Does Paying Extra on our Mortgage Make Sense?

[PasadenaFinancialPlanner]

The question is: Should we put an extra $850 on our mortgage each month in an attempt to get our monthly payment down or could we be doing something smarter with that money? If you need any other details about our financial situation or goals, just ask. I didn't want to write a book if I didn't have to.

I noticed that the original question asked whether there was something smarter to do with the money. I offer the following simply because the investment opportunity cost has not gotten much attention.

Sometimes, people wonder whether the accelerated pay-off of mortgages and other debts would make sense. Whether to accelerate debt repayment depends upon: A) availability of sufficient cash flow or assets to make the added debt payments, B) the net after-tax debt interest rate percentage, C) expected investment return on the funds used to make accelerated debt payments, and D) personal risk aversion.

If a person is the average investor and holds the asset allocation of the average investor, that would be about 25% cash, 20% bonds, and 55% stocks. When you evaluate debt repayment trade-offs, you should use nominal rates of return that include inflation, since future debt payments are also made with nominal or inflationary dollars (rather than with real or constant purchasing power dollars). Over many decades, the compounded inflation rate has been very close to 3.0%. The compounded nominal dollar return with inflation for cash assets has been about 3.7%. (Makes the last few years of negative real dollar cash returns seem even more bizarre.) The nominal return for bonds has been about 5.7%, and the nominal return for stocks has been about 9.3%.

Since this person would have to reduce his/her financial assets to retire the mortgage debt more quickly, then the other side of the accelerated payoff analysis is the foregone expected rate of return on financial portfolio assets. Because the average investor would have the choice between paying of debt or investing those funds, it is necessary to figure out the weighted average expected investment return for comparison purposes.

For this average investor the expected nominal return of the portfolio would be (25% times 3.7% for cash) plus (20% times 5.7% for bonds) plus (55% times 9.3% for stocks), which equals 7.18%. Therefore, this investor would expect an average annual return for the portfolio of about 7.2%. Of course, there could be significant year-to-year fluctuations in what portfolio returns actually might turn out to be.

Compare this expected 7.2% portfolio return with the case for paying off some mortgage debt. First, you need to take into account the impact of taxes on this comparison. With mortgage debt, you may obtain an advantageous tax-shield on mortgage payments. This is especially true, when A) the payments are earlier in the overall repayment schedule and thus consist of more interest payment than principal repayment and B) the taxpayer is in a higher combined federal, state, and local income tax bracket. The calculations would be complex, but clearly the true interest cost would be noticeably lower than the nominal interest rate.

Because of "investment tax location optimization," these accelerated payment funds would more likely be held in taxable accounts as equities and would be subject to long-term capital gains tax rates, if the portfolio was passively managed. Since some long-term capital gains taxes can be avoided for years and then paid at lower capital gains taxes at the federal level, perhaps the expected after-tax return would sink modestly below the 7.2% expected outcome. Again, the after-tax computations are complex and depend upon multiple factors.

Nevertheless, the bottom line is that for an average investor, when he accelerated repayment of a mortgage debt, "earns" noticeably below the mortgage interest rate on an after-tax returns, but pays for it with a perhaps a 6.5% to 7% after-tax investment opportunity cost. In effect, when additional investment assets are diverted to make additional payments on low cost debt, then one loses the potential investment return on those assets. Unless an investor has a portfolio far more heavily weighted toward cash and bonds, then accelerated mortgage repayment is not preferable to investing the funds that would have gone toward accelerated debt repayments.

Of course, there is more risk or variability – both positive and negative – involved in holding more investment assets rather than paying down debt. While accelerated debt payments would have a lower overall expected financial value in the example just provided, they are not subject to the same future variability, as an investment portfolio. One dollar more of debt paid off is one dollar of debt not owed – without the future investment uncertainty.

