February Mortgage Update: Mortgage misconceptions or why you should not get your financial advice from the MMM forum

Last month (January):
Years left: 1.166667
P =$1,147.93, I =$66.47, Escrow =$809.48

This month (February):
Years left: 1.083333333
P =$1,152.47, I =$61.93, Escrow =$809.48

Amount saved from prepayment:  $0

Because of my addictive personality, I’m not allowed to join any forums.  That doesn’t mean though that I don’t occasionally read fora even though I can’t participate.  Occasionally I have to say something, and since I’m not allowed to join, the something gets to spill over onto the blog.

In this case the forum in question is Mr. Money Moustache’s, and the “someone is wrong” thing is a few misconceptions about mortgages.  I know we’ve written about them before, but they obviously bear repeating!

  1. Mortgages work differently than student loans or credit card debt because they keep the payment the same each month and just remove months off the end with pre-payments.  That means that payments early in your mortgage are worth more than payments later in your mortgage because the mortgage, unlike other investments, doesn’t reamortize each month.  That means the amount you’re saving from pre-paying is different depending at what point you’re at in the mortgage.  You can see this by looking at an amortization spreadsheet, like this one from GRS.
  2. A common misconception is that you are increasing your risk pre-paying the mortgage because you can’t get the money back in an emergency unless and until you pay the entire thing off (and thus finish your mortgage payments).  That’s not actually true.  If you prepay your mortgage, you can, in an emergency, re-cast/re-amortize for a small fee (usually ~$250) and get lower monthly payments by lengthening the amount of time that you continue paying on the mortgage.  For example, right now my mortgage payment is a little over $2000/mo with 1.08333 years left.  If I re-amortized, my payment would be just a little bit more than what I’m paying for escrow, but I would be paying that sum over 13.4 years instead.  (And I have to pay for escrow even if the mortgage is gone!)  All that pre-payment means that in an emergency I can cut my monthly required payment, even though there’s still time left on the mortgage.  You don’t end up with quite as much ready cash so if you’re expecting an emergency you should keep it, but if the emergency is a low-probability event that may happen after years of pre-payment, you can likely recoup enough in lowered payments to get you through for quite a while.  [note that if you have a nonstandard mortgage, the rules may be different — you may not be able to as easily reamortize an adjustable rate mortgage.  Check with your lender if this is a concern. ]

Are there any money misconceptions that bother you?  What do you do when someone is wrong on the internet?  Do you belong to any fora?

43 Responses to “February Mortgage Update: Mortgage misconceptions or why you should not get your financial advice from the MMM forum”

  1. Leah Says:

    How is this different from student loans? If you pre-pay, does that lower the monthly payment? In my one student loan, I prepaid the entire amount the month before it was going to start accruing interesting, so I’m not 100% sure. But I though my husbands’ students loans stayed the same each month even though he prepaid.

    Money misconceptions that bother me:
    – how much an item cost as an excuse for not selling/needing to recoup money even tho something continues to cost money (like a piece of property or a car). Cut your losses!
    – buying something on sale “saves” money. ARGH. Only if you would have bought it regardless. Maybe you should stop shopping instead.

    • nicoleandmaggie Says:

      I think it depends on the student loan. Not a lot if experience here either.

      • becca Says:

        Student loans vary. For mine, I think the default was “applies as early payment of next month”. That is, it *neither* reduced the term of the loan *nor* reduced the amount of interest paid. You had to indicate you wanted an extra payment applied to the principal, which I always felt was a dirty rotten trick if you are trying to pay down your loans. And it can be even more complicated if you have multiple loans with the same servicer. *shakes tiny fist in fury at Sallie Mae* SO glad I do not have to deal with this, even if my loan payment was small and the interest rate not appalling.

      • Norwegian Forest Cat Says:

        My student loans also apply overpayments toward the next payment, regardless of the amount. However – I also have an interest rate deduction that’s coupled to auto-debit, so I have to pay the same amount of money every month and the lender just re-distributes it across the loans that haven’t been paid ahead (+ interest accrued on the ones that have been paid ahead). In time this will mean the term of repayment is shortened, but the only way to change your monthly payment is to go through your lender to switch to one of the other payment plans (instead of standard, you can pay based on income over a longer time frame).

      • nicoleandmaggie Says:

        Unscrupulous mortgage lenders will also apply pre-payments to the next month if you don’t specify you want it to pay down principal.

  2. Bardiac Says:

    Another thing about mortgage prepayment is that in an emergency, you might be able to get a loan based on the equity in your house. It may not be ideal, but emergencies are rarely ideal.

