Category: Real Estate Analysis

Is It Better to Rent A Home Or Buy?

In this article, I am going to tell you something you already know, or sort of.  To make sure I need you to answer a question;  Is it better to rent a home or buy?  The overwhelming response to that question is it better to purchase a house instead of renting one.

Although you answered the question that it is better to purchase a home, I am going to use Truth Concepts calculators to prove it to you.  Don’t stop reading because you think you know it all.  Stick with me and I am sure you will like the results. Plus there is a bonus idea at the end if you read it all.

Using a Maximum Potential calculator I am going to illustrate your rent costs over a 30 year time period.  I am assuming your initial rent is $1,000 a month and there is 4% inflation in rent in your area.  As you see below the total amount of rent checks you will write over that time is $673,019.

If you were to purchase the exact same house let’s say the purchase price would be $360,000.  In the current economic environment, we could get a 4%, with a 20% down payment ($60,000), 30-year mortgage.  Using the Loan Analysis calculator we see the following:

The most glaring thing you will notice is that the monthly payment is initially about 40% more expensive, $1,432.25 versus the $1,000 a month rent.  Looks like to me if we limit our vision of the problem to the initial monthly cost then renting is cheaper.  But then you notice that the total amount of mortgage checks for purchasing the house is $515,609.  Oops, looks like purchasing is cheaper.

Wait a minute are we really comparing apples to apples?  No, of course not, when you are renting and the toilet springs a leak what do you do?  Call the landlord and they come and fix that leak.  A similar process happens with every other problem with the house.  In some cases, the landlord takes care of the landscaping including mowing the lawn.  So we need to think about repair costs as well as other maintenance fees.  Oh and don’t forget the property insurance and property tax.

Using the same Maximum Potential calculator we can calculate how much you will spend on these items.  Please note in the annual income (really a cost in our story) I put the total monthly cost of the property tax, insurance, and repair, i.e. $375.  I then multiply that by 12 to get the $4,500.  The following is the result:

So in addition to the mortgage, we have an additional cost of $252,382 for purchasing a house, bringing the total to $767,991.  We also have to consider the down payment.  Like I assumed you decided to avoid private mortgage insurance so you came with 20% or the purchase price or $60,000.  At this point, it looks a bit more expensive to purchase a house than to rent.  (Purchase is $827,991 versus renting $673,010.)

With a lot of variables and issues, it might seem hard to actually know which is the best. Luckily at Truth Concepts, we have a calculator to help us out.  (Really do we need to KNOW if it is cheaper to buy a house versus renting?  We already know it is better to buy.  We know because everyone knows that.)

The Real Estate Analysis calculator is useful in our current situation – evaluating the purchase of a personal residence.  When you enter the numbers from above and click on the “personal residence” button right above the ROR box, you get the following:

Are you surprised by the result the calculator helps us to arrive at?  Like I said, I am going to tell you something you already know.  It is better to purchase a house than to rent it, from a financial point of view.

Let now consider some other reasons people feel that buying is better such as:

1)  Appreciation of the asset over time, that we enjoy as the owner.

2)  Tax advantages that we have not discussed, but the calculator allows us to account for them.

3)  Equity build-up that we get back when we sell the house.

4)  There is an emotional sense of pride from ownership.

5)  Control of the asset.  In other words, you can make changes to the house as you see fit.  You can put up a new wall or take one down, paint, nail etc.

6) You can borrow against your equity!

You should be asking yourself, why is this article even written?  Everyone knows that purchasing a home is better than renting.

Here is the heart of this article:  Purchasing life insurance is better than renting it.  (Whole life versus UL or term.)  Why is whole life better?  For all the reasons this article has pointed out and then some.

Now for the bonus, I promised: Can you see a new way to use our awesome software to help your clients see the WHOLE truth about financial decisions?

 

-Jason Henderson for Truth Concepts

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Why You Shouldn’t Retire, You Should Retool (John & Jane Jones Pt. 8 of 9)

“I am ready to retire,”  John was quick to state at the beginning of our annual meeting.

There were several things I wanted to talk to John and Jane Jones about this year since they would be soon turning 60.  But when I heard John say this, my plans for the meeting took a back seat.

“Are you serious?”  I asked John.  “Do you think you are ready to retire?”

“I have no idea,”  John answered.  “I am making nearly $185,000 a year, which is a lot more than what I was making when I started, but it sure does not seem like we are getting anywhere.”

Jon was frustrated and I needed to learn more about the source of the frustration, so I started to ask him a few questions. “Do you have any idea how long of life expectancy you have?  There is a great website out there called livingto100.com.  Let’s go to that site and take the short test to get a projection of how long of a life you should be planning for.”

Once we went through the questionnaire the result that came back shocked John and Jane.

“Whoa, I could end up living to age 110?”

“That is a long time.  Let’s put things in perspective.  You started your career when you were 25, correct?  Which means you have been working about 36 years,”  I said.  “Taking a wild guess, do you think you can afford a retirement of 50 years, assuming you do live to 110?”

“Of course not,”  John answered.  “We have been good savers and you have helped us navigate a bunch of difficult financial decisions.  But we have been saving less than 100% of our income.  There is no way I can live for 50 years on what we have saved.  Especially since our standard of living is much higher than the $45,000 salary I had when I started.”

“Is your salary really that much higher?”  I asked,  knowing the answer.  “Let’s put your numbers into a Future Value Calculator to see what your salary should be in 35 years to have the same purchasing power, as it does today,”  I suggested as I input the numbers.

