Coffee heat rising

Should you pay off your mortgage?

Preparing to write the next installment in a series on achieving financial freedom, I ran some figures to compare the result of paying down a mortgage with extra monthly payments toward principal with investing the same amount monthly in a mutual fund. What I discovered runs against my theory that you’re well served to pay off a mortgage as fast as you can.

I still think that’s true if you’re getting close to retirement. In retirement, every debt should be wiped off your books, because you will need all your cash flow to live on. However, if you’re younger—say, anywhere between 20 and 45—and your mortgage rate is low compared to returns on equity investments, it would be to your advantage to invest extra dollars in a mutual fund earning around 8 percent. At today’s rates, this strategy allow you to accrue enough to pay off the principal faster than will throwing a monthly amount at the loan principal. Here’s how this shakes down:

M’hijito and I have a 30/15 mortgage at 4.3 percent. This means that for the first 15 years, we make payments at the 30-year amortization rate, but after the 15 years have passed, we either have to pay off the loan or we have to refinance it. The loan’s principal is $211,000.

We chose this mortgage because, at the time we bought the house, we believed the real estate market was nearing the bottom. We believed the house would drop in value another $4,000 or $5,000 and then begin to rise, probably at around 3 percent p/a. We figured that in five to ten years we could sell or rent the house and either break even or make a small profit. As everyone now knows, this was dead wrong: in fact, real estate was in free-fall, and the house is now worth at best $170,000, but more realistically around $150,000. This turns the loan into a real albatross. One strategy we are considering is to try to pay down principal with whatever extra monthly payment we can make (which ain’t much!), so that in 15 years, the amount to refinance might at least be no more than the house is actually worth, possibly allowing us to sell the house at that time.

In 15 years, with no extra payment toward principal, the loan balance will be $138,338. Monthly principal and interest payments are $1044; PITI comes to something over $1200.

Note that the projected loan balance is less than the most pessimistic present-day valuation. If the market finally has bottomed out and housing increases in value at 3% a year (a figure that is now being bandied about), in 15 years the house will be worth $233,695. That is less than we paid for it, but at least if we sold the house at that time we would walk away with a little cash in our pockets.

With me out of work, about the most we can afford to pay extra toward loan principal is about $100 a month.

Using Excel’s full value (=FV…) formula, I calculated the the return on a $100/month investment in a mutual fund earning 8% per annum. (Over at Vanguard, a number of stock funds and even a few bond funds are returning at this rate; one of them is Windsor II, in which I happen to already have a little cash.) I then used Quicken to run an amortization schedule, and compared the amount a $100/month investment would be worth in 15 years with the amount an extra $100/month principal payment would reduce the loan balance.

Assuming that our mutual fund investment averaged an 8 percent return, if we sent Vanguard $100 a month, in 15 years we would accrue $34,604 (full value =(.08/12,15*12,-100). If we paid an extra $100 a month toward the loan principal, in 15 years we would have paid the balance down by an extra $18,000 ($100 x 180 pay periods). According to Quicken, we would still owe $113,116.

With no extra payments, remember, we would still owe $138,338.

$138,338 – 113,116 = $25,220

Compare that with the $34,604 we would have earned in the mutual fund. Clearly, we would be ahead—by over $9,000!—by investing the money in a mutual fund with low overhead, such as Vanguard and Fidelity offer.

Well, now. Suppose you were not out of work, and so had plenty of cash to throw at the principal. Let’s suppose you really have plenty of cash and you decide to pay the equivalent of an entire P&I payment toward principal. Then what?

If you put $1,044 into a mutual fund every month, in 15 years you would have $361,264. If you paid $1044/month toward principal (in addition to your regular payment) on a $211,000 loan, you would pay off the loan in 10 years.