    • nicoleandmaggie Says:

      Unfortunately some emergencies like jobloss make it difficult or impossible to get a home equity loan.

    • chacha1 Says:

      I think if there is any chance that equity might be needed to cover emergency expenses, a HELOC might work out better than a loan, and can be arranged well in advance (and never used unless needed). Not sure if it’s available to all homeowners though.

  3. Leigh Says:

    Adjustable rate mortgages differ from most of your points. Prepayments don’t remove payments off the end – they lower what the new required payment will be when your rate resets. It does still lower the interest paid though and it lowers what balance you’ll be paying the new rate on too.

    Not all adjustable rate mortgages allow to recast willy nilly. You may need to have made a large payment in the last twelve months.

    I read the Bogleheads forum. MMM is too cheap for me. I hate it when people are wrong on the Internet! One of my friends likes to post on Facebook how the stock market is terrible and you only lose money in it, so why should they risk their money in it when they need all of their money in the short term. I just don’t talk to them about the stock market.

    • nicoleandmaggie Says:

      Yep, those brackets in the second point address that. It sounds like ARM (or at least yours) reamortize at the end of the term. In any case we don’t recommend them for the bulk of US homebuyers.

      • Leigh Says:

        I don’t recommend them for most home buyers either, though they are interesting if you really honestly don’t plan on being in a place for a long time and stick to that. I have a feeling now that we could be here longer than I had initially thought I would, which will be fine since I’m lucky and rates are still reasonably low and I’ve paid down a lot of the balance. I probably would have taken out a fixed rate mortgage if the rental cap on my condo building had been more favorable to renting it out later, but it being what it is meant I would sell when I wanted to move rather than to rent it out.

      • nicoleandmaggie Says:

        And it’s not like you can’t pay it off if you need to.

  4. chacha1 Says:

    I think you defined this before, but just to confirm – in your case, “escrow” refers to property taxes, yes? The state allows (or requires) the finance company/bank to collect and forward the property taxes?

    I don’t know if this is an option in CA. I know for sure my MIL pays property taxes based on a bill she receives from the county, completely separate from her reverse mortgage; and we pay property taxes for our lot based on a bill *we* receive from the county, completely separate from the property loan. Here, “escrow” refers to the period between making a real-property purchase offer and closing it by delivering money, and also to the account in which a down-payment is held (in our case managed by the title company) pending execution of the contract.

    Anyway, a big money misconception that never seems to die is that you can afford something if you can scrape together a monthly payment for it.

    On the whole I don’t care if someone on the internet is wrong; nothing anyone on the internet says will actually affect my life unless I choose to let it. If a person or a site has been repeatedly, offensively wrong – or if it goes from an acceptable personality to a rabid raccoon personality – I just don’t go there. I am one who finds argument stressful, not stimulating (and usually also pointless.) If it’s a matter of a blog commenter being wrong – as in factually incorrect, not as in I disagree with their opinion – I might offer a correction but I won’t engage in a comment war. Life is too stressful already to voluntarily increase the amount of stress in it.

    I don’t participate in fora or discussion groups except for one private forum devoted to a narrow topic.

    • nicoleandmaggie Says:

      escrow is both: essentially it means money that a third party is holding onto until a specific event occurs– doesn’t have to be housing related.

      In my mortgage case, escrow includes both property taxes and home insurance. I think at this point we could get the property taxes separately but we prefer not to deal with that. We did the other escrow thing when we initially bought the house.

      • chacha1 Says:

        Ah OK. Yeah, it’s all separate ’round these parts. :-)

      • Jenny Says:

        For me it was a choice I made when I took out my loan. I could have used escrow but chose not to. (I think if your LTV is below a certain amount you have to.) My budget is based on 2 paychecks a month. For months I get three I move most of the last one into a separate account that I use for property taxes and homeowners insurance.

  5. crazy grad mama Says:

    Not really a misconception, but I’m annoyed by the idea that all money advice is applicable to everyone bugs me. e.g., “Don’t buy a car unless you can pay for it in cash.” (Although I guess we could have paid for our new car in cash, we just chose not to.)

    • Leah Says:

      Yes, especially when someone wants to lecture you about money because you’ve made a conscious choice to do X or Y instead of Z. Maybe I just don’t want to let on that I have cash reserves, or maybe I’ve made a calculated decision to not use said cash reserve.

    • crazy grad mama Says:

      Hmm, I’m also bugged by my apparent lack of grammar in that first sentence. That’s what I get for typing on a tablet.

