With a mortgage, you borrow to save. Sounds weird, right? Let’s take a look.
Do you know what actually happens with a mortgage payment? Sure, you send it off to the bank each month (or, more likely, it’s deducted from your bank account automatically). But do you know what’s really going on?
The easiest way to understand what happens with a mortgage is to look at what’s called an amortization table. Here’s an example of an amortization table for the first ten years of a $500,000 mortgage fixed at 4% for 30 years, with a monthly payment of $2,387.08:
Let’s break this down column by column. The “Year” column, on the far left, is obvious.
“Principal” refers to how much of the loan you’re actually repaid in the given year. So out of the $2,387.08 x 12 months = $28,644.92 you paid the bank in 2012, $8,805.18 went to reduce the amount you owe.
“Interest” refers to the price you pay to the bank for using their money. Of your $28,644.92 paid for 2012, $19,839.74 was interest.
“Total Payment” is just that – the total paid each year. Because your mortgage is fixed, you know what your payment will be every year for 30 years.
Finally, the “Balance” column is the total amount still owed on the loan at the end of the year. So after 2012, you’ve reduced the amount you owe by $8,805.18 (see “Principal” above), meaning you owe $491,194.82 of the original $500,000.
Notice that, over time, the amount you pay per year stays the same, but that the amount of that payment that is interest goes down and the amount that is principal goes up. This makes sense, right? As you pay down the loan, there’s less borrowed money earning interest, so you pay less interest and retire more debt.
So how does all of this relate to savings? Well, assume that you bought the property for $550,000, with $50,000 in cash and $500,000 of mortgage debt. Assume further that the value of the property stays constant over time. If you sold it for $550,000 after ten years, you would have to pay the bank $393,919.80 to pay back the rest of the mortgage. That means you get to keep $550,000 – $393,919.80 = $106,080.20. So your $50,000 has more than doubled.
Now, you might think “yeah, but I paid a total of $28,644.92 / year x 12 years = $343,738.92 to the bank over those ten years and all I have to show for it is a lousy extra $56,000.”
And that is why you don’t buy a single family home, but you DO buy income property. With a single family home, the $300k that disappeared came out of your own pocket! But with an income property, your tenants were paying the mortgage the whole time! You didn’t pay that $343,738.92 over ten years… your tenants did. And better yet, as we’ve seen before, the property probably wasn’t just covering its mortgage the whole time. It was probably giving you additional cashflow, too.
Your $50,000 got you control of a little business that threw off cash to you for 10 years plus also more than doubled the value of your initial investment. And all of that was without any increase in the value of the overall property… it’s just the result of how the mortgage math works.