Big Country Posted December 11, 2007 Share Posted December 11, 2007 SO, I've got a few questions about paying down the mortgage early. First off I guess is does it make sense to make additional principal only payments with the volatile nature of real estate right now. My first inclination is that the real estate market really has no bearing on whether or not it is the right decision, as whether prices are dropping like Paris Hilton's panties or rising like the phoenix, I still owe the same amount of money at the same rate. Thus, the decision is more a calculation of how much extra principal can I pay off, thus reducing x amount of debt at that rate compared to what that money could make if it were invested instead and see what gives me the greater value for my dollars. Now, assuming that the above formula works out such that making the early payments makes financial sense (I have not gotten that far as I want to make sure my logic is correct), would I be beter suited making an extra x amount of a monthly payment throughout the year, or paying a similar lump amount initially. I guess the question is, if I theoretically had $10K that I earmarked towards paying off extra principal on my mortgage, would I be better off say paying off 10K at the beginning of the year directly against principal, or would I be better off placing the money into some form of money market or saving account, paying an extra fixed amount each month, say $800, then applying the remaining $400 and any interest earned as an additional payment at the end of the year? Any input is appreciated. Quote Link to comment Share on other sites More sharing options...
Dragon Posted December 11, 2007 Share Posted December 11, 2007 (edited) Your best bet would be to invest the money and NOT pay down your mortgage. Here's why - Assuming you have a fixed rate mortgage somewhere in the low 5's - you can easily find investment opportunities that over the course of time will yield a greater return, even post tax. Don't do it. It's like the mentality of having "extra" taxes withheld so that you get a refund. Edited December 11, 2007 by Dragon Quote Link to comment Share on other sites More sharing options...
yo mama Posted December 11, 2007 Share Posted December 11, 2007 (edited) The economics of this equation depends on the following factors: - the effective interest rate your mortgage is costing you (interest paid, less tax benefits of interest payments); and - the net rate of return on the potential short term investment of surplus funds (rate of return, less taxes, transaction fees, etc). The "x factor" is likely the rate of return. While some folks are good investors who always make money, they generally have to incur substantial risk for their net rate of return to beat out the effective interest rate of their mortgage. It has been my experience that you will not be able to find a fixed/guaranteed short term rate of return that will beat out simply paying the mortgage down early. And if you're going to pay down the mortgage early, naked economics says pay it all at the beginning of the near. However, other non-economic factors (like cash flow concerns, or the warm fuzzy feeling of having available cash "just in case" certainly factor in to most folks' decision. Another concern is whether your mortgage has a fixed or adjustable interest rate. If it adjusts to a higher rate in the future, then the whole equation changes. Edited December 11, 2007 by yo mama Quote Link to comment Share on other sites More sharing options...
Azazello1313 Posted December 11, 2007 Share Posted December 11, 2007 not sure i entirely understand the question, but i'm pretty sure the answer lies wherever the most favorable interest rate lies. let's say you find a savings account that guarantees 5.2%. let's say your mortgage rate is 5.5%, but when you factor in the tax deduction it's more like 4.5%. if the return is greater than the functional interest you're paying, may as well leave the money in the bank for the time being. but it's a small difference, so if what you're trying to do is gain equity against your house, seems like you might be best off just paying down extra principle each month or whatever. if, like me, you have a second (higher rate) mortgage, then probably your best option is paying any extra toward that bad boy whenever you can. Quote Link to comment Share on other sites More sharing options...
