Help a Reader: Is Pre-Paying a Mortgage a Good Way to "Invest"?

Here's an email I recently received from a reader:

My wife and I are saving for a house that we hope to purchase in the next 3-4 years.  We have been exploring possible "safe" investments but I can't seem to find anything that beats mortgage prepayments.  We have a 30yr fixed mortgage at 6%.   

On the plus side, we are getting a 6% return which is guaranteed.  However, on the negative side the investment is totally illiquid.  My thinking is that the investment (ie. mortgage prepayments) will become liquid when we sell our existing house and buy the new house and will therefore mitigate some of the negative aspects of our plan.  The money used to prepay is extra money that we don't need to access.  Am I missing something?  Is there a better alternative?

What advice would you give him?

Comments

[fivecentnickel.com]

I don't follow. They say they're *going to* buy a house in 3-4 years, but then go on to imply that they currently have a 30 yr mortgage @ 6%. Something doesn't add up.

Something to keep in mind when prepaying a mortgage... If you are intent on paying it off early, you could get a better rate by opting for a shorter mortgage. By taking a long mortgage and then paying fast, you gain flexibility (i.e., you don't have to overpay every month) but you pay for that in the form of a higher interest rate.

[Chris Brooks]

I think his reasoning is valid - it is a safe way to go as long as:
1) they aren't carrying around silly consumer debt (credit cards, auto loans, etc.) - extra money should go to that first
2) they have a decent emergency fund (around 6 months of living expenses). This should mitigate the concern about pre-payments becoming illiquid.
3) they are taking advantage of high-return retirement savings options first. For example, a matching 401(k) is probably a better first choice for those $ than pre-paying the mortgage.

[Meoip]

If you can pay towards the principle do that if not you may look into some other options.

The only downside is finding your dream home and losing it because your current home doesn't sell in time. I am wrestling with this question as well. The return on safer short term investments is definetly lower than prepaying your mortgage. While prepaying your mortgage gives a better return, the loss of freedom may not be worth the gains. HELOCs and bridge loans may be harder to get with tightening credit. That being said if your true goal is saving for the next home, prepaying will keep you from withdrawing money from your savings for impulse purchases if you have to sell your home or get a loan to get the $.

[FMF]

Nickel --

Yes, they currently have a house but will be buying a new/better/different one in a few years. Just wondering if they should put extra into their existing mortgage now or save the money somewhere else.

[AJ Cartwood]

Prepaying your mortgage is fine as long as you don't break the 20% rule

To access your equity, you can always take out a line of credit ... just make sure that it's for investments and not 'stuff'.

[Kevin]

My wife and I wrestled with the same question. In fact, as I read this I wondered if it was me that sent the email and forgot about it. Anyway, we ended up deciding to save the extra money rather than prepay the mortgage to have that extra liquidity.

However, I am rethinking the idea since we already have a nice emergency savings and the rate on the 2nd mortgage we were paying on is 8%. We really don't get the benefit of the mortgage interest either since we are so close to the standard deduction every year. Perhaps rather than paying extra every month, I will just send in big chunks as we save it.

[Tom]

I assume the couple is claiming the Federal mortgage interest deduction on their taxes. Doing so is akin to reducing your effective interest rate by about 2%. That is, deducting from your taxes the interest you pay on a 6% loan is roughly equivalent to NOT deducting the interest for a 4% loan.

Of course this varies depending on your tax bracket, etc. Just keep in mind paying off your mortgage will not really give you a 6% return, it will give you somewhere closer to a net 4% return, simply because your Federal taxes will go up.

So the question really is: Can you find another investment that will net you better than 4%?

[beastlike]

Funny Kevin, I was thinking the same about me, except that the rates are different!

My wife and I are in the exact same boat... However, the next home that we want is going to be new construction. Thus they usually want 20% down and if you have the cash available you can usually pay for upgrades which will therefore lower your property taxes in the future.....

If that's the case, make sure you have a 3-6 month emergency fund and enough savings for upgrades and the downpayment!

[JimmyDaGeek]

Assuming that you have created an emergency fund of 3-6 months of expenses and have maxed out saving money in your retirement accounts and are putting money aside for other savings goals, the real question is what to do with the rest of the money?

Pre-paying your mortgage is not considered "investing." Yes, you would "earn" the equivalent of your interest rate. BUT, because you own the asset - the house - which will appreciate regardless if you pay off the mortgage, you make no extra money putting extra money into your mortgage. The only reason to pay off a mortgage is for peace-of-mind.

It makes more long-term sense to invest the money. If you do that, you should make more money that will give you a greater option in the future to pay off the house, if that's what you want to do.

