…And now, the rest of the story… Part I

Recently, a friend and his new wife moved into a new home in the area.  For both, this was their second marriage and each brought children to the new blended family.  They needed more room.

The wife is an administrator for a local school district, and the husband is in technology sales.  They make a good income, and with their 4 children, they are the picture of the typical, upper middle class suburban family.

When exploring financing options, they had some money from their prior homes for a down payment, but they wanted to explore something other than the traditional 30 year mortgage.  After all, they have to think about college coming up, and eventually retirement.

If not a regular 30 year, they thought about getting a biweekly mortgage because they heard they could save quite a bit in interest over the years.

Though their actual figures were slightly different, this article provides a nice comparison of the options.

But as regular listeners of radio legend Paul Harvey heard, here’s the rest of the story.

(For those of you who don’t know Paul Harvey, he was the voice of the Dodge Ram ‘farmer” SuperBowl commercial.  You can see it here.)

Let’s take the figures from the mortgage article.

Regular mortgage interest	$279,767.35
BiWeekly mortgage interest	$228,232.48
Savings	$51,534.87

Advantage – BiWeekly (obviously!)

If you truly compare apples to apples, ask yourself – how much interest would you have paid on the regular mortgage up to the same time as the biweekly mortgage ends?

Regular mortgage interest	$269,185.06
BiWeekly mortgage interest	$228,232.48
Savings	$40,952.58

Advantage – BiWeekly (still)

But wait…there’s more…

That interest savings is great, but it leads to higher taxes.  Why?  If you pay mortgage interest, chances are that you itemize deductions on your tax return.  So, if your deductions are smaller (lower interest paid), then your taxable income is higher, which mean your taxes are higher.

Assuming you are in the 25% tax bracket, here’s what the savings really looks like:

Regular mortgage interest	$269,185.06
BiWeekly mortgage interest	$228,232.48
Savings	$40,952.58
Less: Increased taxes	($10,238.15)
Net savings after taxes	$30,714.44

Advantage – BiWeekly (getting smaller, but still OK)

However, there’s a cost to those extra tax payments.  (This would show up either as having to pay taxes, or getting smaller refunds).

If you saved those tax extra payments instead, what interest rate do you think you could get?

Using an assumed 7% pre-tax, here’s what the figures now look like:

Regular mortgage interest	$269,185.06
BiWeekly mortgage interest	$228,232.48
Savings	$40,952.58
Less: Increased taxes	($10,238.15)
Net savings after taxes	$30,714.44
Less: Opportunity cost of taxes paid	($5,478.88)
Net savings after taxes and opp costs	$25,235.56

Advantage – BiWeekly (going down!)

Making biweekly payments means that over a year, you end up making an extra regular monthly payment.  In this case, it’s the $1,610.46 figure.  Or, $134.21 per month.

Instead, what if you saved that $134.21 per month (and just made the regular mortgage payment) for the same length of time that the biweekly mortgage would run?  What would you have saved in that side fund?

Assuming that same 7% return (pre-tax), the side fund would have $80,389.56 including almost $40,000 in after tax interest!

Now, take a look:

Regular mortgage interest	$269,185.06
BiWeekly mortgage interest	$228,232.48
Savings	$40,952.58
Less: Increased taxes	($10,238.15)
Net savings after taxes	$30,714.44
Less: Opportunity cost of taxes paid	($5,478.88)
Net savings after taxes and opp costs	$25,235.56
Less:  Interest earned in side fund	($39,589.72)
Net savings after all items	($14,354.16)

Advantage – Regular mortgage with a side fund (by over $14,000!)

But wait, the biweekly mortgage would be paid off at the end of 25+ years where the regular mortgage would still have a balance!!!

Correct, but let’s take a look:

Balance of regular mortgage	$81,559.31
Balance of side fund	$80,389.56
Plus:  balance of tax savings opp cost	$15,706.28
Total available to pay off mortgage	$96,095.84
Net cash after mortgage payoff	$14,536.53

That means, after those 25+ years, you could use the side fund and the invested tax savings to pay off the mortgage at the same time as the biweekly and have over $14k of walking around money!

Advantage – Regular mortgage with a side fund

At this point, what do you think was the look on these couples’ faces? But they were wondering, what if we don’t earn 7% per year on our savings?

The break even rate of return they would need is only 5.33% pre-tax, which is a far more manageable figure.

At that lower rate, the side fund would only have $67k, but the tax fund would have about $14k.  That means between the 2, they would still have enough money to pay off the mortgage at the same time as the biweekly would have ended.

Think about the advantages.  Either way, it’s a monthly payment the family could afford.  But the husband’s job is in sales, which means his income fluctuates monthly.

By having that growing side fund, they could weather any emergencies that came up, or any month where their income falls, or for anything else.

What other advantages do you think this family would gain by having that side fund?

Which option do you think the family went with?  Which would you go with – biweekly or regular with the savings?

Upon seeing the figures, the choice was obvious for them.

As radio legend Paul Harvey used to say, now you know the rest of the story.

Next week, I'll show this same comparison with a 15 year mortgage instead of a biweekly.