Paying down mortgage early

[Fairchild]

Hi everyone--

Is there a benefit to paying extra mortgage payments to the mortgage holder vs. saving up the same money and putting in a MMA until enough is saved to pay off the mortgage?

Everyone always talks about paying an extra payment or more on their mortgage each year as being so great -- but, if we put that money in a MMA each year, wouldn't I have my original amount plus the interest I am earning, too? Do people not do this just because they are not disciplined enough to not spend it, or is there some benefit (interest-wise/tax-wise) to giving that money to the mortgage company each year?

Thanks -- we want to pay our mortgage off sooner than the 30-year term, but we want to know the best way to go about it.

[Scanner]

It's one of those "it depends" issue.

Strictly comparing a MMA vs. a mortgage. . .I think the no-brainer is paying down the mortgage.

You earn a 6% effective return when you pay down a mortgage early (or whatever your interest rate is). When you put in a MMA. . .you are going to get about 4% tops, and if it isn't sheltered. . .more like 2.5% after taxes.

What you are talking about is "leverage" though. Yes, by actually preserving the money in the form of "principal" in your MMA. . .you have more leverage with that money. Although this really isn't so much true as home equity is a good form of leverage.

The other benefit to giving it to your mortagage company is societal.

Most of our economic problem right now is "lack of liquidity" in the mortgage department. . .if everyone sent in an extra payment to our mortgages, the banks have more to lend. . .in fact, they have to lend it to make money. . .thus, it would restimulate the economy.

If Uncle Sam really wanted to stimulate the economy, they would have sent money for 2 mortgage payments that were earmarked rather than going out and blowing it on swimming pools, tatoos, or Disney World.

[cooliemae]

The benefit to putting extra payments on the mortgage comes from the compounding effect. The more you pay-off the less principle there is to accumulate interest. I would suggest going to bankrate.com or somewhere else that would show you a amortized payment schedule. Their calculators let you see the difference if you were to add extra payments versus not. On a $100,000 loan (30yr fixed at 6%) adding $100 per month ends up saving you $40,000 over the life of the loan.

As far as putting your money in a MMA and then waiting to payoff a larger lump sum...you would have to have a pretty good MMA interest rate. The MMA rate would need to be higher than the loan rate to even consider that, otherwise your still going to lose money to interest.

[TBH]

I know people will have lengthy responses for you, but I'd say you should ask yourself these two basic questions:

1. Is that money needed elsewhere more? If you have high-interest debt, like credit card debt, definitely pay that off first. And are you saving adequately in other areas. If your retirement savings are in good shape and you have a healthy emergency fund built up and your income is nice and stable and you STILL have extra money floating around, then you can consider pre-paying your mortgage.

2. Look at the interest rates. If you pay your mortgage early, you'll be saving yourself some money in interest. Is that more than you could earn in interest if the money was sitting in a savings or MM account? I'll use my numbers as an example. My mortgage is at a fixed rate of 5.25%. I can't get more than 4% in a savings account these days. So on the surface there's a 1.25% advantage to paying my mortgage down. Of course, the interest on your mortgage is tax deductible, so if you're in a high bracket you may be better off saving the money and not pre-paying your mortgage. But I'm in a low bracket, so this is negligible for me.

[jIM_Ohio]

In general it comes down to risk tolerance and most of the decision making is more based on emotions and psychology as opposed to what makes sense financially from a numbers perspective.

Here is my take:
If mortgage is 6% or higher, pay it down at expense of some liquidity
If mortgage is between 5 and 6% the decision leans towards paying off, but I want more liquidity.
If mortgage is under 5%, I would invest and maximize liquidity.

Details:
6% is tough to beat after taxes with moderate risk (20-80 type portfolio). Makes sense to pay down principal provided you have around 4-6 months expenses in an EF.

5.5% is possible to beat with a moderate risk portfolio (20-80 asset allocation). Once I had close to 12 months expenses in a liquid account (earning close to 5.5% after tax), I would review the decision to pay off or not. I want more liquidity than the 6% case (to protect in case of job loss or similar). I also want to be debt free sooner or later.

If mortgage is 4.75% or less, Most investors could beat that return, even with a 20-80 portfolio. 100% cash almost beats that return.

A second factor is the size of my pay down amount. If my pay down amount is significant (maybe the amount in question each year is 4-5 months worth of mortgage payments), then the larger the amount, the more likely for me I would pay down the debt. The smaller the amount, the more likely I would be to invest. This again is a liquidity issue.

[Daylily]

Given that your goal is to pay off the mortgage sooner than the 30-year term, why not refinance into a 20-year or 15-year mortgage? I refinanced three years into my 30-year down to a 15-year. At this point, if I continue paying on schedule I am down to 9 years 1 month. I have hopes to pay it off even sooner.

