Whoah, that’s crazy! I can hear some of you who don’t live in an expensive part of the world say. Meanwhile, some of you are surely thinking you can’t get anything livable with a $1 million mortgage. The ideal mortgage amount of $1 million is based on the premise that the ideal income for maximum happiness is $200,000 per person.
Back in 2002, a $1 million mortgage cost around $50,000 to $65,000 a year in interest expense given mortgage rates were 5%-6.5% for a 5/1 ARM or a 30-year fixed. Multiply the annual interest expense by three, and you get $150,000-$195,000, the minimum annual income recommended to take out such a loan.
In 2015, a $1 million mortgage costs around $22,500 to $35,000 a year in interest expense given mortgage rates are now 2.25%-3.5% for a 5/1 ARM or a 30-year fixed. Multiply the annual interest expense by three again and you get $67,500 to $105,000, a far cry from the $150,000-$195,000 you originally needed to make! Note, banks still only lend out 3-4X your income despite a drop in rates.
It is aggressive to think that someone who only makes $79,500 a year in gross salary can afford a $1 million mortgage, but it’s also absurd that one can borrow $1 million dollars nowadays for only 2.625%! I’m not recommending everyone with impecable credit scores, great financial habits, and steady savings rates all get $1 million mortgages. I’m just saying that it’s now possible for someone making $79,500 a year to service $1 million worth of debt at 2.625% if the bank approves.
REASONS WHY THE IDEAL MORTGAGE AMOUNT IS $1 MILLION BUCKS
1) The law says so. The maximum mortgage interest indebtedness is $1 million dollars according to the IRS. In other words, if you have a $2 million dollar mortgage that costs $70,000 a year in mortgage interest, only $35,000 of the mortgage interest can be deducted from your income. Your tax savings is simply $35,000 X tax rate. The IRS also stipulates that you can deduct the interest on a $100,000 Home Equity Line Of Credit if the money is used other than to build, improve or purchase your home. Crazy but true.
2) Maximum government subsidy. The home mortgage interest deduction is one of the largest government subsidies available to all citizens. In an environment when all it seems like the government does is take, take, take, citizens get something tangible and immediate back from the government. The government helps subsidize your lifestyle and lower your taxes. To not take full advantage of such subsidy is a shame, unless you love paying taxes!
3) Keeps you disciplined. For those who live in expensive cities such as San Francisco and NYC, keeping a $1 million dollar mortgage limit helps keep you from going overboard and buying too much house. Plenty of nice houses now cost over $2 million dollars for example. By keeping your borrowing to $1 million, you are forced to come up with a $1 million down payment before you can buy such house. You might think going the standard 20% down ($400,000) and borrowing $1.6 million is fine, but it is not ideal. You start justifying what’s an extra $600,000 in debt at that price, losing your financial discipline. I can assure you that everything because more painful the more you borrow: less deductions, higher mortgage payment, and more stress.
4) Asymmetric risk and reward. In America, when you borrow a ton of money from a bank and can’t pay it back one day, you don’t get stoned to death, castrated, or impaled in the heart by a spear. Instead, you hand back the keys to the bank who agreed to take on your home as collateral in case of non payment. If you are lucky to live in a non-recourse state, the bank can’t go after your other assets! If you live in a recourse state, then a short-sale or foreclosure will temporarily slaughter your credit score for 3-7 years. Better your credit score then your private parts right? Meanwhile, if you happen to invest in the right cycle, you can make a massive amount of money when you finally sell or rent the property out without having to give the bank any of the upside! Isn’t America great?
5) You make closer to the ideal income. Based on my article, “The Maximum Mortgage Indebtedness Depends On Income,” how much mortgage interest you can fully deduct is based on how much money you make. Make too much, and your mortgage interest deductions get phased out. Make too little, which is under $79,500 based on existing rates, and you will feel the strain of the mortgage payments. If you or your household make between $150,000-$300,000, you are in the sweet spot to take on a $1 million dollar mortgage. Be aware if have an adjusted gross income of over $166,800, your mortgage interest starts to get phased out. For every $100 of income over $166,800 you lose $3 of itemized deduction X 33.3% up to a maximum loss of 80 percent of your itemized deductions. Lower rates have moved everybody closer to the ideal income!
MORTGAGE AMOUNTS ARE DIFFERENT FOR EVERYBODY
If you live parts of the country which have wonderful $500,000 homes, then awesome! There is never a need to borrow $1 million dollars. The standard deduction of roughly $6,000 for singles and $12,000 for married couples is probably good enough for most. For those of you who live in expensive coastal cities, then consider $1 million dollars as the cap on how much you should borrow and calculate your mortgage payment to income ratio, loan-to-value ratio, and home value to cash left over after downpayment ratio.
Some of you reading this have liquid assets north of $1 million dollars. A $1 million dollar mortgage is therefore nothing to be afraid of because everything is just accounting. Your goal in this low interest rate environment is to minimize your debt interest expense by refinancing your mortgage and maximizing your government subsidies. Imagine refinancing your mortgage to 2.625% while making 16%+ returns on your investment guaranteed after rebalancing your portfolio? You’re essentially borrowing money for free and then some!
Don’t be afraid of mortgage debt. Instead, cherish what the government has given us and live a wonderful life knowing you are optimizing your finances.
RECOMMENDATIONS TO BUILD WEALTH
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Updated for 2016 and beyond.