[phantom]

the bank may not be able to just lower the rate if they sold the loan to some one else. they may only be servicing the loan and the new owner may not be willing to lower the rate. i suspect you would run into the same sort of thing with a recast. sometimes banks tel you they cant do something because they think you will be too lazy to refinance. if you show up with a refinance and ask them if they can beat it, then you will know if they can or not...

I didn't realize that it was possible for the bank to sell the loan without me noticing it. That's interesting. Like you say though, regardless of why they wouldn't drop our rate last we asked, if we can show them we really will go elsewhere, we will find out for sure what they really can do.

@MonkeyMama - I totally understand where you're coming from with regards to the 30 year mortgage option. In fact, when we first got our mortgage a little over 4 years ago, I convinced my husband to get a 30 year mortgage using similar logic. When he lost his job less than a year later, I felt we'd made the right decision. But, a lot can change in just 4 years. We now have a much healthier emergency fund, and our balance and interest rates have come down enough that we're talking about much lower monthly payments on a 15 year mortgage. So, I'd like to get a 15 year mortgage that we can easily manage and use our emergency fund to handle any risks. I know I went off on a bit of a tangent in my last post, but I don't think we need the flexibility of a 30 year mortgage, so I was trying to think of other uses for it.

@PasadenaFinancialPlanner - Thank you for the detailed analysis of investing verses paying off my mortgage early. I did ask if there were smarter things for me to do with my money, and I appreciate the analysis. However, since my goal is to prepare for the possibility of having less money to work with in a relatively short period of time, I fail to see how investing in a mix of stocks, bonds, and cash would help.

[Petunia 100]

I didn't realize that it was possible for the bank to sell the loan without me noticing it. That's interesting. Like you say though, regardless of why they wouldn't drop our rate last we asked, if we can show them we really will go elsewhere, we will find out for sure what they really can do.

Oh yes. If you have a Fannie or Freddie loan, that is exactly what happened. Your bank sold your mortgage, but they are still the servicer.

[Gailete]

I suggest you save the extra principal payments you might have made in a plain vanilla savings account. You don't know what interest rates will be a year from now, possibly they will be higher and a refi will be unappealing. Sometimes there are unexpected medical expenses with a new baby, and you may wish you had that cash on hand to pay them.

Once the baby has arrived, you can decide at that time if using your saved mortgage principal payments to do a refi makes sense. Or, you could use them to make regularly scheduled mortgage payments and take a longer maternity leave.

Having cash on hand gives you options.

Other than the possiblity of refinancing now, I too would suggest a plain vanilla savings plan. All sorts of expenses creep up when babies are born and with your income cut in half they will be harder to deal with. Even things you may not think about such as nursing the baby is a huge savings and you may count on that until you find for whatever reason you can't nurse a baby and they you get to play the pay for formula game. Last time I saw someone purchasing formula it was $25 a can! It isn't something you can stock up ahead because just the time you do, you end up with a colicy baby that needs a special formula. The list goes on. Cloth diapers or disposable? Cloth is by far the cheaper way to go but check out how much diapers are running these days. Will you clothes fit you again right away or will you need a new wardrobe (besides what you have to buy during the pregnancy--my second baby I managed to grow out of my maternity clothes he was so big!)? Anyhow you see how it goes. One of those expenses might be manageable, but when they all start adding up it is a lot harder. I would much rather have cash available in case of emergencies rather than have it tied up in your house where you can't access it.

Are you planning on living like you have only the one income right now. See how it works. Put ALL your take home into savings and see how living on hubby's income works out. You may find that a refi is an absolute necessity, and other things may need to cut so that you don't have to tap into your savings. I hate tapping my savings account so I try to keep next to nothing in checking so I have to get creative to avoid using anything from savings. But try working on living without that income and see how it goes and what you will have to do to make it work and best wishes!

[Petunia 100]

they can sell the servicing too.
it is important to be clear on these sorts of things or the decisions can be costly.

Yes, but then the payments would go to someone new. There is less chance that would escape your notice.