[maat55]

Hi everyone--

Is there a benefit to paying extra mortgage payments to the mortgage holder vs. saving up the same money and putting in a MMA until enough is saved to pay off the mortgage?

Everyone always talks about paying an extra payment or more on their mortgage each year as being so great -- but, if we put that money in a MMA each year, wouldn't I have my original amount plus the interest I am earning, too? Do people not do this just because they are not disciplined enough to not spend it, or is there some benefit (interest-wise/tax-wise) to giving that money to the mortgage company each year?

Thanks -- we want to pay our mortgage off sooner than the 30-year term, but we want to know the best way to go about it.

Here's two things to think about.

One: Will your MMF earn more than the interest rate on your home?

Two: Would you borrow on your house to invest money in the MMF?

[jIM_Ohio]

Here's two things to think about.

One: Will your MMF earn more than the interest rate on your home?

Two: Would you borrow on your house to invest money in the MMF?

Just because I invest instead of paying off my house early does not mean I would borrow money to invest once my house is paid off.
If A implies B, that does not mean B implis A. (Basic Logic).

Meaning that borrowing from house to invest in MMA is NOT the same thing and setting aside extra cash in MMA while paying down mortgage.

It's not the same to me anyways, here is why. It is about a financial plan which has a stated goal and timeline to complete goals with most efficient use of monies available. My goal is to retire when I am 53 (kids start college that year). I have a check list for retirement at 53.

1) Must have 25X expenses invested in various accounts. This is toughest part of that goal, it takes first priority when looking at any money and cost/benefit analysis.
2) Must have a plan for mortgage payoff. Our mortgage would be in year 20 of a 30 year payment schedule. There is more than one way to solve this problem (extra payments to pay off, taxable account to invest extra payments, combination of both).
3) Must have health care accounted for.

If 1) is not completed, then no need to do 2) at age 53. So if I went with a plan which paid off mortgage sooner (say age 48), but fell short of the 25X goal at 53, that does not work.

So I do the following
Invest aggressively to get 25X. Invest moderately to have a fund to pay off mortgage. It might turn out that 55 is a better age because 2 more years of compounding in both accounts gave enough to meet goal. It might turn out I hit 25X earlier in life (maybe I reach that goal in 10 years), in which case I would then reduce my risk and start paying off the mortgage sooner (instead of investing the difference).

Those are my big 3 issues for early retirement. Just because I invest to pay off my house early does not mean I would borrow money once my house is paid off.

[LuxLiving]

Fairchild,

You've already gotten the direct answer to your question.

I see many people here on the board do keep money out in some kind of seperate account that they are planning to use to make a future pay-off of either house or CCs.

I'll just add that many financial advisors will tell you to keep the money out of the house and invest it instead. And that those who've done it 'successfully' have a much larger bottom line down the road.

I say what you decide to do depends on what kind of secure feeling it gives you to have a paid for home.

Right now today I could easily pay off my home with money that is sitting in a decent paying MMA. My interest rate on the debt is higher than that interest being paid on the MMA. However times change. One thing to consider is what kind of freedom having quick access to extra cash gives you. If something truly !!EMERGENCY!!!came up I could use the cash easily even though these MMA dollars are not designated our Emergency Fund. To get it back out of the house once paid down I would have to either have a HELOC set up, or go make a HEL. Lenders are moody. Interest rates change over time too. Seems to me (I may be wrong) that loan interest rates are generally always higher than savings/MMA interest rates have been.

Kinda rather boils down to - do you want to be a borrower or a lender?

There's a lot more freedom of movement in just keeping the mortgage open and investing wisely. In my case the "I want a paid for house" voice in my head is very loud!

Since we have a bit more cash on hand these days and the market & most folks talking bearish, the Hubster and I are seriously considering taking the plunge and paying ours off. He is also contemplating retirement w/in the next 2-5 years. I personally want it paid off BEFORE he retires. Calculator tape is flying and negotiations continue!

IOW, overall, it's a personal issue based on your time in life and what your goals are. The 'best' financial decisions are not necessarily the same as the 'best' emotional decision. Sometimes a compromise is called for. If you decide to keep it out make sure you invest it safely and don't get all tricky w/speculation! I would rather we had our MMA money in something like bonds, laddered CDs or TIPS - Hubster likes READY cash.

Good luck with whatever you decide!

[StanFatherof3]

I suppose I'm much more emotional about my choice to work towards paying off the mortgage early. I send a little extra to my mortgage company every month because I want to see my house paid off. I know mathematically it may not be the answer. But I just get so excited seeing that balance go down every year.

[aida2003]

If mortgage is 4.75% or less, Most investors could beat that return, even with a 20-80 portfolio. 100% cash almost beats that return.

Hmm... I wonder where cash could beat 4.75% today. Is there a time frame when the 20/80 portfolio would beat 4.75% rate? Sure you've got to earn much more because something will go to the taxman.