“That is nearly exactly what we are making now. No wonder we feel like we are spinning our wheels sometimes,”  Jane said.

“I am going to call up another calculator called the Future Requirement Calculator.  Do you think you could help me plug in the numbers?”  I asked.

“My current salary is $185,000.  My qualified plan, as of the last statement, had $158,640,” John told me,  “We are in the 28% tax bracket and we live on about 60% of our income.  I will get some Social Security, so I am thinking I will need about 75% of my current income for retirement”

Does this look right? I asked.

“Yes, I guess so,” John said, “I really do not know, but the numbers you have are correct.”

I chuckled at his honest response.  “You are right, so far this is not telling us much is it?  When I push the ‘projections’ button the calculator will show us how much you should have in savings to make it through a loooong retirement.”

“That is depressing,”  John exclaimed.  “I don’t have anything near 4.6 million dollars.  How will I ever be done with this job?”

“Please, don’t despair,”  I reassured John.  “This calculator is simply useful as a reality check.  But you said it so I have to ask:  why is it you want to retire?”

“I am tired of my job.  I don’t like it anymore,”  John admitted.

“There is nothing wrong with that,”  I said.  “Tons of people get bored with what they have been doing for 20+ years and they think they should retire when they should just rethink what they are doing.  When a client tells me what you just told me I send them to a website called lifereimagined.org.  It has a lot of great information to help when thinking about retooling for a different career,”  I explained.

“I told John this idea of retiring now was not a good idea,”  Jane said.  “John is in good health.  It is just the job that is the problem.   We have actually been looking around and are thinking about starting a business.”

“Not to be too blunt here, but now you are talking better sense,”  I said with a chuckle.  “What kind of company are you thinking of starting?”

“Well, we think this new field of Cryotherapy has a great future,”  John said.  “Medicaid will actually pay a good price for people to use the equipment we are thinking of buying. But, frankly, I am not sure we can do that either.  We will need to purchase two office buildings that would total $250,000.  Plus two cryotherapy and two vibrotherapy machines for $206,000. ”

“John, don’t be discouraged.  We have known each other for a long time.  I always say you need to know the whole truth about things so you can make informed decisions.  This is a great opportunity to look at as much of the truth as we can about this new business so you can make a good decision.”

“First, let’s take a look at the real estate purchases.   The purchase price was $250,000, right?  And the closing costs were $5,000.  How much are you planning to put down?”  I asked.

“We want to avoid private mortgage insurance, so we will put $50,000 down,”  John said.

“Ok great. What about the taxes, insurance and maintenance costs?”  I asked

“All three are about $500 each,”  John responded.  “And we plan to have the business pay us $2500 a month in rental income.”

“We will look at this over a ten year period,”  I said and pointed to the screen, “How does that look?”

“The rate of return isn’t all that great,”  John said.  “I was hoping for more.”

“This is only part of the equation,” I explained.  “The real money maker will hopefully be the business.  For that analysis, we are going to use a new copy of the same calculator.”

I entered the numbers and asked a few questions.  “What do you see as your employee costs per month as well as your insurance for the company and maintenance costs?”

“We plan to be open 13 hours a day 6 days a week.  We do not want to just hire minimum wage employees, we are hoping to provide a great service and we think we will need to pay employees a little higher than most.  We calculated it would be about $10,000 per month in employee costs.”

Sounds good so far,”  I said.  “what will it cost per visit for a client?”

“About $75.  At least that is in line with what Medicaid will pay,”

“You said you will be open 13 hours a day six days a week, which is essentially 4.5 weeks a month,”  I commented.  “How many clients per hour will you be able to handle?”

“I am not sure how many we will be able to handle, but we think a conservative number is 2 per hour,”  Jane said.

I input all these numbers in the income line and showed them the calculator.

“Now that is a rate of return I like to see,”  John said excitedly.

“As I have said before, it is not about net worth, it is about cash flow,”  I said. “In this case, it’s not about rate of return it should also be about cash flow, and notice how much monthly cash flow you should have,”  I pointed to the screen.

“That is more than I am making now,”  John said.  “Maybe I can retire after all.”

I smiled at him and said, “How about we say you can retool and still have a good income?”

“OK, I like that better.  I need to stay healthy and active,”  John agreed and started to get up.

“Are you finished John?”  I said with a grin.

“I thought we were,”  he said.

“I would like to talk to you about one more thing,”  I said.

“OK, go ahead,”  John said easing back into his chair. He was visibly more relaxed.

“$28,000 in income from the business each month is a lot more than what you are making now.  What do you plan to do with that extra money?”  I asked.

“We are going to enjoy life,”  John said.

Jane was a little more serious and said, “We haven’t thought that far ahead.”

“I am not changing the subject, so stay with me.  What do you think has been one of your best investments so far?  I mean other than the policies you have purchased because we all know that everything else you have invested in or financed was made possible by those policies.”

“Without a doubt, the cabin has been the best.  It has not been a huge moneymaker, but as far as making family memories and personal value to us, the cabin wins hands down,”  John said.

“I agree with John,”  Jane said smiling at him.  “We got it for a great price and have enjoyed it more times than I can count.”

“Exactly what I thought,” I said.  “What made it possible for you to purchase the cabin?”

“The policies,”  John replied.

“Technically that is a correct answer, but I am asking you to think a little deeper here,”  I said.

