Mortgage Prepayment No-No’s
Mortgage Prepayment is always a hot topic! On TV, in Magazines and on the internet I am constantly being hit with the latest and greatest “debt free” Guru’s product or strategy that makes me cringe when they say “How to pay off all debt including your mortgage in 5 years”. It is an absolute that you will pay less interest on a 15 year loan vs. a 30 yr. There is absolutely the sense that owning something and not having a payment makes sense and feels good! Prepaying a loan is good just look at the interest savings! Being debt free is fantastic. Here’s why I cringe… They take a position as an advisor without giving you both sides of the facts. If you chose option 1 and saved $100 dollars you would be happy. If you later found out there was an option 2 that you could have saved you $300 but they didn’t tell you how do you now feel about option 1? What if it wasn’t $300 but $30,000! Let’s break it down and you decide which option is best for you.
Is all Debt the same? NO… You may have secured or unsecured debt. Unsecured debt is your word that you will pay. A secured debt will have collateral like a car, boat or your home. A car and a home loan may not be the same. Two questions you need to answer. Is the interest deductable? Does the secured item appreciate over time? The general answer for these questions would be “No” for a car and “Yes” for a home.
Is all debt Bad? NO… You need to understand your debt and understand if it is a good debt or a bad debt and how it impacts you personally! If you are unable to pay off your credit card in full each month that should be a warning sign that you may be developing bad debt. Your home will appreciate over time and you may also get a tax deduction.
Is Appreciation the same if I have a Mortgage? NO…The rate of appreciation may be the same but a financing creates leverages your return on investment.
HOUSE 1 is bought cash for $100,000 and appreciates at 2% per year for 5 yrs and now has a value of $110,408 or a 10.4% return on investment.
HOUSE 2 is bought for $100,000 with $20,000 down and the balanced financed. Appreciation is the same 2% but what changes is your return on investment. $10,408/$20,000= 52% return!! This is leverage.
Why should I have a mortgage on HOUSE 2? Bingo! This is the real question behind Mortgage Prepayment! If I have the cash why would I have a mortgage? Great question but let me ask, What was the LOI on your money? LOI stands for “Loss Of Interest”. Where did you get the money? You would need to pull from a 401K $142,857 minus 30% (10% penalty and 20% taxes) to net $100,000 to buy the home cash. Ouch! it may be wiser if possible to take a loan from your 401K to get minimum down and pay the loan back to yourself and use OPM for the rest. Unless it was cash in your closet you will not earn any future interest! $80,000 invested for 5 years with a 3% return would be $92,741. That’s a $12,741 LOI. At 5% it would be a $22,102 LOI. You need to determine if it is cheaper to borrow your money or cheaper to use the Lenders money. OPM- Other People’s Money. Think of home equity as a bank account. If you had $100,000 in a 30 yr CD at 2% would that be a good deal?
What about the mortgage payment on HOUSE 2? If you borrowed $80,000 and you are in the 20% tax bracket the net interest paid in 5 years would be $19,234. Remember the LOI if you invested at 5% would be $22,102 money. It would be cheaper to have a mortgage! Money you either put in as a down payment or a prepayment is like investing at the after tax rate of your mortgage!
What if I take a 15 Yr loan instead of a 30 yr to save interest? NO… Mortgages are simple interest. Take a look at the 1st payment of an $80,000 15yr vs. a 30yr loan.
15 Year Loan at 5%: $632.63 total with $333.33 interest and $299.30 principal.
30 Tear Loan at 5%: $429.45 total with $333.33 interest and $96.12 principal.
The interest is calculated on the unpaid principle balance times your interest rate divided by 12. The amortization calculates the amount of principle needed to pay the loan in a set term. On a fixed payment loan a prepayment will shorten the term forcing a re-amortization of the loan. The rate is the rate. A 15 year loan will have a lower start rate than a 30 year because the Lenders risk is reduced. A lower interest rate makes less sense to prepay. Nothing is absoulute and there seems to be exceptions to most financing rules which is my issue with gross generalizations. A 15 year might make sense because your credit score forces you into a higher risk group and the interest rate will be much higher on the 30 yr vs. a 15yr. This is more a factor regarding loan selection resulting from pricing overlays than prepayment and should be considered with a loan professional or accountant.
What other factors should I consider? How does the mortgage fit into your overall money picture? Ask yourself WHY? Here are some common answers:
- I want to own my home
- I don’t want to pay all that interest
- I don’t want a mortgage when I retire
- I want to have security
- I want to build equity so I can borrow it for children’s education
- I want to build equity so I can do a reverse mortgage
Savings are good. Investments are better! Prepaying a loan is saving and using Leverage, OPM and maximizing tax advantages will provide a better overall return by investing in yourself!
Would you choose a or b? You own a home with a value of $400,000.
- a. Home free and clear
- b. $300,000 invested at 5%, $100,000 mortgage at 6%
Let’s assume you are retired and the $300,000 is your 401K and the taxable interest income monthly of $1,250 is offset my your mortgage interest (P&I $599) and tax deduction vs Free and clear who live on SS income only because they wanted to prepay the mortgage and couldn’t afford to invest in the 401K and are now thinking about a Reverse mortgage because they can’t make ends meet. You decide.
By Bill Frantz