Financial Resource Allocation for Your Mortgage
A sound mortgage planning process means building a financial plan first and a financing program second. By "plan" we mean defining goals and setting milestones to reach them, while accounting for the resources available to us.
The goals of the financial plan, set by the household, are varied and differ from one household to the next: buying additional properties, financial independence, early retirement, a comfortable cash flow, fewer worries, living debt-free, and so on. The financing program, by contrast, has a single goal: to minimize the cost of the mortgage, given the financial resources allocated to it.
Usually the goals of the financial plan and the financing program aren't the same, and sometimes they clash. You get the cheapest mortgage by making maximum use of your financial resources — but if you pour all of them in, you can't pursue your financial goals. The reverse is also true: pursuing those goals means diverting money away from the mortgage. So which goal matters more — the mortgage, or the other financial goals?
Since the mortgage is a financial instrument, we'll aim to use it as a tool for reaching our financial goals. And that's what this article is about — how to do exactly that.
The financial resources available to us in mortgage planning
As described above, the financial assets available to us are the down payment (current and future — whatever we accumulate or receive) and the monthly payment. Add our risk tolerance — a financial (and mental) resource — and we have the three factors that most shape the mortgage and its terms. For each one, we have to decide how much to "allocate" toward the mortgage:
a. The down payment: How much capital will we hold back — beyond the amount required to get a mortgage — for other financial goals? And how much extra capital will we put in to shrink the mortgage?
b. The monthly payment: By how much will we raise the monthly payment to shorten the mortgage below the maximum loan duration?
c. Risk in the mortgage: By how much will we increase the risk and volatility to get a shorter, cheaper mortgage?
Before we start thinking about financial optimizations, it's important to remember that the household's cash-flow security, as we described in the previous article, comes before any planning we do here. If we need to, we'll stretch the mortgage out as far as possible and put in more of a down payment, until we reach a positive monthly cash flow. Any optimization is risky and pointless if August summer camps, a car repair that spirals, or a short stretch of unemployment push us into overdraft.
Let's set aside the effect of risk on the mortgage for a moment and come back to it later.
Down payment vs monthly payment
Based on the first two resources — the down payment and the monthly payment — we can divide financial planning into four approaches, or quadrants. Each quadrant has its own pros and cons, and its own situations where it's the right choice.
We'll review the quadrants starting with the first — the upper-right one — and move counterclockwise through the rest.
Quadrant one: high monthly payment and high down payment
We all want to finish our mortgage early. We all want to pay as little interest as possible. And we all want the option to ease off the pace years before retirement. People in this quadrant turn those dreams into action and focus all their resources — a high down payment and a high monthly payment — on reaching those goals. They work to cut the principal and pay off the mortgage as fast as they can.
We advise being in this quadrant when there's no financial risk or uncertainty, and you have (or will have) the means to reach all your financial goals. In practical terms, that means the following situations:
a. The lucky ones who are already set financially: those with significant capital and wealth, or who have a safety net someone else put in place for them. People who don't need to take risks, because all their needs — and their dependants' — are covered.
b. There are no further financial goals after the mortgage: the kids are settled, the current home is our dream home and will serve us for decades, we're in jobs we love with solid job security, and we live at a standard of living that satisfies us.
We also recommend a high monthly payment and a high down payment in the following case:
c. Someone who objectively can't invest their capital. For example, a person approaching retirement with a short investment horizon — they don't have enough investing years left to absorb possible losses.
By contrast, there are cases where people have placed themselves in this quadrant and we advise them to get out of it. How do people end up here in the first place, and why do they get stuck? Here are a few reasons:
a. An emotional and irrational view of the situation. Some people treat the bank as if it were a person; they don't want the bank to "screw them over," they want to get back at it — meaning they want to know they paid as little interest as possible. That's a perfectly understandable feeling, but probably not a financially rational one. You can think of the bank as an enemy that charges us high interest, or you can think of it as a partner — one we lean on to reach our goals, and thanks to whom we can keep money outside the walls of the house.
b. Risk-averse and anxiety-driven individuals — those who think taking out a mortgage means certain loss of the home (which, in certain cases, can actually happen). True, a relationship with a bank instead of a flesh-and-blood landlord is new, but it's hardly unusual. In our view, the bank is the best landlord you'll ever have — it doesn't raise the rent on a whim, but according to objective economic variables. The bank won't evict you because a relative comes to stay; it will only do so if you become insolvent.
c. People facing the need to do financial planning for the first time ("we'll think about it after the mortgage"), or those planning only the current step. Remember that your next financial move will be defined and carried out using whatever resources are left after the current one.
In the world of engineering, this is called Greedy optimization.
Quadrant two: low monthly payment and high down payment
Here we find someone who has chosen to put significant capital toward minimizing the size of the mortgage, but pairs it with a low monthly payment — resulting in a long but small mortgage.
We advise being in this quadrant in the following situations:
a. When a large mortgage creates a cash-flow problem. Just as we described above, if we can't end a typical month with a cash-flow surplus (meaning income exceeds expenses), it makes sense to put additional capital toward reducing the mortgage, and with it the monthly payments. In this situation, we don't recommend putting capital into investments but into reducing liabilities. Cash-flow safety comes first.
b. In the case where a large mortgage causes us anxiety and worry. Some people find a 1.5 million NIS mortgage frightening, while a 1 million NIS mortgage doesn't scare them at all. It's not necessarily rational, but it happens — you can be afraid of numbers and what they represent. It goes without saying that it's worth confronting the fear and using financial analysis to understand how the mortgage size affects the household's expected cash flow. But if the worry is something you can't shake, then it's perfectly fine to be in this quadrant.
By contrast, there are cases where people have positioned themselves in this quadrant and we advise them to get out of it. How do people end up here in the first place, and why do they get stuck? Here, again, are a few reasons:
a. A situation where a significant portion of the capital came from a third party (family), and that third party tied the money to buying a home only, not to any other investment. We understand the parents, of course — they want to make sure we're settled, so they put a condition on the money, leaving us no right to use it for anything else. At the same time, if we've received a large sum from a third party, does that mean we also need to put in a large down payment of our own? Can we use the family's money in full and reduce what we contribute ourselves?
The family wants to help us and see us financially settled. At the same time, responsibility for our household's financial prosperity falls entirely on us. If we hit hard times and need capital we don't have — because we sank it into the mortgage — is that our responsibility or our parents'?
If, beyond a home with a small mortgage, we haven't built up any other investments to grow our capital, that's on us — not our parents.
We'll continue with the next two quadrants in the next article.