After a moment of silence, Jane finally said, “What made it possible was our willingness to save a significant portion of our income.  What I mean is, we had policies that had cash and because we could move fast, we were able to buy the cabin.”

“Exactly,”  I complimented Jane.  “You are not too old to save.  Who knows, maybe something else will come along.  Even if nothing does though you need a place to store the extra cash you are going to have with this new business.  If we plan on you paying about 30% in taxes, you will easily have another $100,000 a year coming in.  Is there a better place to store cash than inside a policy?”  I asked.

“When we first met I thought a whole life insurance contract was the worst place to have money,”  John admitted.  “But now, no, there is no better place.  What do you recommend?”

“I think you should purchase a policy for $50,000 a year for each of you,”  I said.  “You can put the purchase of those policies into your operating agreement for the business and make it official.”

“You don’t have to ask me twice,”  John said.  “But I don’t want to pay premium forever.”

“I was going suggest you purchase a 10 pay policy.  That is a policy guaranteed to be paid up in 10 years,”  I explained.

“Sold! Where is the application?”  John asked.

“Wow, if everyone was as easy to sell policies to as you are, I would have an easier time,”  I said.

“You have our trust.  You have always just shown us the whole truth of things and then we make our own decisions.  Not once have you lead us astray,”  John said.

“It is hard to go wrong with a whole life insurance contract,”  I said.  “I like the peace of mind it gives me personally knowing my clients are protected and will not lose money.  That means I have never had to apologize for recommending or selling a whole life insurance policy.”

“Thank you,”  Jane said.  “Really, thank you.”

“Let’s get the applications filled out,”  John said.  “I want to celebrate our decision for me to retool!”

 

-Jason Henderson for Truth Concepts 

 

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How to Calculate Rate of Return On A Real Estate Investment (John & Jane Jones Pt. 6 of 9)

“Hello, this is John Jones.  I know we have called a number of times with ‘opportunities’ but this time I think we really have one,” John said excitedly as I answered the telephone early Monday morning before my first appointment.

“That is good news,” I said.  “Do you want to tell me about it over the telephone or come in for a sit-down meeting?”  I asked.

“How about tomorrow?” John asked.  “We can come anytime you are available.”

“I am fairly booked up, but this sounds like an important issue for you, I will forgo my lunch and meet with you.  Can you be here at 12:00 sharp?”  I said.

“We will be there,”  John answered.

It was great to see both John and Jane again.  It had been 3 months since our annual meeting, but it had been almost six years since we made many major changes to their policies or plans.  I had made them promise when they were 33 and starting to accumulate a lot of cash in their policy cash values, they would talk to me before making any major purchases.  Through the years there had been a few minor things, but nothing particularly significant.  I made it a point to remind them that opportunities find those who are in a strong cash position.

“Great to see you again,” I greeted them both with a smile and handshake.  “Since we just recently had our annual meeting, let’s forgo some of the pleasantries and get right to the point.”

“Sounds good to me,” John said.  “So we were approached by a friend over the weekend about purchasing his cabin.  A cabin in the mountains is something we have dreamed about for a long time.  Well, at least as long as we have known you.  We would never have thought it possible without the whole truth you have taught us,” John continued.

“Why is he selling the place?” I asked.

“He owns a hardware store in town and really needs some capital to purchase inventory.  His cabin was recently appraised at $150,000 but he is willing to sell it to us for $100,000 if we can close in 10 days,” Jane explained.

“We’ve been there; it is a really nice place.  In fact, I think it is worth more than $150,000 but that is what the appraisal valued it at 4 months ago,” John said.

“How do we know if this is a good thing for us to purchase?” Jane inquired.  “I remember you said opportunity finds those who have cash, but we want to make sure it’s a good financial decision.”

“That is so true.  I cannot tell you the number of people I know who have picked up wonderful investments because they had cash on hand,” I said. “But let’s go through the numbers to evaluate whether buying this cabin is a smart move.”

“I have a calculator – specifically, a Real Estate Analysis calculator – we can use to determine if this ‘dream cabin’ will live up to its name,” I said.   I opened the calculator and said, “As I go down the list here, you can help me fill in the blanks.”

John was right on top of things.  “Ok, the property value is $150,000.  We are buying it for $100,000.  Closing costs will be 3% so $3,000.  No realtor fees.”  Then looking at Jane, “land value was….”

“The appraisal said the land was worth $35,000,” Jane finished John’s sentence.  “We should have just brought a copy of the appraisal with us.”

“That is ok,” I said.  “But it’s good you do have a copy of it.”

“For the purpose of this discussion we are going to analyze this purchase over 10 years,” I said motioning to the calculator.  “Let’s also assume that you are going to pay cash for the cabin.  What would you say property taxes are going to be on a monthly basis?  And maintenance and insurance?”

“They are going to be right around $200 each,”  John said.

“Great.  With this information, what is the rate of return on your ‘investment?'”  I asked.

I could see the excitement in John and Jane’s face leave.  “Don’t worry, this is just a starting point,”  I said.  I want you to see the whole story.  Besides many people say there are only three rules in real estate investing, ‘location, location, location.’  And I agree the location is critical, but I also add three more rules, which I normally put first; ‘financing, financing, financing,'” I concluded.

“I think we can add something in that space for rental income,” John noted.  “Our friend has been consistently renting the cabin for an average of 10 nights a month all year long.  They get $150 per night.”

