CFO of Life #21 Mortgages 101 - When, How and Why?!

Everyone wants to be a homeowner and we all want to have a place we call our own. But many rush into a house purchase just so we “don’t have to pay someone else’s mortgage off while renting”. And as much as this is true, it is not always the case.

That’s why it is important to understand what a mortgage is, how it works and why you should take extra time to learn more about it. 

To start with, the average house price for 2022 in the UK was ￡296,000 and in the USA $348,079. This means that for most of us this would be the biggest purchase of our life. The good news is that prices have been going down for the past 6 months. However, this is not the norm and it is temporary.

So what is a mortgage?

It is a loan you use to buy real estate, a house, a condo, a studio or a mansion. It has 3 key elements: deposit, interest rate and term.

Deposit – This is the sum of money you contribute at the beginning of the loan. Usually, this accounts for 2.5% to 25% of the total value of the property.

Interest rate – the % fee that the bank charges to give you the loan. This can be of two types, fixed (constant) or floating (variable). It is essential for you to choose the interest rate that suits you the most.

Length of the loan (term) – this represents the duration of the loan. It is usually measured in years (10-30 years).

Unfortunately, knowing what a mortgage is is not sufficient to decide if you should take out that loan. There are many more hidden costs that people don't consider when thinking about home ownership.

Those range from property taxes, land taxes, local government taxes, insurance and repairs. When it comes to repairs especially, people extremely underestimate how much they can cost. As if something breaks, you as the owner have to foot the bill.

Also, we often forget about the cost of everyday essentials like a washing machine being ￡400 and a new boiler ￡3 000 to ￡5 000. Simple renovation of a small bathroom can be ￡5 000 and more. And God forbid if you end up needing to change your roof. This is something that can easily set you back 10-15% of the property value.

At the same time, ownership is not all doom and gloom. If you are buying a house as your forever home that changes everything. It makes for a great investment into your future and can act as a "forced savings account". If you are lucky, the property value will also go up with time. So if you change your mind and want to sell that house one day, you will have a good return on your investment.

On the other hand, renting also has its benefits. It is usually quite flexible, you will be tied up only in a 6-12-month contract. So you can be free to relocate to a new place which makes the decision to take a job in a new city or county a lot easier. Or if something needs to be repaired or replaced, you are off the hook.

Simultaneously, renting comes with its drawbacks and everyone who has rented can share a story about a crazy landlord, for example. I have so many I can write a 3-season-long comedy show about it. But more importantly, your monthly payment is an "unrecoverable" cost. You could have put that money towards your mortgage, but you didn't.

However, if you take out a mortgage, а significant amount of your payments will go for “unrecoverable” costs. And what I mean is that for a ￡296,000 30-year-fixed mortgage on a 3.3% interest rate, you will pay roughly ￡170,685 in interest. That is an additional 57.67% of the house value. Or simply, you pay ￡5,689.50 a year to the bank for lending you the money.

When you first take out your mortgage, you will only contribute ￡482.35 (37.21%) towards “buying the house” and ￡814 towards interest. Only when you get to the 9th year of your mortgage, then you will start contributing more towards building your equity than paying off interest. And only towards the end, you will be paying more to "buy back the house" from the bank than to pay them for the favour of providing the loan. If you don’t believe me, check the mortgage calculator on the pinned comment.

Now, this is probably the moment when the penny dropped for you. A lot of people don't consider these details and this is how they get you. 

No matter what, still there is a point in life where it makes sense to buy a house rather than to keep on renting. That is the point where your rent is equal to 5% of the value of the house you want to buy. That will account for all the repairs, potential missed investment gains and any taxes.

Since explaining it would be quite math-intensive, I will share it next week. As a bonus, expect more about how banks decide if you are a good potential customer for a loan, when you become a bad customer and what you should consider if you do decide to take out a mortgage. Then you’ll learn when it is actually worth making the leap if everything checks out according to the 5% rule.

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Post #21 in the series CFO of Life #si #personalfinance #CFOofLife