First in a series
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 four 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: A transaction in which you pay out money now and receive a stream of income in the future based on an agreed upon interest rate, is an investment. 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-tax yield on taxable investments, and the tax rate adjustment affects them equally. For example, a borrower in the 33 percent tax bracket who repays a 3 percent mortgage earns 2 percent after tax. If instead, the borrower purchased a CD paying 1 percent, the after-tax return is 0.67 percent. 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
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.
—The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.