3 borrowing misconceptions to avoid
Monday, September 12, 6:00 am ET
Greg McBride
Mortgage and home equity borrowers often have misconceptions. Because these misconceptions may cloud decision making, let's take a look at three examples and why they are off-base.
'You don't pay any principal in the early years of a mortgage'
This line is often used to justify the choice of an interest-only mortgage. But this is debunked solely on the basis of the higher monthly payment for a traditional, fully amortizing loan compared to an interest-only loan. A fully amortizing $350,000 loan at 5.75 percent carries a monthly payment of $2,042. An interest-only loan in the same amount, at the same rate, carries a payment of $1,677 -- a difference of $365 each month. So if the interest rate and the loan amount are the same, why the big difference in monthly payment? The $365 difference is accounted for by the repayment of principal every month, a chunk of principal that starts at $365 and grows steadily larger each month.
But let's look a little further. With a $350,000, 30-year fixed-rate mortgage at 5.75 percent, the borrower repays $365 in principal with the first monthly payment. That number grows with each subsequent payment, with the borrower repaying a total of $25,332 in principal during the first five years. Contrast this with an interest-only mortgage at the same rate, where the borrower not only forgoes the $25,332 in equity but also pays interest charges that are $3,400 higher in that same five-year period.
Correctly stated, the borrower pays mostly interest in the early years of the loan, a result of the large loan amount and long repayment period.
Some households may wisely choose to forgo the repayment of principal each month, perhaps due to a substantial equity stake in another property or a large down payment. But affordability-strapped borrowers without a large down payment or significant equity are most susceptible to this belief and may pass up the opportunity to build a valuable equity cushion.
'Take money out of your home'
The idea of "taking money out of your home" is as much of a misnomer as a misconception. This is usually used in the context of a homeowner with a large share of home equity that is looking to put money into other investments. But let's call it what it is -- borrowing. That borrowing may indeed lead to wealth creation, but only if the rate of return on the investment exceeds the cost of borrowing. Taking money out of the home is not the same as going to the ATM and taking money out of your checking account. Instead, the homeowner is using the lender's money to generate a return and paying interest for the privilege. This loan is secured by the borrower's asset, home equity.
'Let the lender bear the risk of default'
A third, and potentially dangerous, misconception is the idea of letting the lender bear the risk of a borrower's default. Borrowers taking large loans, especially relative to the value of the home such as with no-down-payment loans, are most at risk. This notion falls apart because the borrower is not in a no-risk position. Borrowers may be able to walk away from an investment property if the market value drops or if the payments become burdensome, but not if it is the principal residence. If homeowners do simply "walk away," where do they live next? How will they buy with a fresh foreclosure to their names? Prospective landlords will be hesitant to rent without some protection such as a hefty deposit. Where does that money come from? The borrower will pay a higher price to rent or buy for years to come.
And the lender may not have the risk the borrower thinks if the loan has been sold to an investor. A secured debt is not one that a borrower can just walk away from, and borrowers don't have the luxury of laying off some of that risk like lenders.
Taking a large loan with no down payment, skipping principal repayment or borrowing from home equity are each perfectly viable solutions for many households. As a borrower, make sure you're doing so for the right reasons and based on complete understanding.
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