Does it always make sense to make extra payments on mortgage

[DDEATH]

Does it always make sense to make extra payments on mortgage?

Ilyce Glink & Samuel Tamkin

Real Estate Matters, Tribune Media Services

February 18, 2012
Q: I hear and see so many financial advisors and experts recommending that people pay off their mortgages by making an extra mortgage payment each year. The reality is that it would be easier for the average person to include an extra $83.34 on a $1,000 mortgage payment than to come up with an extra $1,000 at the end of the year. What the heck, round it up to an extra $85!

While it makes sense to make extra payments now to reduce the principal on a high interest loan, it is very likely future inflation will make the prospect of paying extra dollars now (which are dear) to save cheap dollars later a bad business proposition.

A. You've made two very good points. First, you say that people are better off rounding up their payments to pay down their home mortgages because they will probably not have the money at year's end to make that extra monthly payment. We agree. If you don't have the financial discipline to save money in a separate during the year to pay down your mortgage balance, you are better off rounding up your payments on a monthly basis.

Not only are you better off because you don't have to worry about it at the end of the year (at the holidays, when cash is extremely tight for most families), but you'll get an increased benefit by paying down your mortgage throughout the year. Any payment that reduces principal faster means you're paying less interest on that borrowed sum the following month. So even more of your monthly payment goes toward repaying your principal.

The bottom line is that any increased payment toward your mortgage will save you interest expense in the long term -- at least when it comes to fixed-rate mortgages.

Now, if you are not able to save much money during the year, it's unlikely that you have the discipline to invest your money and more likely that you are spending all that you have. For this type of person, saving on his mortgage payments is probably better in the long term, even given your excellent second point about the corroding power of inflation.

You are correct that with historically low interest rates available, now is a good time to borrow money. In fact, as we were writing this, Freddie Mac's weekly mortgage survey found that 30-year fixed rate mortgages were available for under 3.85 percent.

Financially savvy homeowners borrow when interest rates are low and use that cash for other investments. If you borrow money at around 3 percent (e.g., if you opt for a 15-year mortgage), you can be certain that rates will increase down the road -- and you may even find that your interest rate is lower than the inflation rate. At that future date, you will be ahead of the time when you borrowed the money.

If you borrow $100,000 today at 4 percent and put money into a savings account, you might be lucky to get up to 1 percent per year on that money. So you'd be losing about 3 percent on that money per year. But if five or 10 years down the line, interest rates go up to 8 percent and savings accounts pay 5 percent, you'd be making one percent on the money you borrowed without doing much of anything and taking virtually no risk.

Of course, the right course of action depends on person's ability to invest and their ability to save. Many people are unable to save for a rainy day, much less for retirement. For these people, making extra payments on the mortgage can be a safe way to put money into their home, reduce their debt, and get to the day when they own their largest asset free and clear. This is how most Americans have traditionally built wealth.

On the other hand, if you are underwater on your mortgage, paying down the debt may not be the best solution, particularly if you are planning to sell in the near future or are heading into foreclosure. The dynamics of paying down your mortgage may work better if you have equity in your home.

Copyright © 2012, Tribune Media Services

[ucanit]

The primary reason to suggest early payment of a mortgage is that the vast majority of Americans seek immediate gratification, live for the moment, and have little, if any, self-discipline in all things financial. Meaning, that given the opportunity to have a few extra dollars; if they don't forfeit those discretionary funds (lured by the promise of interest cost savings), they will pi$$ it all away on something that is unnecessary, self-indulgent, and adds no economic value to their existence.

An elementary study of "the time value of money" and a minimal amount of self-discipline will ensure greater economic gain by a relative risk-free investment of those funds; which, by the way, also ensures the availability of "reserve funds" to protect against economic catastrophe.

The folly of early mortgage payment is evidenced by the high number of people who followed that path prior to the bursting of the housing bubble and who wound up (1) underwater on their mortgage anyway, with (2) no reserve from which to keep up with current payment obligations, and (3) an unforgiving lender who would give no credit for early payments made...against current payments due (or past due).

One additional reason for never seeking early repayment of a mortgage...is that it gives your spouse license to consider "early remodeling."