“I was just going to ask you about that possibility.” I entered that and noticed they were staring at my screen to see how that affected the rate of return.

“Now we’re talking! That’s a good rate of return,” John said excitedly. “Plus we have a cabin we can use about 20 nights a month!”

“But we finance everything we buy, right?” Jane asked.  “We have to figure what that money would be worth in the future and look at the difference.”

“You’re right on target, Jane. That is an issue you need to keep in mind.  But can you pay cash for this cabin?”  I asked them both.

“No, of course not,” John answered.

“So we are going to finance the purchase, just as Jane was saying. Let’s take a look at the rate of return when we take a loan into consideration.  Most likely a lending institution will want you to put 20% down and then finance $80,000.  Let’s say you can get a loan with a 5% interest rate, amortized over 10 years.”  I said as I input the numbers into the calculator.

“We can handle a 20% down payment,” John said, and the numbers changed on the calculator. “Oh, that really changes the rate of return.”

“But does the rate change to a value that is unattractive to you?”  I asked John.

“No, I am still interested in the cabin,” John replied, looking at Jane. She nodded her agreement.

“Let’s make a few changes to our calculator,” I said.  “You have policy cash values greater than $100,000.  Why would you go to a bank and pay them the interest instead of using your own cash values as collateral?” I asked.

“It doesn’t seem right,” Jane answered.

“I am going to input $100,000 and assume it is coming from your insurance company with your cash values as collateral.”  I changed the numbers and showed them the calculator.

 

“I like that number better,”  John said with a grin.  “This is great. By using our cash values we are improving the rate of return on this investment.”

“Let’s take a closer look,” I said.  “Notice your monthly cash flow is now a negative number.  How happy will you be to be paying $161 every month to keep the place going?”  I asked.

“We might be ok with it for a while, but it will grind on us, especially if we have a bad month or some unforeseen expenses,” John said.

“That’s why a bank will not loan you 100% of the purchase price,”  I said. “But this is not a deal killer.  You must always remember you are the one in control.  The bank will tell you they will only loan you the money for 10 years.  And under that scenario, this does not make much sense. But, can you determine how long it will take you to pay back that loan?”  I asked.

“Um, I am not sure,” John said.

“You are in control,” I said pointing at them.  “You are the ones who determine the terms of the loan, not the insurance company.  So could you take 20 years to pay back the loan?”  I input the numbers as I asked.

 

“That makes a huge difference!” Jane exclaimed.  “The rate of return went up and the monthly net cash flow is not only positive, it is higher than borrowing 80% from a bank.  ‘How is this a bad idea?'”  Jane quoted one of her favorite movies.

“I know this looks all rosy.  But there is still more to consider,” I said.  “One word: taxes.”

“Ugh.”  John moaned.

“Are you still in the 25% tax bracket?”  I asked.  I input their tax bracket and the capital gains tax as well as the Depreciation Recapture tax bracket and hit enter.

“Always have to pay Uncle Sam,” Jane said.

“Yes, I encourage you to do that,” I said.  “But as you can see, even when we consider the effect taxes have on this purchase, the rate of return is still great and the monthly cash flow is still positive.”

“There is one caveat here,” John said.  “And the reason we were so anxious to meet with you today. Our friend needs to have the money within a week or we cannot buy the cabin.  Can we get that kind of money that quickly?” John asked.

Reaching into my desk I pulled out a loan request form and handed it to them.  “Just fill out this form and you will have the money within a week,” I reassured them.

“Awesome!” Jane said. “That’s so much easier than I expected. And thank you. We will have to invite you up to the cabin sometime!”  Jane said.

“Sounds like fun,” I said.

As John and Jane left I was once again impressed by the power of being in control of a pool of cash to take advantage of opportunities. And I still had time to eat my lunch.

 

-Jason Henderson for Truth Concepts 

 

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15-Year vs 30-Year Mortgage: Which is Better? (John & Jane Jones Pt. 4 of 9)

“I am so glad you two were willing to come back so soon after our third meeting,” I greeted John and Jane as they came into the office.  “There are a number of things I want to discuss with you, but before I do, do you have any questions?”

“As a matter of fact, we do have something we wanted to talk to you about.  Since our meeting last week, Jane and I have decided we need to discuss more of our financial decisions with you,”  John said.  “We should have talked to you

when we got our raise 5 years ago, but we thought we knew what we were doing.”

“No need to concern yourself over the past; you cannot change it, nor can I.  Let’s just try to do the best we can from here on out.  I know for myself, I always try to get the whole truth about things before I make a decision.  Yes, I actually do what I teach others to do,” I explained.

John continued, “When we first met, I wanted to get rid of the policy Jane’s parents purchased for her.  I am so glad I listened to my mother-in-law and came to speak to you.  You showed us how to get out of credit card debt in the most efficient way.  But I also expressed a desire to purchase a home eventually.  Well, we’ve been saving money; in fact, we have saved $25,000 to use as a down payment and have been looking at a house over on Maple Street.  We filled out paperwork to get a 15-year mortgage, but we wanted to get your opinion,” John said.

“Thank you for asking and trusting me enough to consider my opinion.  In fact, I am glad you asked because the difference between a 15-year mortgage and a 30-year mortgage is poorly understood.”  I started to explain, but then thought to ask, “What is your understanding of the difference between a 15 and 30-year mortgage?”