Azazello1313 Posted December 11, 2007 Share Posted December 11, 2007 It has been my experience that you will not be able to find a fixed/guaranteed short term rate of return that will beat out simply paying the mortgage down early. really? there are lots of just plain old online savings accounts out there guaranteeing 5% and upward. if your mortgage rate is in the mid to low 5's AND tax deductible, seems like a pretty easy mark to beat. Quote Link to comment Share on other sites More sharing options...
yo mama Posted December 11, 2007 Share Posted December 11, 2007 really? there are lots of just plain old online savings accounts out there guaranteeing 5% and upward. if your mortgage rate is in the mid to low 5's AND tax deductible, seems like a pretty easy mark to beat. Is the 5% on the savings account tax free? (Probably not). And, depending on one's situation, not all mortgage interest is deductible. (Though, you've got to have a monster mortgage, or have in excess of roughly $150k of adjusted gross income for that to be a problem). Quote Link to comment Share on other sites More sharing options...
muck Posted December 11, 2007 Share Posted December 11, 2007 YoMama beat me to it. You gots to pay taxes on interest earned, too... Quote Link to comment Share on other sites More sharing options...
Azazello1313 Posted December 11, 2007 Share Posted December 11, 2007 Is the 5% on the savings account tax free? (Probably not). wasn't even thinking of it. Quote Link to comment Share on other sites More sharing options...
muck Posted December 11, 2007 Share Posted December 11, 2007 wasn't even thinking of it. It takes a village... Quote Link to comment Share on other sites More sharing options...
theeohiostate Posted December 12, 2007 Share Posted December 12, 2007 I was in the same boat about a year ago, with excess income wanting to pay down my mortgage. Instead of paying more on principal on a 30 year loan, i did a refi and dropped to 15 years. Now the interest owed it MUCH less and my payments have risen to the amount i would have paid anyhow. Dunno if that is the way to go, but that's what i did, gives me a reachable goal of paying off the mortgage , that isn't near my death bed. Quote Link to comment Share on other sites More sharing options...
TheShiznit Posted December 12, 2007 Share Posted December 12, 2007 Allow me to piss on the parade!!!! Sometimes I use this scenario with my clients if it makes sense. There is option A....invest what you would pay either lump sum yearly or monthly...and then after a set amount of years in which you would want to have the house paid off...go back to that investment account and pay it off. Option B...Invest in same investment account and buy a term insurance policy to make sure you goal actually happens in the event you die. Option C...buy a Variable Universal Life policy and overfund the heck out of it. When you want to pay the mortgage off, either cash in the policy or withdrawal what you need to pay it off....you then have options to keep the insurance if you wish. Most of the time I employ option B. Quote Link to comment Share on other sites More sharing options...
polksalet Posted December 12, 2007 Share Posted December 12, 2007 My oversimplified take... If you had you house paid off would you borrow money against it to invest?? That is exactly what you are doing if you invest rather than pay off the crib. Quote Link to comment Share on other sites More sharing options...
yo mama Posted December 12, 2007 Share Posted December 12, 2007 (edited) Allow me to piss on the parade!!!! 1. There is option A....invest what you would pay either lump sum yearly or monthly...and then after a set amount of years in which you would want to have the house paid off...go back to that investment account and pay it off. 2. Option B...Invest in same investment account and buy a term insurance policy to make sure you goal actually happens in the event you die. 3. Option C...buy a Variable Universal Life policy and overfund the heck out of it. When you want to pay the mortgage off, either cash in the policy or withdrawal what you need to pay it off....you then have options to keep the insurance if you wish. 1. Your Option A assumes your after-tax ROI beats the interest rate, net of tax benefits. No guarantee that will work, as discussed above. But someone who knows what they are doing could do well here, assuming they have a tolerance for risk. 2. not a bad hedge strategy against the worst case scenario... one that I have used for myself, in fact. 3. Great strategy, except for the fact that the individual now has to pay for the underlying insurance policy in addition to overfunding the investment function of the policy. Not everyone has that kind of extra cash flow, and the permanent insurance within a variable universal policy ain't cheap (especially if you have health problems, or are old). Plus, you can't generally pull out more than the appreciation from the investment component without incurring income tax effects. This means two things: (i) you're still subject to market risk (but at least its tempered by less onerous tax effects); and (ii) unlike a stand alone investment within a brokerage account, you can't get to the principal portion of the investment tax-free. Bottom-line: just paying down the mortgage is a risk-free, hassle-free, expense-free was to make productive use of surplus cash. It's the floor from which you can't fall off of, if you want to be conservative. Plus, if you're in a state that allows home equity lines of credit (or to a lesser extent, home equity loans), you'll still have access to the funds if need be. It just isn't as liquid. You're leaving some potential upside on the table, for sure. But you can't lose anything. Period. Edited December 12, 2007 by yo mama Quote Link to comment Share on other sites More sharing options...
