Updated: 9/30/2010 12:00 AM ET|
Don't rush to pay off that mortgage
Paying down your mortgage may not be the best use of your cash. Take a look at the numbers and consider these avenues to get more bang for your buck.
Cratered interest rates, a volatile stock market and a dismal real-estate situation make it vividly clear: The only decent, guaranteed return you can find these days is by paying off debt you've already incurred.
If you're carrying credit card debt at 11%, for example, every dollar you pay off earns you an instant 11% return on your money.
That's a great return in a world where:
- One-year certificates of deposit average much less than 2%.
- Yields on short-term Treasury securities are close to zero.
- Many retirement funds are down 40% or more from their peaks.
- Home prices are still bottoming out.
So shouldn't we be tackling all our debt, including our mortgages?
Liz Pulliam Weston
Not so fast.
There are situations where paying down a mortgage makes sense, such as when you're approaching retirement or when reducing your principal will get you a much better deal on a mortgage refinance.
But most people still have better things to do with their money, even in this environment, than to pay down a low-rate debt that's often tax-deductible to boot.
And if you're "underwater" on your mortgage, paying it down is probably the last thing you should do.
The urge to be free of debt
It's not that I don't understand the impulse to speed up the day that you own your home free and clear. There's something psychologically satisfying about knowing the bank can't take your castle.
Besides, the numbers can seem pretty impressive. Let's say you have a 30-year, $250,000 mortgage at 6% interest. Your monthly payments are $1,498.88. By paying an extra:
- $100 a month, you could save nearly $52,000 in future interest and pay off the loan four and a half years early.
- $250 a month, you could save nearly $100,000 in future interest and pay off the loan nine years early.
- $500 a month, you could save nearly $144,000 in future interest and pay off the loan almost 14 years early.
So who wouldn't go for that, right? Indeed, a March 2007 study (.pdf file) co-authored by a Federal Reserve economist estimated that 16% of U.S. households pay extra on mortgages each year. But anyone who really understands money would realize the savings aren't all they're cracked up to be.
For one thing, mortgages tend to be some of the cheapest money you can get, and, as mentioned earlier, the interest is often deductible. If you're in the 25% federal tax bracket, that 6% interest rate may be costing you as little as 4.5% if you itemize and even less when you factor in state income taxes. (Your tax break depends on the amount of interest you pay and the total of your other itemized deductions.) Even if you don't get any tax break at all on your mortgage, though, the rate is still dirt-cheap compared with that on most other loans.
Furthermore, those seemingly impressive interest savings are spread out over future years, when their value will be substantially eroded by inflation. Remember, a dollar 25 years from now probably will be worth less than 50 cents is today, given a 3.1% inflation rate.
Need a guaranteed return? Try 50%
Contributions to a workplace retirement plan will get you a lot further ahead, for a variety of reasons:
- While many employers have recently curtailed such practices, workplace plans often still offer matches, typically 50% of every dollar you put in up to 6% of your pay. If you're not contributing enough to at least get the full company match, you're leaving free money on the table (and missing out on an immediate 50% return).
- You save taxes on the money going in. Federal tax brackets range from 10% to 35%; there are also federal tax credits when lower-income workers make retirement contributions. When the money comes out, you'll owe taxes, but most people's tax rates fall in retirement compared with the period when they're working.
- Even with the recent turmoil, over the long term your money can earn better returns in the market compared with paying off low-rate debt. Based on historical returns, a mix of 60% stocks, 30% bonds and 10% cash would earn an average of more than 8% a year in most 20- to 30-year periods, according to market researcher Ibbotson Associates. You may doubt we'll ever return to the days of long-term gains in the stock market, but we will.
Even if you stick your money in a cash account, the upfront benefits of retirement plan contributions are compelling enough that you should opt to put money there rather than your mortgage.
In fact, the Fed study found that homeowners who prepay their mortgages blow more than $1.5 billion a year, or $400 per household, by accelerating their loan payments instead of contributing more to their retirement accounts.
The research found that at least 38% of those who were making extra payments on their mortgage were "making the wrong choice." Instead, these households would get back 11 to 17 cents more on the dollar by putting the money into a workplace retirement plan such as a 401k.