[DDEATH]

An interesting argument: is one better off having a mortgage on an underwater house, or having no mortgage on it? Of course it would no longer be underwater, but would it be better to pay it off?

[daisycutter]

Excellent topic to be discussed! I presently have about 47,000 left on a 96,000 dollar loan. I took out a 15 year mortgage at 4 and three quarters percent in 2003. The reason for my prepayment is because I want to get that mortgage payment eliminated by the time my children go to college, which is in about 4 and a half years away. Now some might say I'm better off investing in my children's college account with that money. But with interest rates at historic lows, and the need to go more conservative with college investments because my kids are less than five years away, doesn't make sense to go for the sure thing, and eliminate the mortgage debt? There truly is something to be said about being mortgage free, and the freedom of being COMPLETLY DEBT FREE (Dave Ramsey style) Don't get me wrong, my mortgage payments are very affordable on a monthly basis, but eliminating that debt sure as shit would feel damn good right about now!

[DDEATH]

Excellent topic to be discussed! I presently have about 47,000 left on a 96,000 dollar loan. I took out a 15 year mortgage at 4 and three quarters percent in 2003. The reason for my prepayment is because I want to get that mortgage payment eliminated by the time my children go to college, which is in about 4 and a half years away. Now some might say I'm better off investing in my children's college account with that money. But with interest rates at historic lows, and the need to go more conservative with college investments because my kids are less than five years away, doesn't make sense to go for the sure thing, and eliminate the Their mortgage debt? There truly is something to be said about being mortgage free, and the freedom of being COMPLETLY DEBT FREE (Dave Ramsey style) Don't get me wrong, my mortgage payments are very affordable on a monthly basis, but eliminating that debt sure as shit would feel damn good right about now!

Daisy,

Sounds like you're making all the right financial decisions. It's good to see some of you youngsters making the right moves.

My daughter and her husband are about your age. They had a 30 year at 5 3/8 which they were making extra principal payments on and would be paid off in 17 years. Their bank was offering low refinancing and it was a tossup between a 30 year at 3 7/8 and a 15 year at 3 1/4. They took the 15 and now will pay off their house 2 years earlier and pay $200 LESS per month with NO closing costs.

WHAT A DEAL!!!!

I have no mortgage. Would it be wise to take out a 30 year loan (100K) at 3 3/4 for 30 years ($477 a month) and use the money to buy a stock like AT&T which has a dividend currently paying about 5 3/4%?

What do you guys think?

[daisycutter]

DDEATH, That's very interesting! Use the cheap money the fed is giving us, and use it to your advantage! Brilliant! Of course I would never advocate borrowing 100,000 and throwing it all on ONE stock, even if its the best company in the world. Maybe the Professor can come up with a idea for the both of us. How do we take advantage of the almost free money the fed is dishing out? Any ideas Professor?

[ucanit]

As WestTx says, "You guys are making my head hurt!!"

Look, I feel sorta like a hypocrite because I haven't had a mortgage payment in over 25 years...but I counsel folks all the time to amplify today's free cash flow by carrying a larger mortgage balance instead of using up all their savings to make a larger down payment AND extending the repayment of mortgage debt instead of using up the majority of their current income to repay the mortgage quicker.

Here are the caveats: Making large down payments reduces the amount of the mortgage, the number of years of debt, or possibly the interest rate charged (and maybe all of these). Also, reducing the number of years of a mortgage by making larger payments may also result in a lower interest rate. Additionally, making those extra or early payments may also avoid some of the interest required for carrying debt for the full mortgage term. Each of these can reduce the overall cost of borrowed money and are therefore quite advantageous. HOWEVER, more people than you would believe make commitments that come back to bite them on the ass down the road.

Here are the risks: Making large down payments, paying higher monthly payments for a shorter period of time, and making extra or early payments all reduce the amount of "nest egg" to protect against economic life events that can be devastating. They also reduce the opportunity to invest in other things that may provide a much greater ROI than that realized by any possible increase in the value of real estate. The problem lies in the fact that you no longer have, and you may not be able to regain access to, the funds already paid against your real estate mortgage (and lenders are never very appreciative of your previous repayment record when you are presently not able to make payment or are in a financial crisis for some other life event reason).

