The “why” behind traditional mortgage choices

by Michael Eastham, CPA CRMS

Over the years, I have discovered that most people are creatures of habit. We make choices based on the way we’ve done things in the past. This statement certainly proves to be true when people make their mortgage choices. We have all been programmed by our friends, family members, professional advisors and consumer advocates to get a 30-year or 15-year mortgage and pay it off as fast as possible. So we pour our heart and soul, and every extra penny we have into paying additional principal to the bank each month, so we can accomplish that goal. Yet, few of us stop to ask ourselves, “Why?”

Allow me to explain through a brief history lesson, how this mindset came to be tattooed into the minds of the American public. Through my explanation I hope you will see that better options do exist.

As with many of these habits, we must first look back to the Great Depression. Early in the 20th century, when people bought homes, it was very difficult to get a mortgage. One had to come up with a large down payment and there were very few mortgage options. Your local bank was about the only place to get a loan. If you were able to get approved for a mortgage, you would find something in the loan agreement called a “due on demand” clause that allowed the bank to call the note due and payable immediately at any time, for any reason or for no reason at all. This clause did not bother too many people because they knew that they had no choice but to either sign the loan or not purchase the home. Borrowers knew they could not satisfy the mortgage even if the bank invoked their right to call the loan due.

In those days, banking and investment regulation was significantly different than it is today. Banking institutions as well as individuals could invest in the Stock Market using margin loans at a ratio of 10:1. This meant that if an investor had one dollar, he could borrow another nine, giving him ten total dollars to invest.

Then came the Stock Market Crash of 1929. When stock prices started to fall, money was quickly lost in massive amounts, but it was not money that belonged to individuals or banks. It was borrowed money. Investment companies began to make margin calls to its investors to either have them pay the margin loans or risk the liquidation of their investments. So, people began to go to the banks in droves to get cash in order to satisfy their margin calls.

It did not take long before the banks ran out of money. Banks were looking for sources of liquidity and remembered that all their mortgage notes included this “due on demand” clause. They began sending messengers to homeowners, telling them to pay the mortgage loan in full immediately. Since most homeowners were not able to satisfy these loans, they simply turned in the keys and walked away, losing their homes and all the equity they had developed over the years.

Thus the mantra was born: “Pay off the mortgage as soon as you can” so that you are not at the mercy of the bank. Some people, to this day, will commemorate their last mortgage payment by hosting a “mortgage-burning party.”

Well, since that time, things have changed significantly. Lenders can no longer have a “due on demand” clause in a mortgage note. In fact, the only way you can lose your house to foreclosure is if you do not make your mortgage payments for a period of time. Yet, to this day, many people still believe that you are in a much safer position with a smaller mortgage, holding fast to that old mindset.

I would argue that your home is safest when you own it in one of two positions: 1) either mortgaged to the hilt, or 2) free and clear. I can hear you now, asking me, “How can having a big mortgage on my house be safer than having a small mortgage?”

Let me explain by giving you a quick example. Suppose I were a mortgage banker, responsible for a portfolio of delinquent loans on homes that were once worth $300,000. Today they are worth $200,000 due to a soft real estate market, yet some of the borrowers had loans of $100,000, while others had loans at $175,000 and $250,000. Now, which would I most likely foreclose on? Of course I would foreclose on the one that owed only $100,000, and maybe the one that owed $175,000. But what am I going to do with the one that owes $250,000? Most likely I would work with that family and try to help them through this tough time, hoping that someday, they would get back on track with their payments.

With the capital gains exclusions, potential tax benefits, mortgage choices and safe, conservative investment choices that exist today, it certainly makes sense to consider using a mortgage as a financial planning partner by either 1) getting a larger mortgage and controlling the money you would have used as a down payment, or 2) by removing some of the equity that currently exists in your home and controlling that money yourself.

Too many people still see their mortgage as a foe, looking at life through the “glasses of the masses,” doing things “the way we have always done it”, without first asking “Why?”