Most people interested in owning a home at some point have heard the word mortgage. While it is a word used primarily in real estate, the concept is much simpler than many think. A mortgage, most simply put, is a loan given to you secured by a piece of real property. In layman’s terms, it’s a loan given using your house as collateral. While many people take it for granted that a mortgage is a necessary evil in the process of owning part of the American dream, I’d like to introduce a new way to look at mortgages. Once you understood what they really are, you can learn how to make them work for you. Prepare to be amazed at the power of the simple mortgage.
First off, lets discuss how most loans work. If I want money to buy something I cannot afford, I have two options:
- Save up the money and buy it.
- Borrow the money from someone else
Pretty simple right? Now the first thing to know about borrowing money is, unless it’s coming from a close friend or family member, nobody is going to give it to you for free. The money someone charges for the right to borrow their money is called interest. This is a familiar term to most people. Interest can be paid back several ways, but the most common method is making payments that include both the amount of money borrowed (called “principle”) and interest. Banks, credit unions, people, anyone lending money really, all make money doing so by charging interest. Now before you start to gripe about how high interest rates can be on typical loans like credit cards or personal loans, let’s think about why those interest rates are so high.
If I lend you some of my hard-earned cash, I can’t use it while you have it. This costs me something. Interest is how I’m compensated for that. In addition to the fact I can’t use the money, there is also the risk that you might not pay it back. Crazy concept I know, but believe it or not, some people actually haven’t paid back money they borrowed. Shocking.
To mitigate this risk, lenders often ask for collateral. Collateral is simply something the borrower offers for the lender to keep if the borrower fails to pay back the money. This is a very simple concept and can be seen in the most basic of ways when someone is trying to buy something and realizes they left their wallet in the car. If the person actually intends to come back and pay for the item, they will often say something like “Here, you can hold onto my cell phone. If I don’t come back, keep it.” This is collateral in its most basic form. A gesture of confidence offered by the borrower to show they intend to pay back the loan. It’s also often the only protection the lender has on getting their money back should the borrow default. If you want to understand collateral, you must understand it is risk protection for the lender. The more valuable the collateral, the less risky the loan.
Now, how do lenders determine how much interest to charge on a loan? Well, the answer is usually “as much as they can”. Luckily, because we live in a capitalistic society, there are other lenders competing for our business so rates cannot get too high with one lender. What you will typically find is that loans given with no collateral (referred to as unsecured loans) have much higher interest rates than loans secured by an item of value. The most common form of unsecured loan is a credit card. The credit card companies are letting you use their money to buy something with no way to guarantee you’re going to pay it back. To make up for this risk, they charge very high interest rates for the privilege and convenience of using their money. Makes sense right? If you want a loan with a lower interest rate, you need to help protect the interests of the lender. This is why secured loans are almost always so much cheaper. Examples of common secured loans are automobile loans, jewelry loans, and yes-mortgages. If an automobile loan is not paid back, the lender can repossess the vehicle (those evil repo men), sell it, and recover all or most of the money they lost in the loan. Once you understand this concept, a mortgage starts to make a lot more sense.
A mortgage is really nothing more than a loan someone, usually a bank, gives you using the house as collateral. The “down payment” you make is really just meant to minimize the amount of money the lender can lose if you don’t pay the loan back. When the loan is secured by real estate, the loan is called a mortgage. If the borrower fails to pay their mortgage, the bank can begin the process of taking the home back. In the real estate world, this is known as a “foreclosure”. All it means is the bank is taking the collateral you promised in exchange for the money the bank gave you to buy the house. Once the foreclosure process is complete, the ownership of the home (referred to as the “title”) changes hands from the borrower to the lender (in most states). The lender now has the right to do with the home what they wish in order to get their loan back. This is very similar to the process involved in the repossession of an automobile loan.
The reason a mortgage can be such a powerful wealth building tool is the fact the interest rates are usually kept quite low because the house itself has such value. Now, when taking out a mortgage on investment property, not only are you getting an interest rate much lower than if the loan was unsecured, you are also using that mortgage to acquire a property that generates cash flow FOR you. In other words, you’re borrowing money to buy an asset at a low rate, then using the rent from that asset to pay back the money. This is different from a car loan, or jewelry loan, or almost any loan, because the money borrowed to purchase something that doesn’t generate income.
Think about it. When you took out a loan to buy your car, did your car make you money to help pay back the loan? The answer is almost always no. In fact, cars usually cost even more money in the sense of needing gas, repairs, insurance, etc. When you buy a car with a loan, you are paying money to borrow money to buy something that will cost you more money. NOT a good wealth building strategy.
When you borrow money to buy a rental property, you are paying money (at a lower than normal interest rate) to borrow money to buy an item that will MAKE you money. The trick is to buy a property that will make you not just money, but more money than the interest, principal, tax, insurance, and any other costs associated with owning the asset. This isn’t nearly as hard to do as you’d think. Rent is a beautiful thing.
This is why loans secured by mortgages are often referred to as “good debt”. You’re borrowing money that will make you much more than it costs to borrow it. Repeating this cycle over and over can be a sure-fire way to build long-term and sustainable wealth. Learn to use the benefits of a mortgage to your advantage and you can build up your cash generating assets WAY faster than if you didn’t borrow the money. Increase your good debt while getting rid of the bad and watch your net worth grow!