“Well, the banker says the 15-year mortgage is better because we get our house paid off sooner and there are fewer costs to the mortgage,”  Jane said.

“Is getting your house paid for as soon as possible one of your goals?”  I said looking at Jane.

“Yes, it is.  As John’s parents got close to the end of their mortgage, his dad lost his job and they lost their home.  It was rather traumatic for John and he does not want to go through that again, nor does he want me to ever experience it,” Jane said sympathetically.

“Oh, I’m sorry. I’m sure that was unpleasant,”  I responded. “Let’s remember the goal of getting your house paid off as soon as possible as well as the desire for peace of mind as we discuss the costs of a mortgage, ok?  I can tell John has a valid concern about having a mortgage hanging over his head in the event there is a job loss or some other unforeseen situation.  This is not unique to you. Most people are worried about their ‘monster’ mortgages. But what I have found is often, when we have fears, we make decisions that increase the likelihood of that fear actually occurring. In other words, a decision made to pay off a house as soon as possible to avoid the scenario your family experienced, might actually lead to a greater risk of losing the house.  This will become clearer as we go along.  I am going to use a special calculator that will help you see the whole truth about 15 and 30-year mortgages.”

Opening my ‘loan analysis’ calculator, I first input their numbers on the left side of the calculator and called that loan 15-year mortgage.  I pointed to the screen and asked if the calculator had come up with the same payment they were shown at the bank.

John said, “Yes that is the principal and interest portion of our payment.  But it does not include our private mortgage insurance payment.”

“I just love working with you two.  You are intelligent, honest, and don’t miss much.”  I complimented John.  “I will discuss the PMI in a little while, but for now let’s focus just on the loan.”  I then entered the same loan amount and interest rate for a 30-year mortgage.  I also pulled up the comparisons between the two as a starting point for a discussion.

Pointing to the calculator I asked them, “with which loan will you be paying the least amount of interest?”

 

Jane was quick to answer, “The 15-year mortgage, just like the banker said.”

“Good. Let’s put a fine point on this issue.  If we take the total payments using the 15-year mortgage – $299,574 – and subtract the original balance of the loan, we end up with $74,574.  Doing the same with the 30-year mortgage we come up with $161,706 ($386,706-$225,000).  With this simple calculation we are able to say the 15-year mortgage has fewer interest payments, right?  However, can we comfortably say the 15-year mortgage costs less than a 30-year mortgage?”  I asked.

“Well, yes we can.  Can’t we?”  Jane said.  “Knowing you there is probably more to it.”

“Jane, you are learning quickly. With this simple calculation, all we can really say is the 15-year mortgage requires us to pay less interest.  But one of the big problems with this simple calculation is the whole truth is being ignored.  For starters, this simple comparison is comparing a 15-year mortgage over 15 years to a 30-year mortgage over 30 years.  Is that really an equitable comparison?  And, could that comparison obscure some potentially detrimental information?” I asked.

“No, now that you point that out, it is not equitable.  To answer your second question, yes I would imagine there are issues that might cause the total costs of the two mortgages to change,”  John answered.

“Yes, John,” I agreed.  “You should realize the vast majority of Americans look at this comparison and say the 15-year mortgage costs less, so therefore, I should use that mortgage.  Please, please notice my careful choice of words.  I have talked to you about interest expense or interest payments, but not cost.  Most people equate the two words.  Although interest payments are costs to the mortgage, they are not the TOTAL cost of a mortgage.  Let me explain it a different way.

“Most people would say the cheaper of the two mortgages is the 15-year mortgage, right?  But considering interest payments, what would really be the cheapest way to purchase the house?”  I asked.

Both John and Jane looked at each other and were silent for a while.

I finally broke the silence and said, “In other words, what method of buying the house requires me to pay the fewest interest payments?”

“Oh I see what you mean,” John said.  “I would pay the least amount of interest payments by paying cash for the house like my uncle.”

“Exactly,” I said.  “If you took the cash out of your current assets and paid for the house, you would have zero interest payments.  That is absolutely true.  However, no consider this: what would be the cost paying cash over 30 years?” I quickly called up a future value calculator and input $225,000 earning 4% for 30 years.  “Now assuming I could make 4% on my money for those 30 years, how much have I missed out on in 30 years?

Mumbling to himself, John said, “745,537 minus 225,000 is $520,537.  Wow, that is a lot of money any way you look at it.”

“Yes, it is.  Do you think you would be happy if you realized you passed up that much money because you thought the cheapest interest payment ‘mortgage’ was to pay cash for your house? Before you answer, what else needs to be considered?  Didn’t you free up a monthly mortgage payment?  How much would you have after 30 years if you diligently put $1,074.18 – the same amount you would have paid the bank with the 30-year mortgage – into an account earning 4%?” I asked pointing to a new calculator.

“The same number?”  Jane asked.

“I know that is a little puzzling, but yes, the same number.  If you took $225,000 out of your assets and purchased the ‘least interest payment mortgage’, i.e. paid cash, and then put the 30-year mortgage payment into an account earning 4%, you would end up with $745,534 in that account and own your house outright.  On the other hand, if you purchased the ‘maximum interest payment mortgage’, i.e. the 30-year mortgage, and left your money in your account, after 30 years, you would have exactly the same amount of money ($745,534) and you would own the house.  Now comes a very important question: “When comparing paying cash to a 30-year mortgage over 30 years, which of these two methods ‘costs ‘ you the most?  The ‘least interest payment mortgage’ or the ‘maximum interest payment mortgage’?” I asked and waited for them to think it through.