  6. First Gen American Says:

    My favorite misconception and even really really smart people say it: it’s good to have a mortgage for the tax write off.

    How is getting 1/3 of the interest back in a refund better than not paying interest at all? Even if it meant the difference between itemizing deductions vs not, the math still never worked in favor of giving money to the banks.

    When you are deducting expenses…it means you are spending.

    Similarly, I think a lot of people understand how tax brackets work.

    • Leah Says:

      Pretty sure almost no one understands how tax brackets work :-( I hear so many misconceptions on taxes, how they’re paid, what people pay, etc. The worst part is that people vote based on their misconceptions.

    • Sara Says:

      When my sister was considering buying a house at the height of the boom, people kept telling her (an accountant) how much better it would be for her taxes “because then you can itemize!” Really? So she should pay interest for a tax deduction that puts her barely above the standard deduction? When I was in high school and got my first job, she taught me how to do my own taxes and explained the standard deduction as the “freebie” deduction–I wish more people would get that message.

      • Leah Says:

        Plus the freebie of not having to save receipts and justify your deductions! I love being able to drop stuff off at thrift stores and not need a stupid donation receipt.

  7. bethh Says:

    This isn’t a misconception, I don’t think, but this reminds me I have a mortgage-paying question. I keep running the numbers, and given that my interest rate is 3.35%, no matter how I slice it it SEEMS like it makes more sense to save in a taxable index fund and then pay off the mortgage with great chunks of cash. But I rarely find anyone advocating for that which makes me second-guess myself. I think the concern is that the person doing the saving won’t actually set the money aside, but is there some tax implication I’m missing, or something, that would make it smarter to pay more on a monthly basis directly to my mortgage provider, rather than planning to pay off around the 15th year? I’m 3 years in on a 30-year loan.

    • nicoleandmaggie Says:

      What you’re missing is risk. Paying down your mortgage is a safe investment (like putting it in an FDIC insured savings account), putting it in the stock market is more risky– higher potential returns but more fluctuation.

      There are some tax implications (if you itemize) that reduce the effective interest rate, and with the way that mortgage works (check out the amortization worksheet), early pre-payments are worth more than later pre-payments so the interest rate isn’t quite as easy to figure out as it would be for a cd or credit card.

      But for a 3.35% interest rate, the big thing is risk. Next time I have a break I’ll dig up our lengthier post explaining this. (Remember: the stock market doesn’t always go up, and it often goes down right when you need money!)

      • SP Says:

        I don’t totally understand how student loans and mortgages are fundamentally different in the way prepayments work. I’m prepaying my student loan (not aggressively, but casually). I have it set up to just send the same fixed amount every month (2x the payment at the time I set it up) – no matter what the bill is. I think they recast it with each overpayment on their side, I ignore that. Does that work out differently than a mortgage prepayment, which is typically not recast?

        And are early payments more valuable even if you figure that the value of 10k in 2015 is more than the value of 10k in 2020, etc.? (NOTE: not an economist, forgive my ignorance! I took one single “engineering economics” class, so have heard of net present value, but don’t fully understand how to apply it in my normal life.) Would that change if the mortgage was indeed recast? Maybe I must spend some time with your spreadsheet linked.

      • SP Says:

        i also confirmed that the extra is going to principal, because someone’s comment above had me scared that they weren’t doing that. Seems like it would be illegal not to and to simply advance your due date!!

      • Leah Says:

        After reading comments above and remembering my husband’s student loans, his student loans just moved the payment date ahead. So, when he would pre-pay, they’d say “oh, you don’t have to make a payment next month.” Of course, he would. At one point, his online payment thing told him that he didn’t have to make payments for something like two years.

      • nicoleandmaggie Says:

        @SP– I think it varies among student loan processors. The kind DH had many years ago worked like a credit card, but it seems like different people have different kinds now. Not my area of expertise!

        What you don’t want is to just push the payment forward so you’re still paying them interest on that money you already gave to them. Either you should get lower payments because it reamortizes OR it should pay down the principal so the end date is later. Prepayment should result in less paid over all, not the same amount paid.

    • nicoleandmaggie Says:

      p.s. A LOT of people do advocate for that because in the long-run it is mathematically better. But if you may be reading a more risk-averse part of the internet.

      • bethh Says:

        Thanks! I’ve been putting 600/month into an index fund (this is after 16% pre-tax and 5% post-tax going to retirement funds – not maxing them out but getting close on the pre-tax 401(k)); maybe I’ll do 300/month prepayment and 300 into that index fund. I’m tempted to do a high 4-figure/low 5-figure principle payment to get it below x00k – it would feel nicer than watching that amount in the bank just evaporate as it has been lately!

