A few times a year the conversation comes up about buying a home: is it better to pay off faster or slower? The question came up today, so I responded with the information below. This information was given to me while in the Air Force (Thanks Msgt. Headland) by a man who invested in real estate on the side.
We are going to treat APR here as if it does what it claims, provide an "overall" cost of the loan. There are many factors that can cause APR to be misleading, so read more at WikiPedia's APR article.
You need to address one question: will you ever sell this house? The answer is more than likely yes, and it changes the way we look at the cost of the house: we are concerned with the return on the investment, not how much we owe when we sell.
Jack and Jill set out to buy a house. The each find one for $100K, and 5 years later sell it for $140K.
Jack gets a 15 yr mortgage at 6.0% APR, making the monthly payments $831.25. Jack also adds an extra $200 per month to help pay down the loan faster and avoid interest. Jill gets a 30 yr mortgage at a higher 6.5% APR, making her monthly payments $616.64. Jill doesn't add anything extra to the monthly payments. Let's see how they do:
| Jack | Jill |
| Buy House | $100,000.00 | $100,000.00 |
| Sell House | $140,000.00 | $140,000.00 |
| Monthly Payment | $1,031.25 | $616.64 |
| Principle @ 5yrs | $61,816.69 | $93,408.22 |
| Payments @ 5yrs | $61,874.88 | $36,998.59 |
| Gross From Sale | $78,183.31 | $46,591.78 |
| Net | $16,308.43 | $9,593.19 |
Well it looks like Jack is ahead, after 5 years he made a $16K profit whereas Jill made $9K. But there is one number missing: $414.60 or the amount Jill is playing less than Jack. After 5 years that's $24,876.28, add it to her $9K and Jill's over $34K - more than double Jack. She could have chosen to make a car payment with that money, or saved it away in a mutual fund (she does seem pretty smart after all). Even if you go back and give Jill an 8% APR, she is still above Jack.
In the end, it's best to spend as little on a house as possible. Don't feel bad about taking a zero down option, rolling in the cost of closing, and opting for a 30 year term over 15. Run the numbers, then compare the results before deciding which is better.
All the numbers for this I crunched in OpenOffice Calc. If you want to do the same, you can follow a great guide at OpenOffice Calc Tips: Financial Functions
Posted By Mike On Wednesday, December 20, 2006
Filed under mortgage investment |
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