Questions from readers about why and how to pay off a
mortgage early out-number those I receive on any other
topic, including loan origination. Borrowers typically spend
only a few weeks, at most a few months in acquiring a
mortgage, but they usually have the mortgage for many years.
During that period their financial circumstances may change,
the economy may change, or they may change, any of which may
stimulate an interest in accelerating the repayment of their
mortgage.
For this series of articles, I have divided the questions
into 4 groups: mortgage repayment as an investment, monthly
payment management, systematic extra payment plans, and
extra payment tricks and gadgets. This article considers
questions about repayment as an investment.
Q: Why do you view mortgage repayment as an investment?
A. Transactions in which you
pay out money now and receive a stream of income in the
future based on an agreed upon interest rate, are
investments. This is what happens when you buy a bond or a
CD, and it also describes what happens when you repay your
mortgage. The income received from a mortgage repayment is
cancellation of interest that you would have had to pay
otherwise. The difference between receiving $1,000 of
interest, and eliminating the payment of $1,000 of interest,
is one of form but not of substance.
Q: How do I determine that allocating extra funds for
mortgage repayment is my best use of excess funds?
A: Define and then assess the alternatives.
If you don't use your extra income to repay your mortgage,
how would you use it? If the answer is that you would invest
it, then you should compare the rate of return and the risk
of loss on mortgage repayment to that of the other
investments available to you. The rate of return on mortgage
repayment is the interest rate on the mortgage, and there is
zero risk of loss. In the markets of early 2016, it is very
difficult for most borrowers to find a better
investment.
Q: Would this apply to a high
tax-bracket borrower who deducts mortgage interest payments?
A: Yes, what matters is the after-tax yield on the mortgage
repayment relative to the after-t ax yield on taxable
investments, and the tax rate adjustment affects them
equally. For example, a borrower in the 33% tax bracket who
repays a 3% mortgage earns 2% after tax. If instead, the
borrower purchased a CD paying 1%, the after-tax return is
0.67%. If the before-tax rate on the repaid mortgage is
above the before-tax rate on the taxable investment, the
same will be the case after taxes.
Note
that if the alternative investment is tax-exempt, its
before-tax and after-tax returns will be the same. The more
complicated case is where the alternative investment is
taxable but the taxes are deferred. Those interested
are referred to
How Do Taxes Figure in the Loan
Repayment Decision?
Q: Isn’t it better to make extra
payments in the early years of a mortgage when the regular
payment goes largely to interest, than in later years when
most of it goes to principal?
A: No, the return on investment is not affected by where the
mortgage is in its life cycle. While the allocation of
scheduled payments between principal and interest changes
over the life of the mortgage, extra payments go entirely to
principal, no matter what stage of its life cycle the
mortgage is in.
Q: If I have two mortgages, which
do I pay down first?
A: In general,
pay down the mortgage carrying the higher rate, because that
results in the larger return on investment. However, if that
mortgage is fixed-rate while the lower rate mortgage is
adjustable rate, the decision must consider the possibility
that the rate on the adjustable will increase in the future.
For a discussion of this issue, see
Mortgage Prepayment When You Have
Two Mortgages. Note
that the decision process is quite different if the two
mortgages are on different properties.
Q: Is there any point in making
extra payments when you know you will be selling the house
in a few years to upgrade?
A: Yes, extra payments today mean a smaller
loan balance to pay off when you sell, which means that you
will net more at closing than you would have otherwise. The
larger proceeds from sale will make possible a larger down
payment on your next home, which will reduce all origination
costs that vary with the loan amount. These include mortgage
insurance, title insurance and origination fees.
Q: Should seniors close to
retirement pay off their mortgage?
A: It is a
prudent move if they have the assets to do it, because the
rate they are paying on their mortgage is higher than the
return they can earn on assets having a high degree of
safety. Paying off their mortgage also clears the way for a
reverse mortgage in the future, should the need for
additional income arise. If the senior’s payment burden
after retirement is heavy and the borrower has significant
equity in her primary
residence, it may makes sense to repay the mortgage balance
with a reverse mortgage, which eliminates the required
monthly payment.