“Um, there is no difference in cost between the two.  So it must also be true that there is no difference in cost between a 15-year mortgage and a 30-year mortgage either when you look at over a 30-year timeframe,” John mused.

“Spot on John,” I said.  “Remember, the 30-year mortgage had a total interest charge of $161,706. When the interest rates are exactly the same, there is no difference in cost when comparing the three different mortgages.  But, and that is important BUT, there is a huge difference between the three when we take into consideration other factors, or…” motioning them to say it with me, “the whole truth,” we said in unison.

“For a few minutes let’s analyze the three from a safety and security point of view.  Jane, you told me John’s dad lost his job and was unable to make the monthly mortgage payments which resulted in the family losing their home.  We do not want that to happen.  With which of the three methods would we be the most likely to lose the house if we could not make the payments?”  I asked.

“The 15-year mortgage has the highest monthly payment requirement, so that would be the hardest one to keep going in the case of job loss or something similar,”  John said.  “So I suppose from a safety and security point of view, paying cash is the safest.  But we don’t have $225,000 to pay cash.”  John frowned.

“Neither does most of America, so what is the next best thing?”  I asked.

“Well, the next best would be to have the smallest monthly payment,”  John responded.

“But you have been considering the 15-year mortgage with a payment of $1,664.30 a month -”  I was saying when John cut me off.

“Oh yeah, I see what you are saying, get a 30-year mortgage but pay the $1,664.30 every month, then if something happens we would only need to pay $1,074.18,”  John said with a smile.

“Well, that is a good thought, but let’s look at it more closely.  If you make the higher payment, you would be paying $590.12 extra toward your principal every month.  This would allow you to pay your house off sooner.  But let’s assume for a moment you lose your job in the beginning of the 11th year of the mortgage.  At that point you would have paid $590.12 x 10 years x 12 month = $70,814.40 extra principle.  How much of that money would the bank allow you to access after your job loss?”  I asked

“A big fat zero,”  John said.  “My parents had paid extra payments on their house and we still had to move.”

“Right again,” I agreed.  “What if instead of making the $590.12 extra principal payment each month you make the same $1,074.18 payment and then put the $590.12 into an account that is readily available in case you lose your job?  Take a look at our example of you losing your job at the beginning of the 11th year.  If you had saved the $590.12 each month in a different account, you would have more than $70,814.40.  That amount would allow you to continue to make the mortgage payments if you lost your job for almost 5 and a half years.  How long was your dad out of work when you were younger?”  I looked at John

“A year,”  John answered.  “Just long enough for things to get really tough.”

“Can you see why the 30-year mortgage might be a better choice at this point?” I asked.  “There is still more to consider; let’s now talk about these three options in light of taxes,” I suggested.

Using the Loan Analysis Calculator, I input the savings interest rate and then put in a 25% tax bracket for the two of them.  Pointing to the calculator I asked, “Which of the two mortgages is more costly when we include tax deductions?”

“How is that possible?”  John asked.  “The 15-year mortgage is roughly $40,000 more expensive.”

“The reason it’s more expensive is that with the 30-year mortgage you get more tax deductions,” I answered.

“This is all great information and helpful, but there is one problem I see here,” Jane chimed in. “The banker said he would lower our interest rate if we took the 15-year mortgage.  In fact, he said he would give us a 3.75% interest rate.  Does that make much of a difference?”

“Great question Jane,” I said. “That is easily answered by plugging in that number.”  I changed the interest on the 15-year mortgage to 3% and said; “I am going to go even further down on the interest rate to 3.0% to emphasize a point.  Does the lower interest rate change the overall decision?”

“Well, the lower interest rates do make a difference, but the 30-year mortgage still appears to be cheaper by about $3,400,”  Jane responded.

“What about inflation? Does that have any bearing on a mortgage?  Should we include inflation in our decision process?” I asked, and then answered, “Inflation is a factor in all financial decisions.  Let’s take a look at how it impacts these mortgages.”

“Mortgages are a rare case when, in a sense, inflation is on your side.  You see, with each passing year, you are paying with dollars that are decreasing in value.  Put another way, each year the payment of a monthly mortgage becomes easier and easier because it’s a fixed amount.  In theory, our income is increasing which means the mortgage payment is a lesser part of your total income,” I explained.  “Using a future value calculator I want to show you what your mortgage payment will feel like in 30 years.”  I started the calculator, and input the numbers for them to see.

“Is that for real?”  Jane asked.  “Our mortgage will feel like $331.19?  That doesn’t seem possible.”

“Yes, a little hard to believe,” I agreed with Jane.  “But that is the effect inflation has on our money over time.  I want to be clear here.  You will still write out a check for $1,074.18.  The check will FEEL like $331.19.”

“Now, we are going to circle back to an issue you brought up before John, private mortgage insurance. In order for you to avoid paying the PMI, you would need to put $50,000 down on the house on Maple Street, correct?”  I asked.

“Yes, but we do not have that much money,”  John confirmed.

“Do you remember what we talked about in our first meeting John?” I asked.  “In case you have forgotten, by looking at things in a ‘big picture’ frame of mind you were able to refinance your debt and get that paid off in about five years.  How have you done with that plan?”  I asked, knowing the answer.

