How mortgages work

How mortgages work

Real estate has an advantage in that it allows you to use a lot of leverage if you want. Let's see how leverage affects your returns assuming you make a $20,000 downpayment on a $100,000 home. Because you're only putting down 20 percent, you're using quite a bit of leverage.

Let's say that home prices in your area then rose 10 percent and your home is now worth $110,000. But your home equity, which is now $30,000, would show an increase of 50 percent.

This gives you an idea of how leverage can work in your favor.

Of course if home prices dropped 10 percent, your home equity would be only $10,000 and you'd have a loss of 50 percent. But since home prices generally increase, the leverage you can use when buying a home usually works in your favor.

Should you pre-pay your mortgage?

When you buy a home, you almost always need a mortgage. Most mortgages are amortized so that you pay off the principal and interest both during the life of the loan. Your payments remain constant, but the early payments consist of mostly interest, while the later payments are mostly principal. If you make extra principal payments, you really can reduce the total cost of your mortgage.

But if you already own a home and are wondering whether you should make prepayments on your mortgage, the answer is probably "no". Some books have impressive tables that show how you can save tens of thousands of dollars in interest by paying off your mortgage early, but these are a little misleading.

You can save by prepaying your mortgage, but you also can divert those extra mortgage payments into retirement accounts and have tens of thousands of dollars worth of financial assets after a few years.

If your employer offers something like a 401(k) retirement account, and offers to match your contributions, you should save through your 401(k) at least up to the employer's maximum match.

This is better than prepaying your mortgage. Although your mortgage is debt, and you want to get rid of debt, it's cheap, secured debt that has a low after-tax cost.

Also, if you pay off your mortgage and don't invest in tax-sheltered retirement accounts, you're not getting the diversification you need. Believe me, you'll be unhappy if your neighborhood takes a turn for the worse and you have all your money tied up in your house.

Finally, if you have kids, note that paying off the mortgage may limit their ability to get financial aid. Currently, the parent's home equity is considered an asset for need-based aid, while money in retirement accounts is not considered.

So unless you have to pay mortgage insurance, it's generally best to consider making extra mortgage payments only after you've maxed out on making deductible contributions to your retirement accounts.