Wednesday, March 20, 2013

Should You Pay Off Your Mortgage As Quickly As Possible?

 Paying Your Mortgage Off Faster May Be A Great Idea or A Horrible Idea

Los Angeles based Mortgage Broker, Bill Rayman of Mortgage Capital Partners, addresses a number of myths and misunderstandings about the mortgage business and in particular how it can affect you in refinancing and even whether or not you should consider refinancing. 

Myth #3: Should I pay off my Home Loan as Soon as Possible or Interest-Only Loans are Bad!

Myth number three is that it makes sense to pay off the home as quickly as possible.  A corollary of that myth is that interest-only loans are bad.  The fact is, it is not necessarily bad to pay off your home, and often it is simply not a good choice what so ever.  There are several components to this answer. 

Not All Debt Is Bad

The first is, not all debt is bad debt.  Considering that you might be borrowing potentially hundreds of thousands of dollars for ten, twenty or thirty years, and you can lock that interest rate in today at 4% or even lower.  Plus, the interest on that money is very likely tax deductible.  Therefore, if you are in a 25% tax bracket which is close to the national average, a 4% interest rate means your effectively borrowing at 3%.  Where else can you get debt like that?  Certainly not from your credit cards.

How Might You Use the Funds You Have Rather Than Paying Off Your Mortgage?

The second reason to consider not paying off your mortgage is this; think about the use of the funds.  Paying down the principle, which is to say increasing your equity in the house, feels like a good thing and I respect that a really good reason to do it something is merely that it feels good.

From a strict financial point of view, however, your house is an asset.  When you put money into any asset you want to see that the asset appreciates in value... that it grows.  It sounds somewhat counter intuitive until you realize no matter how much you put in to your house in terms of the equity, but whether you put down 100%, or you borrow 100%, the price of your home is established by the market.  Therefore, paying money into your mortgage is technically a zero rate of return.

With that in mind, the issue that comes up is the big one.   If you don't put it into your home by paying down principle, what else could you do with it?  Right now, the investments in the market are very poor.  CDs are paying on average 1.6% in the country, but that’s today.  Looking further down the road, we’ve been accustomed to five, six, seven, eight percent returns on investments.  So if you can borrow from the bank at three, four, or five percent, you can put it in stocks or even just very secure treasury bonds and end up with a positive result.   You are doing what a bank does,  borrowing low, and you’re investing high at a secure rate.

Another reason for holding on to your cash is this.  You might have been dutifully paying down your mortgage over the years.  Now you are sick and need cash, or have other reasons why the cash would be very helpful.  But for a variety of reasons you can no longer refinance. You are now in a situation where you don’t have cash in the bank, but have a ton of cash in your home's equity.  If the money that went into paying down the mortgage had gone into a savings account, it would now be readily available.

Think in Terms of Net Worth.  Paying Off the Mortgage Is Old School

The key words that you should be thinking about are net worth.  When you add up your home and all your other liquid assets, less your liabilities, that’s what your worth is.  So whether you own a $100,000 home of which you owe $90,000 and therefore you have a net worth of $10,000; or you have a $100,000 home of which you owe $100,000 but you have $10,000 in the bank, you still have a net worth of $10,000.  They are the same, except from my own recent personal experience, I couldn’t count the number of people that would have been better off having the cash outside the house. 

Home Equity Is A Tempting Asset If You Should Lose a Lawsuit

A third reason to consider not paying off your mortgage is to recognize that the more you own of your home, the greater your equity share.   Arguably the more visible that asset is to a potential creditor the more likely they are going to be looking to claim it.

There is a wonderful story from the 1930s, where Walt Disney owed Bank of America $7 million dollars that he had borrowed to finance Snow White.  He and his brother laughed, because they realized that the last thing Bank of America was going to do was foreclose on them.  In fact, the bank wound up giving them more money because they couldn’t afford to take the studio from them.  Luckily for both Disney and Bank of America, Snow White was a hit and they were able to pay the loan.

For you, it is similar.  Just imagine if you own a home that is completely paid off versus your neighbor who has the exact same home but owes the bank 90% of the money.  You both have some kind of financial problem.  I can’t promise you, but hypothetically I’ll promise you, if the bank has to choose who to go after, they’re coming after you because your house they could put on the market and sell and get their money back.  The person who owes the bank a lot of money, that house isn’t worth anything and they are more likely to keep the house. 

If You Want to Make Those Extra Payment, Here Are the Best Methods

If you decide that you have plenty of cash on hand to deal with emergencies, don't really want to use your cash to invest in other places, and want to feel good by paying the mortgage off faster, you have choices of how to do that. 

One is to make extra payments.  Some folk decide to pay an extra payment every quarter.  Or you can just add money to each payment.  You can also just send a check any time you feel like paying off some principle.

A second method employes a tool called a home accelerator loans that give you a lot of flexibility on how to do that.

An excellent method is to refinance to a loan that has a shorter term to it.  Now the shorter the term means your going to make a larger payment, but that payment is going to be largely equity.  The shorter-term loans and here I’m talking about a ten, fifteen, or twenty-year loan.  Not only will you pay it off quicker because the timing is shorter, but the interest rates on the shorter-term loans are generally anywhere from a quarter to three-quarters of a point less than a thirty year fixed.

Using a $500,000 mortgage at a 30-year fixed rate; over 30 years you will pay $466,000 in interest.  If instead you did a 15-year loan, the interest rate is a little bit lower.  At the end of 15 years you will have paid $176,000 in interest.  The difference is roughly a little short of $300,000 in interest.  Well if you figure the interest you don’t pay over 15 years you’re really saving legitimately, out of pocket, roughly $20,000 a year.  So if you can afford the higher payment and the goal is to pay down the house quickly, save yourself a lot of interest and do a shorter term loan.

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