Finally, I would NEVER advise anyone to borrow money against anything they prefer not to ever have to live without in order to have funds to put at risk in another type of investment. Borrow against a second home? Sure, you don't live there. Borrow against your only home...hell no! BUT, here's the deal. You CAN use your primary home as leverage when (1) you have another investment that provides good ROI AND a guaranteed value that can repay the debt against your home, or (2) you know beyond any shadow of a doubt that you will be able to make every mortgage payment and never, ever, default on the mortgage and lose your home.

If you really want to leverage your current home, I wouldn't advise taking a lot of risk (i.e.; single stocks or even some of the more risky mutual funds). Go with something that has some type of guarantee...like federal, state, or local government backing. For example, Vanguard has several state-based bond funds (Florida, California, New York, New Jersey, Ohio and Pennsylvania) that have averaged 6-8% over the past 20-30 years. With these you can really reduce the risk of any leverage you are willing to use against assets that you really don’t want to lose.

[DDEATH]

Ucanit, thanks for the info.

My hypothetical mortgage payment ($477 mo) would be easy for me to make. It is only about 11% of my monthly net income and unless the government goes broke and/or my CSR stops paying me, there is only a very minute risk that I would have to default on any payments. Also, I could always sell the investments to pay off the loan.

Of course I would diversify......... there are many ways I could make that 6-8% return in relatively safe investments.

Actually, my biggest worry is real estate taxes. Right now, I am just under the income limit for a Senior Tax Freeze Exemption for my home. That exemption is worth about $3,000 per year now, and will grow in the future. If I go over the limit, I will lose that much each year until I sell the house or we die! Another $6-8,000 a year in income (dividends) would put me over that limit.

It would be nice if I could borrow that money and put it all in my IRA, but my added problem would then be in about a year, when I turn 70 1/2 and have to start mandatory withdrawals.

Decisions, decisions decisions......... my head is hurting!

[ucanit]

DD, you do find yourself in a precarious position. Try to make a little more and, if the least little thing goes wrong, you'll wind up worse off.

I know you're going to tell me to go get my tin hat , but there are a lot of situations like yours that are "baked in the pie" or, should I say programmed into the system to manipulate and control the wealth of citizens.

Another example is the CSRS Windfall Elimination Provision for SSI, which will reduce my SSI annuity by 40%. This provision dissuades a lot of folks from even attempting to work a few years to earn additional retirement benefits...thus locking them into a lower income bracket.

Also, as I have mentioned before, working a few hours (10) each week after I retired is going to cost me an additional $40 per month for Medicare Part B over the amount you will pay. This provision also causes a lot of folks to decide not to even try to make a few more bucks to increase their income or their wealth. Truth of the matter is that this provision also applies to investors who might receive enough dividends or capital gains to put them over the MAGI (Modified Adjusted Gross Income) threshold, which also makes a lot of folks throw up their hands and say, "Why even try to improve my financial situation."

Similar scenarios exist for such government assistance programs as Unemployment Insurance, Disability Benefits, Foods Stamps, Aid for Dependent Children, etc. The limitations and penalties for trying to improve one's lot in life often negate any desire to do better...pretty much locking people into an income bracket despite any desire to improve their economic situation.

Say what you want, but you’ll never convince me that this shit just happened. I am certain that it is by design, intentional and planned…by whomever!!! Hell, maybe you have a guess!!

[daisycutter]

Its nice to see that i'm not alone in tackling debt, and trying to accumulate REAL wealth by investing heavily in my thrift savings plan, and other investments. Its seems to me that we live in a world of complete financial stupidity! People live for the here and now, and don't give a rats ass about retirement planning. I just read in today's paper that people are going back to their old ways of racking up debt, and putting everything onto their credit cards again. I remember telling my wife that after a brief period of paying down debt, people would go right back to using their credit cards once again, because they lacked the discipline to say no to themselves. People feel the need to accumulate a bunch of useless garbage, in order to keep up with the family next door. Will anyone ever learn that real financial wealth is accumulated by living BELOW your income, and investing the rest? In reality I think it comes down to one thing: THE LACK OF DISCIPLINE! I guess the time I spent in the marine corps, was time well spent!