Caveman_Nick Posted December 12, 2007 Share Posted December 12, 2007 1. Your Option A assumes your after-tax ROI beats the interest rate, net of tax benefits. No guarantee that will work, as discussed above. But someone who knows what they are doing could do well here, assuming they have a tolerance for risk. 2. not a bad hedge strategy against the worst case scenario... one that I have used for myself, in fact. 3. Great strategy, except for the fact that the individual now has to pay for the underlying insurance policy in addition to overfunding the investment function of the policy. Not everyone has that kind of extra cash flow, and the permanent insurance within a variable universal policy ain't cheap (especially if you have health problems, or are old). Plus, you can't generally pull out more than the appreciation from the investment component without incurring income tax effects. This means two things: (i) you're still subject to market risk (but at least its tempered by less onerous tax effects); and (ii) unlike a stand alone investment within a brokerage account, you can't get to the principal portion of the investment tax-free. Bottom-line: just paying down the mortgage is a risk-free, hassle-free, expense-free was to make productive use of surplus cash. It's the floor from which you can't fall off of, if you want to be conservative. Plus, if you're in a state that allows home equity lines of credit (or to a lesser extent, home equity loans), you'll still have access to the funds if need be. It just isn't as liquid. You're leaving some potential upside on the table, for sure. But you can't lose anything. Period. This is sound advice IMO. You are already committed to the debt on the house. Dealing with that debt smartly is never a bad option as compared to taking on other commitmnents that might strain your cash flow. As an alternative to paying down interest only, you could also look at a re-fi over a shorter term. This has the potential for better benefits if you don't mind committing to that extra money each month. And you can still pay extra if you can afford it. Quote Link to comment Share on other sites More sharing options...
muck Posted December 12, 2007 Share Posted December 12, 2007 No need to refinance for a shorter term. All that does is restrict your options down the road should something short-term befall you. Keep it as a 30 yr note, but ask your banker (or do it yourself in excel) to figure out how much you'd need to send in each month from today forward to have it paid off in ______ years; and then send that in. That way, you don't pay the costs to refinance (appraisal, bank fees, mortgage filing costs, etc), and you leave yourself a little wiggle room in case you lose your job and are out of work for a few months, there are expensive health issues, college for your kids is more expensive than you thought it'd be, etc. If you refinanace and subsequently hit a tough economic patch, it'll increase the likelihood that you'll have to sell your home just at a point where that would be wholly inconvenient for you to do so. Quote Link to comment Share on other sites More sharing options...
The Irish Doggy Posted December 12, 2007 Share Posted December 12, 2007 No need to refinance for a shorter term. All that does is restrict your options down the road should something short-term befall you. Keep it as a 30 yr note, but ask your banker (or do it yourself in excel) to figure out how much you'd need to send in each month from today forward to have it paid off in ______ years; and then send that in. This is exactly what I'm doing on the 2nd mortgage. Its a 20 year, but I'm on pace to pay it off in 12-13 (not that I'll be in this house that long...). But I skip the extra payment as necessary when things get tight. Quote Link to comment Share on other sites More sharing options...
Yukon Cornelius Posted December 12, 2007 Share Posted December 12, 2007 my house is payed off... and i have some things i would like to fix up is it wise to take out some equity or to take out of a retirement account.... Quote Link to comment Share on other sites More sharing options...
