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Money-Saving Mortgage Advice By There's nothing like owning your own home free and clear. That's a goal near to the heart of almost everyone who has ever held a mortgage. Oh, the things you could do without a mortgage payment! Paying off a mortgage is a noble goal, and one that can serve you well in retirement. But hang on, there's no rush. Despite the claims that you can save a fortune in interest by paying off a mortgage early, spreading the payments out over 30 years can be much smarter than putting your extra dollars into additional mortgage payments. The interest
paradox Starting to make accelerated payments halfway through a 30-year mortgage will save you very little in interest. It would be better to put those extra payments into a money market account until they are actually due Let the bank pay you interest instead. Another problem is the way some lenders handle additional payments. Not all lenders automatically recompute the interest you owe if you reduce your principal faster than they expect. Instead, they follow their amortization table, which divides each payment into a set amount of interest and principal. So even though your balance is lower, the interest you are paying doesn't change. With this type of mortgage, an early payoff amounts to a long-term, interest-free loan to your mortgage company. Yikes! The paradox is that even if you work it right and do save tens of thousands of dollars in interest, that decision could cost you far more in terms of lost opportunity. The real question is: What is the best use of your money? The anti-mortgage Let's look at what might happen with a $100,000 mortgage at 7%. You could pay it off in 30 years at $665 a month, or in 15 years at $899 per month -- and you'd save about $78,000 in interest with the 15-year option. But suppose you went for the 30-year option, sending $665 to the mortgage company and sending $234 to an index fund -- your anti-mortgage account. That's the same amount out-of-pocket every month, right? Fast forward 15 years. Your mortgage has been paid down to $74,018 and you have $106,397 in your anti-mortgage account (assuming an average annual return of 11%). At that point, you could, if you chose, convert your anti-mortgage account to cash, pay the capital gains taxes due, and use what's left to pay off your mortgage. Assuming a federal capital gains tax of 20% and a state capital gains rate of 5%, you'd even have about $5,000 left over -- but don't spend it, you'll be needing new carpet soon. The anti-mortgage account gives you options. You could cash it in and pay off your mortgage early if you prefer, or you could keep saving and building up your net worth as you pay down your mortgage. Or you could do any of the myriad other things that cash money is good for. The value
of cash Investing lets you build up a portfolio of securities that are easily converted to cash. Cash can make a lot of mortgage payments if you're collecting unemployment. Cash will also make car payments and buy groceries. Of course, if your house were paid for, you could always raise cash by taking out a new mortgage, except, oops, you're out of work. Bad timing. You might be able to get a mortgage, but not a very big one and not at very favorable rates. To get a decent mortgage loan, you need more than a lot of equity in your home: You also need regular income, which makes owning your home less useful in an emergency than you might think. Here's an even better idea: Use the earnings from your investments to make your mortgage payments. Yep, that's right. Once your anti-mortgage is big enough to pay off the mortgage at one time, you can use the earnings from the account to make the monthly payments -- and keep the cash! Here's how. Remember the example above where you ended up with an anti-mortgage account worth $106,000 after 15 years? Let's assume you retired at that point and don't want the burden of mortgage payments. Who could blame you? You could cash out your anti-mortgage account and pay off the mortgage, OR you could keep your money in the index fund and simply withdraw enough every year to make your mortgage payments. If you pull $10,600 out of the account each year, that will cover your mortgage payments and the capital gains taxes on the withdrawals. Here's the best part: By the time the 30-year mortgage is paid off, your investment account will have dropped a grand total of $2,000. (Again, we are assuming an 11% average rate of return). Talk about having your cake and eating it, too! For the same cost as a 15-year mortgage, you've paid off the mortgage, enjoyed 15 years of no mortgage payments, and you've got $104,000 in cash. Don't believe us? Take a stroll over to our Personal Finance area and play around with our mortgage calculator and savings calculator. Run some scenarios and see what happens. Then proceed to Part 2 where we discuss a few more reasons not to pay off your mortgage, and a few reasons why you might want to consider it.
