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While we can debate whether it is better to rent or buy a home, there is no arguing that on average, Americans save very little. Before the recession kicked in, Americans spent 2 to 5 percent MORE than they made. In other words, collectively, we had a negative savings rate. One of the most important features of buying a house is that it forces you to save money every month at ever increasing rates. Here's how it works and how to make sure that you don't get off the savings path with home ownership.
The most common mortgage financing home ownership is the 30 year mortgage. While some people can squeeze by with a 15 year mortgage and others opt for more exotic interest-only products (which have become more rare), the 30 year mortgage is the staple of the U.S. housing market.
Saving on Your First Mortgage Payment
That monthly payment that you make has two components: principal and interest. In the beginning, interest dominates and the amount that you save through principal pay-down is fairly limited but likely more than the average person was saving. On a $250,000 mortgage at 5.5% the initial payment of $1,419.47 includes a principal payment of $273.64 or roughly 19% savings. Drop the interest rate down to 4.5% and on the very first payment, you are saving 22% of it. This is often forgotten in the buy vs. rent calculators that are out there. So how many renters that are out there would actually save $274 a month.
Savings Grows Over Time
Over time, that rate of savings grows considerably. After 10 years, the rate of savings on your $250,000 loan increases to 33% or $471 a month. After 17 years more than half of your payment goes into savings. The longer you stay in your home with the same fixed rate loan, the faster you pay down your house and the more equity you build. Today's unique interest rate environment combined with lower housing prices makes the math even more compelling. Some people have snagged mortgages as low as 4 percent, barely above the official rate of inflation. On a four percent loan, your savings rate on your first payment is a whopping 30%.
Threats to Your Forced Savings Account
So if the owning a home with a fixed rate mortgage is a forced way of building your net worth, why don't people have that much equity in their houses? Two words come to mind: Refinancing and Home Equity Lines of Credit. Just when consumers get into the peak years of equity building, they get a tempting offer to refinance their mortgage. Refinancing can make perfect sense if the interest rate is low enough but if you reset the clock at 30 years, you are putting off your savings. Ideally if you are 10 years into your first loan and you refinance, you refinance into a 15 year loan at a lower rate. Similar payments but faster date of payoff. But most people are tempted by the lower payments and refinance into another 30 year loan, which ultimately is likely a mistake.
The second way that people ruin their forced savings is by tapping their equity with a Home Equity Line of Credit. While there are perfectly good reasons for drawing on a line of credit including emergencies, higher education expenses, or real home improvements, many people use the HELOC to buy toys or take vacations. Resist the temptation and keep your forced savings account intact.
So when you are thinking about buying a home versus renting, you really need to factor in the likelihood that without a forced savings account that you are going to be able to save $100,000 on your own in the next 10 to 15 years. If you don't think you are going to save a dime, a house might just be your ticket to automatic savings.
Related Articles:
How to Get a Cheap MortgageLow Rate Mortgages: The Benefit You Never Heard of
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