Economic Considerations in Building a Financing Program

Buying a home is just one of the many financial goals we want to reach over our adult lives. It's such a big, demanding goal that it's easy to forget life goes on after the purchase closes. Down the road we'll have other financial goals, and we want to make sure the mortgage we build today doesn't come at their expense — and that we actually reach them.

The articles that follow, which sum up and build on the topics we've already covered, deal with the economic considerations to weigh when planning your mortgage. We'll discuss the true cost of a mortgage, the importance of planning ahead, and what really makes a mortgage optimal. We'll look at how to put your financial resources to work (alongside the level of risk in the mortgage) to reach your other upcoming financial goals — not just the mortgage itself.

Is the repayment ratio really the most important parameter in mortgage mix planning?

We want to pay the lowest price for everything we buy, and that includes our home. The standard measure of a mortgage's price is the repayment ratio — how much interest and indexation we'll pay for every NIS we borrow from the bank. If we really want to pay the bank as little as possible, we can take a smaller, shorter mortgage. Since the bank charges interest on our outstanding debt, the smaller the debt we take and the faster we repay it, the less interest we'll pay.

But is the cost of the mortgage (and the repayment ratio) the only cost? What about the cost of the down payment — the price and the tax we pay to liquidate our invested assets? And what about the cost of the investment opportunities we give up on money we could have invested but didn't, because we chose to pay off the mortgage quickly?

As we wrote in the article on the down payment a mortgage requires, our household's economic worth is total investments, minus total liabilities, combined with our cash flow. Cutting the repayment ratio (by either of the two methods above) comes at the expense of our investments. If taking a smaller mortgage means cashing out a profitable investment portfolio, we have to count the capital gains tax as part of the purchase cost. And if finishing the mortgage sooner means choosing a very high monthly payment, it's worth counting the investment opportunities we forgo as part of the cost of the mortgage (though that's trickier to pin down).

With all that in mind, is it possible that taking a larger mortgage could actually save us more money? Looking at the repayment ratio alone, of course not. But our point is that this is exactly where you should take the wider view.

Key emphasis in mortgage planning - some mistakes are hard to fix

If a larger, more expensive mortgage saves us hundreds of thousands of NIS in capital gains tax, it's probably the better deal. If a low mortgage payment gives us flexibility and lets us seize other financial opportunities, it's probably the better deal too. So to tilt the situation as much as possible in our favor, we need to look at all the financial instruments at our disposal in a different light.

To plan and reach our financial goals, we'll draw on the financial resources available to us: the down payment (how much money we have on hand) and the rate at which we generate new capital over a given period, usually a month — that's our cash flow. We'll also have various financial instruments at our disposal: shares, bonds, short-term loans, deposits, and of course mortgages and general-purpose mortgage loans.

Unlike the other instruments, a mortgage has a built-in drawback: you can only take one out after buying a home. That drawback matters, because we buy a home so rarely that some mortgage decisions end up being irreversible. And an irreversible mortgage mistake can hold us back from reaching our next financial goals.

The true rules for an optimal mortgage

FINWIZ was founded to solve, in a mathematical and engineering way, the problem of the optimal mortgage mixture — that is, how to build the best possible mortgage mixture that minimizes the repayment ratio. To our surprise, we found that the mortgage mixture isn't the hardest part of taking out a mortgage. The borrower's own irrationality is. Even though our systems build complex mortgage mixtures in 30 seconds, we still need long meetings to make sense of clients' behavior and show them the irrationality in the moves they make.

We came to understand that an optimal mortgage isn't the one with the lowest repayment ratio, but rather one that meets the following three conditions:

First rule for an optimal mortgage

The monthly mortgage payment, now and in the future, isn't expected to push the household into a deficit. During planning, we recommend confirming that future cash flow (after the mortgage) comes to at least 10% of disposable income.

Second rule for an optimal mortgage

The mortgage doesn't keep us up at night or stress us out. We can treat it exactly like rent. It really is rent — with perks!

Third rule for an optimal mortgage

Make early mortgage prepayments only when they pay off financially. On one hand, there's clearly an economic benefit to repaying a mortgage and finishing it ahead of schedule, and every prepayment gives us a real psychological boost. On the other hand, the cost of the mortgage is sometimes lower than the expected return of most long-term investment instruments.

We need to understand what our money could earn us if we invested it instead. That's what's known as the return on alternative investment.

If the return on our investments beats the mortgage interest rates, prepaying makes no economic sense. But by how much does the return need to beat them? By 1%? By 2%? The excess return has to be positive, and big enough to cover the tax on investments, the risk of putting the money to work, and the psychological cost of investing it instead of paying off the mortgage.

The gap between the cost of financing and the return on the money is called the leverage spread

Keep in mind that the leverage spread can be negative and your investment can still turn a profit. That's because investing the money over time lets you defer the tax (on the gains), which boosts your economic profit.

Insights from the leverage spread calculator

The calculator lets you compare two strategies: holding the mortgage and investing the money versus repaying the mortgage and investing the freed-up monthly payment. The leverage spread shows the difference between the net return (after tax) and the mortgage interest rate — when it's positive, leverage works in your favor.

The bottom line is the Capital Gap vs. Alternative, which shows how much money you'll gain or lose from the leverage strategy over the entire mortgage term. The key takeaway is that even a modest leverage spread adds up to substantial sums over time thanks to compounding — but capital gains tax narrows the effective spread and has to be factored in.

Want to practice building the optimal mortgage mixture? Try our mortgage calculator and see how every choice affects the total cost.

Good luck!