A word about investment
returns So where did that 11% come from, anyway? Did we just pick it out of the air? No, 11% is the average annual return (CAGR) for the S&P 500 over the period from 1926 to 2000. We used the S&P 500 as our benchmark for two reasons: 1) The 75-year history gives us confidence in our expectations of its future performance, and 2) virtually anyone can duplicate the S&P 500's future performance simply by investing in a well-managed S&P 500 index fund. (If you decide to invest in other mutual funds, stocks you pick yourself, or pork bellies, all bets are off.) Estimating the S&P 500's future performance is the key. We know that its average return has been just a shade over 11% over the last 75 years, but we don't know how it will do next year. We don't even care. Next year's market performance is disturbingly unpredictable. But over 30 years, the span of a typical mortgage, the average return of the S&P 500 has been relatively consistent -- and always higher than fixed-income investments. All the depressions, recessions, crashes, crises, booms, bubbles, and busts simply balance each other out if you wait long enough. Warning: Statistics ahead! During the history of the S&P 500 there have been 46 30-year periods starting with 1926-1955, 1927-1956, etc, and ending with 1971-2000. The average annual returns for those 46 periods ranged from 8.5% to 13.7%, forming a nice bell curve with the mean at 11%. Of course, you won't average exactly 11% per year from your index fund over the next 30 years, but based on the past performance of the S&P 500, you have a 98% chance of getting more than 7% and an 83% chance of getting better than 9%. Your most likely average return will be between 10% and 12%. Feel better? If the statistics didn't do it for you, just hang on to this thought: The worst average annual return by the stock market over a 30-year span was 8.5%. Reasons
to prepay • Guaranteed returns. When you invest in stocks, your return is not guaranteed, but paying off a mortgage early gives you a solid, tangible return on your money. If you are looking for a guaranteed return, accelerating your mortgage payments gives you that, while index investing can't. Of course, with a low-interest mortgage, the return isn't very high (if you have a high-interest mortgage, refinance.) • Forced savings. Some people just won't save, but they will make the mortgage payment. You do what you have to do to increase your wealth over the years. (You might also consider automatic investment plans. Most mutual fund companies will gladly pull a fixed amount out of your bank account each month and invest it as you have specified. The money's gone before you miss it.) • Emotional satisfaction. Sure, that's a legitimate reason for paying off a mortgage early -- as long as you understand how much you are potentially giving up. Guidelines
for accelerated payoffs 1) Make sure your other cash needs are funded first: Retirement accounts, college funds, etc. Sinking all your spare cash into your home is under-diversification at its worst. 2) Start early. Making regular payments for five years on a 30-year mortgage then switching to a 10-year mortgage will cost you far more in interest than starting out with a 15-year mortgage. If you are well into a 30-year mortgage, run the numbers to make sure that you understand just how little you will really save.3) Talk to your lender. To actually save money on interest, you need a "simple interest" mortgage where each month's interest is calculated based on the declining balance, or you need to reamortize the mortgage based on a faster payment schedule. Lenders may charge to reamortize so ask how much that costs, too. Tax considerations A second consideration is that while we used 20% as our federal capital gains tax rate in the examples in Part 1, investments made after January 1, 2001 and held for more than five years will qualify for the new extra long-term capital gains rate of 18% (8% for those in the lowest tax bracket), making long-term buy-and-hold investments even more attractive. Speaking of capital gains, the first $500,000 in capital gains on the sale of a principal residence can be tax free, so doesn't that make paying down the mortgage a better deal? Nope. The capital gain is the increase in the value of the home when you sell it. You subtract your net proceeds from the cost of the home to find your capital gain. The mortgage balance doesn't affect the capital gain in any way. All tax considerations favor paying off your mortgage slowly and investing the difference.
Q.
Does paying off my mortgage early make sense? I've heard it isn't a good
idea, but I've also heard you can save a fortune in interest. --R.M.,
via email
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