“Yes, I remember.  It was a real eye-opening meeting for me.  I am proud to report that we have followed the plan pretty close to how it was originally laid out.  We have had a few hiccups along the way, but for the most part, we are on track. We were supposed to have the debt totally paid off in 62 months but it is going to end up taking 68 months.  We will have that debt paid off in 5 more months,” John reported.

“Great.  I am so happy to hear you say that, but probably not as happy are you are being able to say it.”  I nodded to both of them.  “The best part is that lousy whole life policy Jane’s parents purchased for Jane now has more than $52,000 thousand dollars in cash value, just waiting for you to use for a great opportunity.  What if you borrowed enough money against your policy so you can avoid paying PMI?”  I suggested.  “You need 20% down on the house on Maple to avoid paying PMI. Looking again at our calculator, that would mean your total loan amount would be $250,000.  Can you see what your monthly loan payment would be?”  I asked as I pointed to my screen.

“It would be $1,193.54,”  Jane answered.  “I do not understand, wouldn’t we have two loans?”

“Yes, that is correct you would have two loans, I am just combining them here.  You will have a $200,000 loan from the bank on the new house.  You will also have a loan for $50,000 against your policy cash values.  This also means you will have two payments to make each month.  You will write a check for $954.83 to the bank on the $200,000 mortgage, and one for $238.71 to the insurance company.  Going this route will save you a ton of money that you would have otherwise paid for private mortgage insurance.  Well, let’s calculate just how much PMI would cost you over time.  The first year the PMI would cost you $3,937.50 ($225,000 x 0.0175).  Then each year for 14 additional years, you would pay $225,000 x 0.0045 or $1,012.50 per year.  Making the grand total $3,937.50 + ($1,012.50 x 14) = $18,112.50.  Additionally, the $1,012.50 (paid in monthly payments of $84.38), would be eliminated.

“When you came into the office today you were thinking of a 15-year mortgage at 3.75% which would require a monthly mortgage payment of $1,636.25 and a PMI charge of $84.38 per month, or a total of $1,720.63.  May I propose that you continue to allocate the same amount each month to pay off your home?  The first two portions of the $1,720.63 are being paid to the bank and the insurance company leaving you $527.09 per month.  Are you following my calculations?” I asked.

With a pleased look on his face, John said, “Yes, yes I am.  This is great. Please keep going. Oh, wait a minute I have a question.  What about the $25,000 in cash we have saved up for the down payment?  What are we going to do with that since we are borrowing $50,000 against Jane’s policy?”  John asked.

“Wasn’t that fun to ask me what you are going to do with $25,000 in cash you have saved up?” I grinned at John.

“Now that you say that, yes that felt good,”  John replied winking at Jane.

Jane quickly spoke up and said, “Shouldn’t we just borrow $25,000 from the policy and use our $25,000 in cash?”

“Good question.   Before I answer, let me ask you both a question.   Before today, how were you looking at your $25,000 down payment?  Was that just money lost?  Or were you planning to get that back?”  I quizzed them.

“It is just a down payment.  Nothing more, nothing less.  We have to have it to buy a house,”  John said.

“I have said this a number of times, but it’s very important you understand this fundamental principle – it is critical to your financial prosperity: You finance everything you buy,” I said emphasizing the last part.  “You are – or were – going to be ‘financing’ that down payment whether you realized it or not. But you had not considered how you were going to recoup the value of that $25,000.  Even though it is a cash down payment, YOU are financing it.

“Now, back to your question, Jane. You should borrow against your policy the full $50,000 and pay that loan back with interest to the insurance company,” I said. “Once you close on your house, take your $25,000 cash and pay down the loan against your policy. Of course, at that point, you will only owe $25,000. Then, if you make the proposed payment of $238.71 per month, how long will it take for you to pay off the loan against your policy?”

“That is a long time,” Jane said.

“Not really,” John said.  “That is just a little longer than 10 years.”

“Last week you both filled out applications for a $3,000 per year policy.  Did you both reduce your qualified plan contributions to $1,000?”  I inquired.

“The very next day!”  Jane said.

I chuckled at Jane’s enthusiasm.  “Here you are a week later, and if you choose to follow what I have proposed, you will have an additional $525.09 available each month.  That is $6,300 more available to you every year.  What if we modified your applications and made them each for $6,150 each?”  I asked.

“I don’t see why not,”  John said.  “But what about the $370 per month we will have available once the credit card debt is gone? If I remember correctly, we’re planning to purchase a policy on me with that money.  Could we increase my policy from $6,150 to…” John used the calculator on his phone to multiply $370 by 12 and add it to $6,150.  “… $10,590?”  John asked.

“John, if you twist my arm I might be convinced that would be a good idea,”  I replied as seriously as I could.

Both John and Jane laughed.

“I can tell both of you like the idea of modifying the applications you filled out last week,”  I said.  “But before we do that, I want to back up a little and review what we have talked about today.  When you walked in you were excited to purchase your first home.  You were fairly convinced that a 15-year mortgage was the best mortgage for you to have.  One of the reasons you liked the 15-year mortgage was you were going to have your house paid off in a shorter time period, thus reducing the risk of a repeat of John’s childhood tragedy when his family lost their home because dad was out of work for a year.”

“Now you are thinking about going with a 30-year mortgage.  You are thinking that is the best mortgage for you because the total costs are the least.  The risk of losing your home due to economic trouble is less.  You will get the best tax advantages with the 30-year mortgage.  But don’t you want to have your house paid off?”  I asked them.

