Amortization 101 - #3 - The Greatest Trick Ever Pulled
/This is part 3 of a 3 part series
Amortization 101 - #1 - Where Does Your Interest Lie?
Amortization 101 - #2 - Your Friendly Neighborhood Bank Isn't So Friendly
The Difference Between Residential and Commercial Loans
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The majority of my previous two posts have focused on home loans and how the game isn't in our favor while most of the population is tuned out.
Guess what? It's the same in the commercial arena and no one notices it there either.
Here's the main difference between the two loan categories: Commercial loans will be amortized over a certain period, 20 or 25 years, for example. However, they typically require a balloon payment at some fixed point, way before the end of the amortization period. 10 years, for example.
Take that in to consideration for a moment.
In ten years, you either need to come up with all the money owed to the bank or refinance. At 10 years, you will have paid roughly 70% of the total interest owned on a 20 year loan. Time to refinance.
Do you see the scam?
The bank gets to hit you with new fees, points, etc. Also, you are likely to refinance for more money now - either to improve the property or just to take additional cash out.
Essentially, this was how all loans (including residential) were prior to the Great Depression. They were short term, with short amortization schedules and balloon payments. Unfortunately, too many people were losing their homes because they couldn't afford the balloon payments. A large chunk of the population couldn't even afford the large down payment that was required to get into the home. Add to this pressure the fact that banks were collapsing at the same time for various reasons, some of which included loan defaults.
The federal government entered the fray to stop further collapse. First, they created an agency (Home Owner's Loan Corporation - HOLC) that developed a 20-year fully-amortizing loan. This was to help buyers get into homes with a lower down payment and then insure monthly payments were achievable over the long haul.
Since the government wasn't (and shouldn't be) in the loan business, they needed to sell the new loans that were created. However, investors wanted to believe the mortgages were solid and would perform. Therefore, the federal government created the Federal Housing Administration (FHA) to provide the necessary mortgage insurance to increase investor confidence.
The HOLC was later replaced by the Federal National Mortgage Association (FNMA or Fannie Mae) in 1936.
The housing market recovered and then exploded following the advent of the new fully-amortizing loan. In 1948, the fully amortizing loan increased to a 30 years maximum. Our loan of choice hasn't even been around 70 years yet!
As a nation, we haven't looked back since then.
The modern fully-amortizing loan was created by our government as a way to help save the banks that were going under during the great depression and to spur more home purchases and development.
Do you see anywhere the terms "personal finance," "personal wealth" or "individual retirement?"
The fully amortizing loan was developed to fix a broken system. Why would you ever think it was intended to make its citizens wealthy? Oh, that's right, because we never talk about this stuff in school.
We only know what we're told by the banks and government that continue to loan and insure these mortgages.
What About the Mortgage Interest Deduction?
Okay, so I'm hammering on the amortization schedule as it relates to your mortgage and how you're going to get screwed if you’re not paying attention.
This is invariably when someone is going to bring up the mortgage interest deduction.
“Wait, don’t I save on my taxes by paying interest on a mortgage?”
“Yes, you do, but -”
“If I pay off my house, I’m losing out on the great tax savings I’m going to get with that interest deduction.”
We, and this is the collective we – Republicans, Democrats, real estate brokers, bankers, contractors, accountants, home buyers, you name it – have made the tax man in to the boogeyman. He’s here to take all my money and my first born! How am I going to save my money from him? I know! I’ll borrow a large sum of money to purchase my home. Then I can write off all that interest.
Sucker.
First of all, the mortgage interest deduction only works if you itemize. If you don’t itemize your deductions, then this is moot argument.
Here's a very quick and dirty look at the deduction:
You own a nice home with a $200,000 mortgage.
You paid interest to the bank this year on your home loan equal to $8,000.
Since you're itemizing, you'll get the home interest deduction.
You’re in a 25% tax bracket.
You saved $2,000 worth of taxes this year.
You win. The tax man loses.
But you still paid $8,000 to the bank interest.
Wouldn’t it have been better to not pay the $8,000 in interest and just pay the $2,000 in taxes?
For a more in-depth discussion, check out Chris at keepthrifty.com and his article: FACT CHECK: THE HOME MORTGAGE INTEREST DEDUCTION. Since he did a fantastic job on this, I am not going to to hammer this any further.
Here's a point that gets lost often, though ... your mortgage deduction gets less and less the longer you own your home.
Remember, interest is front loaded in the amortization schedule. The longer you stay on one amortization schedule, the less interest you will pay each year until the house is finally paid off.
Therefore, the mortgage interest deduction (MID) is one of diminishing returns.
The advantage of this deduction is really only beneficial if you continue to hang around the front-loaded portion of the amortization schedule. And why the hell are you doing that? You're either frequently buying a new home or refinancing.
When both the banks and the government are telling you this deduction is a huge benefit, shouldn't you perk up and say WTF?
It’s an Unfair Advantage to the Rich
Derek Thompson wrote an article for The Atlantic in May of this year exposing “The Shame of the Mortgage Interest Deduction.”
The gist of the article was that the MID unfairly is tilted towards homeowners with large mortgages.
It was well-written, but missed a major point. It focused on wealthy home buyers, saying they were the only ones benefiting from the interest deduction. If you want to know who the real winner is of the mortgage interest deduction, follow the money.
Not the piddly amount saved by the homeowners. Look deeper.
The banks are the biggest winners. (Jump back up to the previous section of this post and re-read the section on the MID to figure out where it's happening)
American citizens are encouraged, by our government, lending institutions and investment advisers, to buy homes using financed dollars. They are later encouraged to refinance and "unlock equity." They are encouraged by the media to continually upgrade their homes. All of these loans come with the ability to claim some sort of tax benefit.
As American citizens, we gleefully file our taxes and think we’re “saving” money with our loans.
WE CAN'T FINANCE OUR WAY OUT OF TAXES, PEOPLE!
We are going to pay someone.
The Greatest Trick Ever Pulled
“The greatest trick the devil ever pulled was convincing the world he didn’t exist” – Roger “Verbal” Kint played by Kevin Spacey in The Usual Suspects.
Is the taxman a boogeyman? Oh, yeah. No doubt about it.
I’m not a fan of big government, but we are getting a military, roads, social services, and more for some of our money. Is there waste? Oh, yeah. Lots of it and you can find its source smack dab in the White House and Congress (regardless of party affiliation). They create a lot of waste and then they send the taxman out to fund their projects by picking our projects.
The taxman is definitely a boogeyman.
However, he’s getting outflanked every day by the banks.
And no one seems to notice or care.
The banks say, “We’ll fund your dream home” and we line up with an application in hand. Yet, we never ask how the amortization schedule works.
The banks say, “You want a car? We got your back.” Guess what? They’ve got an amortization schedule for that.
Any time an entity sends you an unsolicited offer for a home loan, refinance, or credit card, do you think they are doing it out of the goodness of their soul? Nope, it's because there's an amortization schedule hidden in there.
The banks are not your friend.
Have you realized that yet?
What do you think?
Are amortization schedules and
the mortgage game rigged
or am I just off my rocker?
Source Material:
The American Mortgage in Historical and International Context
How Mortgages Work