The study didn't mention Roth IRAs, but they're another account you should take advantage of if you possibly can. You don't get a tax break upfront, but the money comes out tax-free in retirement.
If you're already maxing out your retirement funds, though, your next step still shouldn't be making an extra mortgage payment.
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Determining if it makes sense to allocate money into paying down principle on a mortgage or instead putting it into a 401K account depends on various factors and the dollar amounts. For example, let's look at the following perspectives in deciding where best to use your capital:
- Investment Return
Is investing in your house a better retrun than the stock market? Dependiing on what years you look at, the stock market's average return is not impressive, particularly when you factor in inflation rates and investment fees. Some of the rates I have seen in this article and posts are not what I believe to be accurate. I would say, on average and depending on investment choices, the annual ROI on equities over the past 16 years has been around 3%.
Same goes for investing (adding equity) to your house. What usually determines if it is a good decision is at what price did you buy and sell at. Apreciation on housing was great in the 90's but lousy over the past several years. Buying a house as an ivestment is even worse of an idea when you factor in the cost to mainatin the house (repairs, maintenance, interest, etc.)
From an investment perspective, I would say either asset class is about equal.
Decreasing some of your personal contribution to 401k account to apply to a mortgage won't impact the Company contribution amount as long as you contribute at least 6% to your 401K, the limit of most company 401K plans contributions. For example, let's say you are over 50 years old and you can contribute 23.5K to your 401K plan, the company is only going to contribute up to 6% of your annual salary. So if you are making $125K, you only need to contribute $7.5K to get the 100% match.
However, decreasing your Personal Contribution does increase your taxable rate. But remember, the only things for certain in life are taxes and death -- you eventually will pay taxes on the money. If you will be in a lower tax rate when you retire, than it will save you a little money the more you contribute to a 401K (up to the limit), but for most people, the difference will not be a huge amount.
Paying down your mortgage principle will reduce the respective borrowing cost (interest) on that amount.
When you compare the difference between "higher taxes and lower borrowing costs" you probably will find it will be a wash.
That brings us to the last perspective - Risk Perspective:
Here is where I couldn't agree more with the author. There are particular times when it is more financially prudent to pay down mortgage debt, such as to get a lower interest rate when refinancing or when getting close to retirement and protecting your income stream and principle is more important.
In closing, I think the best way to determine what is best for you is to select a specific dollar amount that you would be working with, and see how the numbers compare.
Are you joking on this article? You point to a tax savings on the mortgage interest when you know there is a movement to take the mortgage tax deduction away. Then you note the inflation rate. I suppose you are suggesting that my fixed mortgage payment actually costing me less in the future is enough to compensate for the reality of a 30 year note at 5.5%. On an approximate $200K note, if you pay at the minimum amortization schedule, your house will cost you over $400K. Yes...it will. 360 payments at $1135 per month. So, if you pay cash for your home versus a 30 year note....you save...yes...200 grand. That is the overly simple math but it IS the math. How in God's name can not paying off your house early be considered good financial advice? Sure, pay your credit cards first. Sure, max out any employer contribution (thats just free money..take it), but wait on your mortgage? Foolish advice from a writer that is clearly connected to the established financial community.
For me it took a combination of both paying down my mortgage and paying into my 401K. And there are alot of jobs that pay 50% match into your 401K - Wal Mart, School System and others. All of which I worked for. And my investments over the last 20 years has averaged well over 8% a year with Well Fargo Investments - William Monroe CFP. And this is not a political issue. My savings don't depend on whose in office or their policies. It depends on my life choices.
Where are these people who are going to pay off a 30 year mortgage who are retired and in their late sixties and seventies? You People will all be DEAD and your kids will pay off the Mortgage !
You make it sound as Life After retirement is a Cake Walk ! As we get Older we Don't get Healthier ! The old Body just doesn't function like it did when you were Twenty One!
All of you Guy's know what I mean, without those Blue Pills, getting laid three times a night is a Dream of yesteryear ! Pay off all of your Bills and live within you means ! That's something the Obummer Administration hasn't learned to do yet. Vote the BUMS out in November or you won't have any Money to worry about paying those bills with !