“Yes, we do,”  John said.

Turning back to the Loan Analysis Calculator I scrolled down to the 121st  month and said, “At the beginning of the 11th year of the mortgage, how much will you owe on your mortgage?”

 

“We will still owe $196,960.00,” Jane said.

I then put on my computer screen the funding calculator showing the cash values of the new $10,590 annual premium on John and said, “Notice the new policy will have $124,849 of cash value.”

“Please write that number down,” I instructed them.

I then imported the values from the policy Jane’s parents had originally purchased for her into the same calculator.  Pointing to the screen I asked, “How much cash value will be in Jane’s policy?”

“Wow, $97,810,”  Jane said softly.  “Mom and dad sure were smart to buy that policy for us.”

“Remember I showed you it would take 130 months to pay off the $50,000 loan for your 20% down payment you are going to take against this same policy.  So the number will not be quite $97,000 -”  I was saying.

John interrupted, “But pretty close.”

Smiling, “Right.  So add $97,000 to the number I had you write down.  What do you get as a total?”  I asked.

John and Jane looked at each other as Jane said, “$221,849!”

“This is unbelievable,” John said.  “We will be in a position to pay off the house in 121 months from now.”

“Sooner than that,” Jane said.  “I am also getting a policy for $6,150 a year remember,” looking at me.

“Isn’t this fun?”  I asked.  “You are right Jane.  However, some opportunity might come along – you may want to use the cash in your policy as seed money for another venture.  I remember you saying that you would like to start a business from home so you can be with the kids.”

“I want to address something John just said.  Will you really be paying the house off?  Or will you be in a position to refinance your house?” I asked.

“We finance everything we buy,”  John said.

“Right,” I agreed with him.  Let’s modify those applications.”  I said. “And remember, I’m always as your coach to help you understand the whole truth and thereby make better decisions.”

“Yes, let’s do that.”  Both John and Jane said together.

 

-Jason Henderson for Truth Concepts 

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Truth Concepts on YouTube.com

Visit Truth Concepts on YouTube.com Today!New Truth Concepts Client Presentations!

We’ve been busy loading up our Truth Concepts YouTube channel  with videos for you! Now there are 15 videos featuring Todd Langford and/or Truth Concepts software.

The YouTube channel houses our Truth Concepts, Truth Concepts Academy, and Summit videos, as well as several presentation videos and  Banking for Life excerpts and outtakes with Todd Langford.

Eight of the newer videos are from a client event at a local insurance brokerage. We recorded and “screen captured” Todd’s presentations and divided it up by topic. (FYI, Todd’s presentations followed a presentation by Nelson Nash, you’ll hear him refer to Nelson who is in the audience.)

Truth Concepts: How Banks Make Money (1 of 8)

Even most bankers don’t understand this. (If a bank has a 6% spread between the savings rate and lending rate for customers, they are NOT making 6% on their money!) The reality of bank profits – especially when interest rates are low – is frankly shocking. Approximately 15 minutes.

Truth Concepts: Maximum Potential (2 of 8)

As we mentioned in an earlier email, many advisors like to use this calculator in their first meeting with a client. It outlines what a client’s full financial capability and demonstrates that if you’re saving too little, a chasing higher rate of return isn’t necessarily the answer. Approximately 10 minutes.

Truth Concepts: The True Cost of Paying Cash (3 of 8)

Todd explains opportunity costs and why they matter so much. (Not suitable viewing for Dave Ramsey fans!) Approximately 7 minutes. 

Truth Concepts: Qualified Plan (4 of 8)

Todd examines the real rate of return in a typical qualified plan. What impact does a company match, a typical fee, and taxes have on the dollars in a 401(k) or other tax-deferred retirement plan? It’s not a pleasant surprise to see how much of “our” money ends up in someone else’s pocket!  Approximately 14 minutes.

Truth Concepts: Funding Calculator (5 of 8)

Todd Langford discusses whole life cash value in the context of other savings vehicles (with some interesting commentary on the “safety” of FDIC-insured accounts) and busts the “buy term and invest the difference” myth with hard numbers and compelling logic.  Approximately 16 minutes.

Truth Concepts: Car Financing and Borrowing (6 of 8)

Todd shows the reality of “0%” vehicle financing, then compares the results of making major purchases through bank loans, cash purchases, certificates of deposit or whole life cash value. Emphasizes the advantages of having and using your own capital.  Approximately 23 minutes.

Truth Concepts: Real Estate (7 of 8)

Todd explains the advantage of participating mutual company dividends and analyzes the powerful potential of using cash value to finance other assets and sound, cash-flowing investments. See how leveraging your cash value can produce exponential benefits when combined with other strategies and investments.  Approximately 11 minutes.

Truth Concepts: Laffer Curve on Cash Flow (8 of 8)

Todd gives a contextual history of income taxes and how lower taxes can actually translates into more money for BOTH taxpayers and the government.  Approximately 5 minutes. 

Visit Truth Concepts on YouTube.com Today!

Click on links for individual videos above or view all available videos on the Truth Concepts YouTube channel at: http://www.youtube.com/user/TruthConcepts.

Can you see the potential of using Truth Concepts software to analyze various financial strategies and communicate with clients about essential financial concepts?

Join Todd in Houston for our next LIVE 3-day training for hands-on training with Truth Concepts calculators. At this writing, our next event is October 22-24, 2014 in Houston, TX. See our Truth Training page for current dates, details and registration.

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