Caveman_Nick Posted December 12, 2007 Share Posted December 12, 2007 No need to refinance for a shorter term. All that does is restrict your options down the road should something short-term befall you. That is not telling the whole truth of the scenario. It is just telling the downside. The upside is that on a 30 year note, paying roughly the difference between what you would pay on a 20 year note cuts your 30 year note to approximately 23 years. That's a significant difference in out of pocket expense. I am not saying to do one thing or the other, but I made this choice in the past and when I felt that I could handle the 20 year payment, I did just that to save the money in the long run. Quote Link to comment Share on other sites More sharing options...
muck Posted December 12, 2007 Share Posted December 12, 2007 That is not telling the whole truth of the scenario. It is just telling the downside. The upside is that on a 30 year note, paying roughly the difference between what you would pay on a 20 year note cuts your 30 year note to approximately 23 years. That's a significant difference in out of pocket expense. I am not saying to do one thing or the other, but I made this choice in the past and when I felt that I could handle the 20 year payment, I did just that to save the money in the long run. I have no idea how your math drew you to that conclusion... Quote Link to comment Share on other sites More sharing options...
Caveman_Nick Posted December 12, 2007 Share Posted December 12, 2007 I have no idea how your math drew you to that conclusion... I did this out with my bank a few years back. We went over how paying extra money towards the principal would pay down a mortgage and compared it to refinancing over a shorter term and at a (typically) lower interest rate. The difference was approximately 3-4 years in payoff time paying the same amount of $$ out of pocket. Quote Link to comment Share on other sites More sharing options...
Azazello1313 Posted December 12, 2007 Share Posted December 12, 2007 I have no idea how your math drew you to that conclusion... well, the shorter note is going to have a lower rate, that would make the math work out. but i'm basically with you, that extra flexibility is probably worth what it costs for most people. Quote Link to comment Share on other sites More sharing options...
Caveman_Nick Posted December 12, 2007 Share Posted December 12, 2007 well, the shorter note is going to have a lower rate, that would make the math work out. but i'm basically with you, that extra flexibility is probably worth what it costs for most people. I wasn't trying to say differently, either. I was just pointing out another option. Quote Link to comment Share on other sites More sharing options...
muck Posted December 12, 2007 Share Posted December 12, 2007 Ah...the lower interest rate... Also, accelerating principal payments will accelerate the time to getting rid of PMI. Quote Link to comment Share on other sites More sharing options...
Dragon Posted December 12, 2007 Share Posted December 12, 2007 Sorry, but I really think you are making a potentially HUGE financial mistake paying off the mortgage early. Take the money and invest it in a "low to moderate" risk mutual fund instead of paying off the balance. This will afford you: A - More Income (net of tax) over a 5+ year time period. B - The flexibility of being able to use the funds as you wish without "refinancing". C - The flexibillity of changing your investment and increasing "A" from above. Do the math. It will be as clear as day. Quote Link to comment Share on other sites More sharing options...
Caveman_Nick Posted December 12, 2007 Share Posted December 12, 2007 Sorry, but I really think you are making a potentially HUGE financial mistake paying off the mortgage early. Take the money and invest it in a "low to moderate" risk mutual fund instead of paying off the balance. This will afford you: A - More Income (net of tax) over a 5+ year time period. B - The flexibility of being able to use the funds as you wish without "refinancing". C - The flexibillity of changing your investment and increasing "A" from above. Do the math. It will be as clear as day. As someone that has used the strategy you speak against over the last 15 year to great success, I can only say that my family's financial health has benefitted greatly from our approach. I know have the flexibility of sitting on that asset for the next 30 years and then banking on the sale of it as a retirement nut, if I even choose to do so. I have more income now to put towards 401K and all of my cash flow to put towards whatever investment I want. JMO, but working towards being debt free leads to a better life with less stress. No mutual fund will offer you the security that paying off your house will. I have invested in both over time, and seen plenty of loss in the mutual fund arena. My home only continues to appreciate. Quote Link to comment Share on other sites More sharing options...
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