      • nicoleandmaggie Says:

        It’s hard to say what the right thing to do is. After you have a reasonable emergency fund, pre-paying the mortgage generally makes more sense than putting money into a lower interest savings account, but it’s all about your risk tolerance as to whether additional money should go into taxable stocks or the mortgage. I basically stopped prepaying when I felt like the amount owed on the mortgage was not something we would need to worry about if DH lost his job. (Or I should have stopped prepaying at that point, I think inertia kept us prepaying some time after that point.)

        What I like to do is run through worst case scenarios (job loss, stock market crash, etc.) and think about what the different options give me for those. And not in terms of what would have been optimal, but in terms of would I still be ok. (Like if I don’t need the money, I can ride out a stock market crash.)

  8. Debbie M Says:

    * If you are renting, you are throwing money away [whereas if you are buying, you are not]. But when you are buying, besides paying off principal, you are also paying off buckets of interest, closing costs, property taxes, required insurance that costs more than renter’s insurance, and repairs and maintenance. Plus you often feel you need to fill up the house with furnishings and decorations. Plus you are much, much more likely to spend money on renovations. And you are in charge of the mowing.

    * The magic of compound interest. Yes, it’s magical. But it is mitigated by the antimagic of compound inflation.

    * College. I love college. I am so glad I got to go. Same with grad school. I learned so much in so many fields. I got rewarded for thinking. I met great people. I got to live in cool cities. And it made a great half-way house between living with parents and jumping into the real world. But my degrees helped me with my career and earnings almost zero.

    * The idea that you have to fit in with the Joneses–some of it’s true, but some isn’t. (Yes, you should dress up to go to court and neaten up for interviews.)

    * The idea that saving is hard and weird but spending is normal. That the goal is merely to not run out of money at the end of the month.

    * That you should spend money trying to look young. Yes, you should use sunscreen and do exercise. But face creams? Hair dye? Botox? Boob jobs? So sad. Well, maybe we should do this to get treated better in society, but I’m going to pretend I don’t have to. I’m an introvert and enjoy many activities where the other people don’t have to look at me, like reading books, so it might be different for me than for other people. Also, I’ve decided my grey hairs are pretty and my jowls are like a family heirloom–all the women on my mom’s side have them.

    Mostly I only access parts of the internet where people agree with me and thus are not perceived by me to be wrong. When someone is wrong on the internet anyway, they are usually only partly wrong and I get to say, “Actually, it’s different in this situation.” Occasionally I get to remind people that gender differences are not that big. More often I get to explain that conservatives and even Republicans can be reasonable. Or if it looks like they will happily always be wrong, I move on and probably don’t hang with them anymore if it looks like a place I generally wouldn’t enjoy.

    Sometimes I’m the one who’s wrong or at least ignorant and I get to figure that out. That’s awesome! I learn a lot about parenting, gender issues, discrimination, medieval sewing, and of course money tips from my contacts.

    I do belong to some fora, but my online interactions are mostly within my favorite blogs (hi, grumpies!), on Facebook, and via e-mails.

    • crazy grad mama Says:

      Yeah, compound interest is not that magic when interest rates are below inflation.

      College is a tricky one—I agree with you in theory, but I worry that in practice it’s become a de facto job requirement. i.e., nobody cares what you actually learned, but they care that you have that degree.

      • Debbie M Says:

        Yes, there is definitely education inflation, if for no other reason than to have a defensible way to get rid of loads of applicants when you have way too many.

  9. SP Says:

    I love the plural fora! I read some fora, but don’t comment. Misconceptions that bug me are mostly just those of the racist/sexist/ignorant variety, like women are “naturally” better at this or that, or muslims are anti-american, or people who just say something that sounds scientific but doesn’t actually make sense…

    related to personal finance, i guess misconceptions would be:
    * the mortgage interest tax deduction largely benefits the middle class (it benefits ME, but the more expensive your house, the more you benefit).
    * renting is throwing money away
    * buying a home means you give up all your freedom and never travel and are house poor
    * basically anything dogmatic. There are usually lots of right ways to do things (and lots of ways to do them wrong)

  10. Leigh Says:

    On the internet being wrong: yesterday, commenters on APW were suggesting people find Edward Jones advisers :( e.g. “I second having an Edward Jones adviser. I love mine and let him focus on his areas of expertise.”

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