Well, we've decided to pay-off our 15-year mortgage that carries 4.75%. We'll do that in stages when some of our CD's expire. So, yes, for us it's very much emotional than financial (esp. DH will be happy about that ).
The reasons we will possibly do that:

1. 401k's and RothIRA's are maxed out;
2. No other debts;
3. We've been investing weekly/monthly in some funds/DRIP's in a taxable account for a few years;
4. We've got substantial savings and I don't know whether it's prudent to continue adding to them considering today's CD rates; We'd like to reduce the savings a bit.
5. Our itemized deductions exceed standard deduction by a small amount, so tax savings are less than $200 (maybe even less, I haven't done 2008 tax planning yet);
6. After paying the house off by April or May'09, we'll be able to replenish our savings again within 3.5-4 years (it could be 1-2 years sooner but we'll have one addn'l childcare expense by Feb'09) + add some more $$ to taxable investments.

All this scenario is based on that everything works fine in our lives. We'll execute our plan in stages because we'll have a baby in August and then hopefully grandparents from Germany will be able to come to babysit for a few months when my maternity leave is up. And also we'll be watching Fed's actions though I doubt they'll increase rates anytime soon.

If we don't pay off early, then our last regular mortgage payment would be late 2015, I think, because we did some prepayments the first two years we obtained the mortgage in 2003.
If we go with our plan, we'll have $20k+ in interest savings. Sure I've heard that inflation depreciates interest, but particularly for my DH it's great savings .

[jIM_Ohio]

Hmm... I wonder where cash could beat 4.75% today. Is there a time frame when the 20/80 portfolio would beat 4.75% rate? Sure you've got to earn much more because something will go to the taxman.

First- all other points you posted alknowledged. Right now cash beating 4.75% by itself would be tough. Maybe some long term CDs combined with other investments. Most people which pay off mortgage will not regret it- emotional decision for sure. But to respond as to how I would allocate money to beat 4.75% in todays market:

RPSIX is a 15-85 mutual fund which could beat 4.75% after taxes (7%, taxed at 25% is still 5.25%). This fund keeps money in cash (not all of it, but some)

PRPFX is a 30-5-16-16-16-16 mutual fund which has little tax distributions and has historically returned more than 7% per year as well before taxes. This fund also keeps some money in cash.

Both funds could have share prices swings >1% each day (not often, but does happen), so tread lightly if you do not like moderate short term risk. week over week and month over month these funds are SOLID.

[aida2003]

RPSIX is a 15-85 mutual fund which could beat 4.75% after taxes (7%, taxed at 25% is still 5.25%). This fund keeps money in cash (not all of it, but some)

PRPFX is a 30-5-16-16-16-16 mutual fund which has little tax distributions and has historically returned more than 7% per year as well before taxes. This fund also keeps some money in cash.

Both funds could have share prices swings >1% each day (not often, but does happen), so tread lightly if you do not like moderate short term risk. week over week and month over month these funds are SOLID.

At the first look, the 2nd fund looks better. Per M*, the first choise doesn't beat 4.75% (except the 5-year time frame) and has more tax exposure: T. Rowe Price Spectrum Income Report (RPSIX) | Tax Analysis

Sure, past results don't guarantee the future.
Overall, they seem to be good choices to explore and from a good fund family.

BTW, could you clarify for me "PRPFX is a 30-5-16-16-16-16" allocations because at a quick look I didn't see them on M*? Thanks

[jIM_Ohio]

At the first look, the 2nd fund looks better. Per M*, the first choise doesn't beat 4.75% (except the 5-year time frame) and has more tax exposure: T. Rowe Price Spectrum Income Report (RPSIX) | Tax Analysis

Sure, past results don't guarantee the future.
Overall, they seem to be good choices to explore and from a good fund family.

BTW, could you clarify for me "PRPFX is a 30-5-16-16-16-16" allocations because at a quick look I didn't see them on M*? Thanks

PRPFX-
25% of fund is gold
5% is silver
the other 70% is equally divided amongst:
natural resources/utility stocks
high growth stocks
US government bonds (I bonds or TIPs maybe??)
swiss francs

so it is 25-5-18-18-18-18. Had my math wrong before, oops.

RPSIX I look at 5 and 10 year returns (7.44% and 6.16%) when making the case for it.

[tripods68]

My compelling arguments to pay off our mortgage early I we could ($278K mortgage balance 27 year left). Not that I don't agree with you guys. I do.

1.) I would save over $200K in interest payment

2.) Saved extra $1600 a month towards adding to our ROTH contributions, EF, and adding more 529 contributions for our two children.

3.) Take longer vacation each time than our normal 2-3 weeks.

4.) Loss in job - We would worry less (knock on woods).

5.) Set early retirement date.

6.) Ease of mind and live a less stressful life.

No MMA return would compel me NOT to pay off our mortgage. In the meantime, we just have to plug away everyday. Maybe in 15 years we could.