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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
While
it is very true that a shorter mortgage incurs far less interest
than a longer one, simply paying off your existing mortgage faster
might not save you as much as you think. The key factor is that
you pay most of the interest in the early years. It takes eight
years to pay down the first 10% of the principal when you amortize
a loan over 30 years. The rest of what you've shelled out is
interest. By the time you are halfway through a 30-year mortgage,
you've paid 67% of the interest. By year 20, two-thirds of the way
through the mortgage, you've paid 84% of the interest.
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
Imagine
if you will, an anti-mortgage account. Instead of sending a bunch
of extra bucks to your mortgage lender every month, you send them
to a broad-market index
fund.
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
There
are two common reasons people cite for paying off their
mortgage early: To provide a safety net in case they lose their
job and to reduce income needs in retirement. The prospect of
losing your home because you can't make the mortgage payments is
scary -- no doubt about it. And the prospect of devoting most of
your retirement income to a monthly mortgage isn't much better.
But let's look what happens if you choose to invest instead.
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
In Part 1
we compared paying off a low-interest mortgage ahead of schedule
with investing the additional payments in an index
fund. We assumed an annual return of 11% for the index fund.
In a sense that's like shooting fish in a barrel -- if you have a
loan at 7% and an investment bringing in 11%, it's pretty obvious
that you will do better by investing than by paying off the loan
early. The problem is that while mortgage rates are clearly
spelled out and (except for adjustable rate mortgages) fixed,
stock market returns are not. In essence, our entire argument
rests on the performance of the stock market.
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
Even
with the odds greatly in favor of investing versus an early
mortgage payoff, for some people the bottom line is not the only
consideration. Let's look at some legitimate reasons one might
chose to pay off a mortgage early and then discuss the best way to
go about it should you decide that an early mortgage payoff is in
your best interest.
•
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
Most
of the pay-off-your-mortgage-early debate is emotional: The desire
to own your very own piece of the Earth that no one can take from
you, or the fear that investing will not provide the kind of
return you expect. If those emotions are winning the argument in
your mind, first argue with yourself some more. But if you end up
deciding to pay off your mortgage early, here are some guidelines
for making the payoff process work in your favor:
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
It
may seem like we've saved the most important point for last, but
actually tax considerations are not a driving factor in this
debate. Tax savings are icing on the cake for those who pay off
their mortgages slowly. If you
work it right, paying off a mortgage quickly reduces the interest
you pay, but that also reduces your mortgage interest deduction.
While it's silly to spend money just to get a tax deduction, it's
also silly to give up a tax deduction unless you net more money
somewhere down the road. In this case though, we've seen that the
investing option is likely to put more money in your pocket even
before we consider the tax break, so what was the point of giving
up that tax deduction again?
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.
Convinced?
If you find
yourself still on the fence, try using our mortgage
payment and savings
calculators to compare the net effect of investing versus making
additional mortgage payments for your particular situation. And
the Buying
a Home discussion board is a great place to bounce ideas off
Fools who've "been there."
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