last thing you want to do , because: 

 You get no tax break when giving the bank principal. You save on taxes only when you pay interest.

Money you invest is taxed at a lower rate than what you save in tax deductible interest. Therefore, you want to maximize your interest payment while minimizing your principal payment.

Money you give to the bank is money you'll never see again ~ Unless you refinance. If you think this notion is absurdly obvious, you haven't come across any of the thousands of consumers who tell me the reason they're hurrying to pay off their mortgage is so they'll be able to borrow against the equity later. ( gat a new mortgage) to pay off their kid's college tuition bills.  Talk about a bizarre strategy! These folks are struggling to give the bank all their money now, merely so they can borrow it in the future! Why don't they just invest their cash so that it earns competitive returns and remains available for use when ever needed?

 And the most important reason you don't want to give the bank any more money than necessary? Because Cash is King. Having a home fully paid for is one thing, but being able to cover that unexpected medical expense is another. You'll need cash to pay for a family members wedding, or to send a kid to college, or just bail someone out of jail. 

If you loose your job, not owing the bank any money on your house will be of small consolation when they repossess your car because your house rich and cash poor. 

One can refinance their house, take the equity that it has accumulated, and invest it and let that equity earn interest rather than sitting there doing nothing on a piece of paper. Some investments earn tax- deferred interest. In other words, you do not have to pay taxes on them until the money is withdrawn. This is usually at a lot lower tax rate.

And if nothing else convinces you, consider this: there are many of our clients who are the most financially successful of all Americans. They carry a mortgage. If you want to build wealth like they do, it's time you start managing your money the way they do. Start with your mortgage.

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