[beastlike]

Tom,

A savings account will get hit with 25% tax too or at least 15% capital gains tax… They also said that their itemized deductions (i.e. - the money they can deduct for mortgage interest) is close to the standard deduction so really, 6% is what they are losing!

[No Debt Plan]

I would prefer the liquidity, if they can afford it. As someone mentioned, even with a high return on a savings account you have to pay taxes. 6% up front (depending on their tax situation... standard vs. itemized) is a nice return, too.

[Kevin]

beastlike - I wasn't aware new construction required 20% down. I assume you could get around that with a 2nd mortgage? We are getting antsy in our little house now that we have a little one (and 2 big dogs in the way).

[Gary]

Check the following Consumer Guide site which states it is not a good idea to pre-pay.

http://www.consumerreports.org/cro/money/credit-loan/prepaying-your-mortgage-3-08/overview/prepay-mortgage-ov.htm

[beastlike]

Well, when we bought our first home (that was also new construction) we basically got them to come down from 10% to about 12k or about 5% and that meant we had absolutely NOTHING left in savings. At least we had a couple months to save up again.....

Then, a year ago we were going to buy a new home and they wanted 20% down... I think you can get them to go lower, but they want that just in case you back out. Ideally it would be nice not to put anything down as Gary mentions, but then the Builder would completely lose out if you backed out, so they will require something!!!!!!! NO question about it. If you can't come up with 10 - 20% of the home's value, then new construction isn't for you (unless your the contractor and take out that kind of loan).

[beastlike]

Kevin - I don't see why a HEL wouldn't work to use as the down payment and then just rolling your current mortgage and HEL into one home loan when you move in.... Just make sure you can sell your home in time for the new one.....

The first house we had no options to get 10% down since we didn't own a home at the time.....

[Kevin]

We'd definitely have at least 10%, but the remaining 10% or more we put down would most likely come from equity, which isn't exact until that house is sold. If we prepay the mortgage, it may be more skewed. A couple new home builders are running promotions here to move in for $1, so I'm guessing they are getting more flexible with the market the way it is.

[beastlike]

Wow! That's crazy... Yah, I guess they are willing to do anything to get some home sales! I don't think there doing that here in chicago yet.....

[Meg]

The problem with putting your downpayment "savings" into your current home is that in many cases home-buyers buy their new house BEFORE the old house sells, with a bridge loan. Then the bridge loan (usually interest only) is re-financed into a permanent mortgage when the original home sells (which can take months).

In order to get the best financing on that bridge loan, the bank would much rather see you have a big pot of cash than a low LTV on your current home (I'm a banker). Plus you'll get better rates if that bridge loan is only 80% or 90% of the new home's value (in fact most banks won't loan you more than that).

At least make sure you have PLENTY of money for closing costs and a downpayment before you start funnelling extra $$ into the mortgage.

The real benefit to pre-paying your mortgage comes over long periods of time. If you pay a bit more today, you lower interest payments a LOT over a decade or more. But if you know you're going to sell in a few years, it makes very little sense to pre-pay your mortgage. You actually won't be earning 6% on that money at all. You'll barely be earning any.

[Meg]

And BTW you most certainly have to have money to put down on your new construction. At my bank we will only lend 90% of the cost to build or 80% of the home's "as-complete" appraised value - whichever is lower.

We don't actually take the 10% mind you; we simply only will give you a loan amount for $900,000 if your home will cost $1,000,000 to build. Different banks will do it differently though.

[Chris Brooks]

There's some crazy advice happening here. e.g.,

"I don't see why a HEL wouldn't work to use as the down payment and then just rolling your current mortgage and HEL into one home loan when you move in"

So let's say I have $40,000 equity in my current home, and am buying a $200,000 home. So... I should take out a HELOC, borrowing the money against my current home, and use that to buy another home? That's insanity!

There's either two scenarios involved here:
1) I sell the house I have (with $40k equity), in which case I can easily use the equity as the down payment on the new home (minus expenses, but I'm rounding here)
2) I don't sell the house I have before buying the new one, in which case I'm risking all of the equity I have in the current home to buy a new one. And then hoping I sell the old house while I carry two mortgage payments. This is the sort of behavior that leads to the foreclosure crisis we are facing right now.

The other comment "get around that with a 2nd mortgage" is sending the same message - transfer all of the risk to the lenders, which is going to be harder and harder to do as the originators are (finally) starting to wisen up and revert to better underwriting practices.

Finally, the comment "to access your equity, you can always take out a line of credit ... just make sure that it's for investments and not 'stuff'" is just as uninformed. Borrow against the equity to invest your money is just another term for margin investing - risking an asset in the hopes that an investment will pay off. What if the investment tanks, you have an income crisis, and are unable to pay the HELOC?

People - save money from cash flow and use it for investments. Risk money you can afford to lose - not money that is leveraged off an asset that you need to survive, like your home.