Paying your mortgage ahead takes money principal off the END of the loan and interest from the payment to the end. With rates now hovering around 4%, those paying 25% income tax have a realized interest expense of only 3%. Over the life of your loan, you will do better investing that money - fully fund 401(k)s and IRAs for the tax benefits and you only need that 3% yield to keep pace, or elsewhere, without preferential tax treatment, your money needs to earn 5%. In the long run, this is a very reasonable expectation.
Further, inflation is running at about 2.1%. One of the great things about mortgage financing is that you get to repay the loan with "tomorrow's dollars", which are worth less than today's. You'll inflate your way out of the loan and toward the end, the payments will seem cheap.
Since your loan is front-loaded with interest, extra payments early on have, by far, the greatest impact. If you're so concerned, borrow less. And for all those touting how they have or will "pay off my mortgage __ years early" - great. You'll realize all of your savings at the END of the loan. Your payment hasn't changed. What could you have done with that money and the interest you "saved" over the same period.
Run the numbers, then comment. Educate yourselves.w
Bullfeathers! The faster you can get out of debt, the better. No exceptions. When are Americans going to wake up? Following the traditional methods of the so-called ‘financial experts’ is what has created 15 TRILLION DOLLARS in Federal debt as well as 15 TRILLION DOLLARS in NEW PERSONAL DEBT in America. The system is set up to enslave us financially, period. My wife and I were introduced to the system at Paxeon Financial a couple years ago and it has literally changed our lives. Everyone discouraged us, but guess what, so far we’ve saved more than $48,000 on our mortgage, without paying a dime more out of our pockets and will have an extra $379,000 for retirement. The ‘experts’ can keep their advice.
I am going to take another route in this and agree with Liz. Most people right now say pay off your house which is essentially paying to the mortgage company extra to eliminate your interest payment. Sounds good in theory and its safe. However what about this?
1. The safest investment out there is a highly diversified mutual fund. Most mutual funds have a rate of return of 8% annually over the long term.
2. The average income increases by 3% annually (we hope).
3. As your income increases, your taxable amount and tax rate increases.
4. Using a normal amortization table of a mortgage over 30 years, you will pay 1/3 more of the value of the mortgage ($200,000 loan and after that time, will pay in total $350,000, give or take).
Lets say you have 25 years of working life left in you and 25 years left on your mortgage. Your loan was for $200000. You better hope that your house increase in 25 years to $350,000 since that is the amount you really will pay for it. So at the end you have $350,000 asset.
Now, lets say you take that mortgage and change it to an interest only mortgage (you will have to refinance once since most interest mortgage is 10 to 15 years before the principal is applied). From that, you would free up $400 a month (amount applied to principal) that you would invest in a mutual fund. Using a simple rate of return calculator, that $400 a month over 25 years compounded annually at a nominal 8% would net you $378,000.
Break even? Not so fast.
Add 300 more a month (like you would to pay off your mortgage faster), would net you $663,000.
And that is not even using Liz's advice to invest in the mighty 401K with company matching which would net you even more.
With income rising (even at a small rate) and your mortgage interest annually going down, you lose out when filing income tax. Take a look at your current return. Schedule A offsets the taxable income. Your taxable income will only increase as you work (god willing) and your schedule A amount reduces with will equal PAYING MORE IN TAXES.
So you paid off your house early, what is going to offset your taxes? Unless you are planning to give a lot to charity or expect a huge medical bill, nothing. So add $10,000 to taxes each year that you will pay.
So in 25 years, most will have a house....that is old and need of repair.....hopefully it is free and clear and you didn't refinance. And hopefully you paid off all your debt or you will end up taking out a reverse mortgage to free up that money to assist in your living.
Or, you can have liquid assets of up to $600,000 or more depending on your investments which can use to cherry pick a new house of my choice of all the foreclosures out there and underbid, pay it off and have extra money left to live off.
Good article overall. If anyone isn't maxing out their employer matching retirements before paying extra on their mortgage, then they should. It is free money that will most likely earn a return. Even if stays even, it is still free money. MAX them out people. Do employers even do that anymore ;)
The other stuff, I'm not so sure about. MAX out employer matches.
And here are great benefits you'll receive:
- you'll have to keep working until you are half dead.
- you'll be a financial slave forever.
- your family will loose the house if something happens to you when you are old but not done with payments yet.
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