[Zook]

Color me confused. They are looking to buy a house in 3-4 years and what to know if they should pay off the mortgage they don't have yet, early?

The trailer is in front of the truck here.

Save your tail off for the down payment of the home and set aside monies for closing and for furniture/fix-ups inside the new home and go from there. It is human nature to want to paint, add this or that to their new home. Prepare with 4-years out.

Make sure both of you are saving $10,000 a year into your Roth's and getting the company 401k match if possible.

If you save $10,000 a year into the Roth's and $10,000 a year into a home fund you will be ahead of the game in a big way, compared to the average Joe. It will be tough trying to "make money with your money" right now with money market and CD's hovering in the 3% range, but at the very least get that money making something. You may even want to buy a Vanguard Target mutual fund and let that grow for the 4-years.

It always depends, but in general, I recommend sending off one extra payment a year to your mortgage. If you have a $1000 mortgage payment, I would recommend sending off $1075 a month instead with the $75 earmarked to principal. Depending on your bank, you may want to write an extra check.

With rates in the 5-6% range I don't think one should focus on simply paying off the note. Save for retirement, both can be done at the same time. Take it one year at a time. The next year if you have been saving like crazy, you might have room for two extra payments.

You can't take out a loan for retirement.

[beastlike]

Chris Brooks -

Are you recommending that people sell their current home first, then live on the street for 5 to 8 months while they build your new home? Okay, I understand that people can rent an apartment or live w/ the parents, but, for example, what if you have a dog? Some apartments don't accept that and some parents may not let you dog live in their house? Maybe you can find a place to live but 3 hours away from work, that's not going to be fun for the next 6 months!!!!

Not only that, but moving all the stuff you accumulated in the first house twice isn't fun either!!!

If worst came to worst, you can always rent out your "old" home or sell it faster by dropping the price a bit......

[Matt]

Honestly, if it were me, I'd keep the money in a more liquid form, especially if I knew I was going to buy soon. (3-4 years out is "soon" in real estate.) Even if you're not comfortable with mutual funds, you can get 5%-ish rates from online savings accounts. That's a 1% interest differential for 3-4 years (if you wait the full 4 years, the difference between the two will be about $50 for every $1000 you save, and that's the total for 4 years, not annually), which frankly is not very much in the grand scheme of things. Plus, you run the risk of that equity being eaten away by further drops in the housing market. (Remember, home equity may be a safe long-term investment, but it's not necessarily safe in the short term.) And if you can't sell your old house immediately when you buy the new one, you could be in a serious bind.

Just because you don't need to access that money NOW (and good for you) doesn't mean that when it comes time to buy a new house, move, and sell your old house (and that's the order you're almost certainly going to have to do it in) you won't need to access the money at least for a while.

My advice?

1. Save the money somewhere liquid. Get as much interest as you can, but don't go crazy over it.
2. Buy a new house when you find the right one.
3. DON'T put the savings into down-payment equity for the new house, unless either you can't get the deal done otherwise, or you've already found a buyer for the old house. Instead, use it to provide you with a cushion for the period when you're making payments on two mortgages.
4. When you sell the old house, THEN put the sale proceeds and your remaining savings into equity on the new house. (Cash-out refinancing may be getting harder, but cash-in refinancing will remain easy to get for a very long time. Or if you don't want to do a cash-in refinance, just send a big check to the bank to apply towards the balance on your existing loan.)

It's not the maximum-return course of action, but it is the maximum-safety-with-decent-return-anyway option, and it sounds like that's the option you're actually looking for.

[Juley]

Even if you think you don't need liquidity, be conservative. In my case, I became disabled at 34 and can no longer work. We had just bought a house. Job loss and illness happen (not always at the same time). Forced early retirement is rampant. My brother was coerced into retirement at 59, way before he was financially ready to retire.

Market conditions can change. Lender climate is changing. Given the unknown, I like to sock it away at the maximum earnings possible. Don't pay off the house in full, you want the credit on your report when you apply for a loan for the new house.

My best advice, real estate, at least where I live, is the absolute best investment tax-wise and appreciation-wise. Save up that downpayment and buy ASAP, while it's a buyer's market. Find a foreclosure & fix it up. Rent out the house that's nearly paid off, hang on to that equity. You can always borrow against it later if need be.

Max out retirement as well, in a Roth not Traditional IRA. The write off isn't worth the tax you'll pay when you retire, unless you are very close to retiring.

Look at Vanguard Money Market Funds which are not taxable in your state and see if & see if that isn't worth a slightly lower dividend rate.

I'm happy to report my huband and I have prospered in spite of misfortune, by investing and spending very carefully. Don't waste a lot of money on fancy cars, though safety is important.