But by putting the cash into a mutual fund returning 8 percent, in 10 years you’d earn $190,995. Since in 10 years, with no extra payments, your loan balance would have dropped to $167,901, you’d still come out ahead:

$190,995 – $167,901 = $23,094

In other words, if you put the amount of an extra loan payment in an 8% investment, in ten years you would have enough to pay off the mortgage and still leave $23,000 in your pocket. If you used the same amount to pay toward the loan once a month, you would pay off the debt but would have no cash left over.

The conclusion is obvious: If your goal is to pay off your mortgage, you’re better off investing a regular payment in a decent mutual fund than paying the same amount toward principal.

This assumes your mortgage interest rate is lower than the rate of return from an equity fund. Note also that my figures do not take into consideration the small tax advantage gained by paying mortgage interest; this factor also would tend to improve the picture if you invested in the market.

Risky? Sure. But we now know that investing in real estate is wildly risky, too: more so, it develops, than the stock  market. My stock investments are rapidly regaining their pre-crash value, but there’s no credible sign of any recovery in the real estate market here. Even if the value of the house starts to increase at 3% p.a. today, in 15 years it won’t be worth anything like what we paid for it. If property values remain flat for any length of time (as it appears they will), we will lose not only our shirt but our pants, socks, and underwear.

I used to think my father was crazy because he refused to buy a  house until after he had saved enough to pay for it in cash. All the time I was growing up, we lived either in company housing or in rentals. His reasoning indeed was crazy—he bought into The Protocols of Zion, an irrational tract that led him to believe all mortgage lenders were part of a hallucinatory international Jewish conspiracy. However, the effect was that when he retired at the age of 53, he had enough cash to buy a house and a car and to support himself and my mother in a middle-class lifestyle without having to work.

Crazy like a fox, that old boy was.

A rabid fox, but still…

Mortgage loan modification strategy

Just sent off a wad of paper to the loan officers at the credit union. My favorite spy there tells me that because I’ve been laid off my job, we have a shot at getting our mortgage payments reduced, at least for a while.

I’ve asked to have the principal cut, since the so-called “investment” house is now worth about $50,000 or $60,000 less than we owe on it. What a flicking fiasco!

What We’re Hoping For

Of course, they’re not going to do that. The credit union’s loan officer says they have been cutting the interest rate by reamortizing the loan over 40 years. This is a temporary arrangement, lasting at most two years. After the period is over, the customer may be given an opportunity to refinance, or simply to allow the rate to revert to what it was, with no detriment to credit rating.

Because the credit union has never been involved in federal loan programs, this is a private loan modification, not part of a government stimulus plan.

Rates are at 5.09 percent today, and so, since our rate is already down to 5.3 percent, I’m afraid this wouldn’t make much difference for us. However, if the loan were reamortized over 40 years, then our mortgage payment would drop by $141 a month for the next year or two. That would help a little. Not much, but some.

I’ve also asked them to change the terms from 30/15 to a straight traditional 30-year mortgage without zinging us for refinance costs. In a 30/15 mortgage, your payments are based on amortization over 30 years, but the payment comes due in 15 years. If you haven’t sold the house by then, you have to refinance. Because we thought we would own the house for five or at most ten years, this looked like a pretty good deal at the time.

Now, though, it’s beginning to appear that the house will not regain in its value in the 12 or 13 years remaining to run on the 15-year part of the present mortgage. And if history repeats itself, in another decade you can be sure that interest rates will be through the roof. Even if we  have paid down the principal some, we could end up with payments that are no less than what we’re paying now, which is WAY too much.

If the property value has not risen significantly after the initial 15 years ends, we’ll have to bring cash to the table to keep from losing the house, since we will not be able to refinance it at that time unless we add a chunk of money to the equity. And because I will never get another full-time job at my age, we will simply not have the cash to do that. Effectively, we will have been paying rent on that house at a rate far above the going rental rate in that neighborhood.

Nightmarish

M’hijito is feeling trapped. He’d thought we would be in a position to sell in five years, given that the market seemed to be at or near its lowest point at the time we bought. Because we failed to recognize that real estate was in free fall, we completely misjudged the actual value of the house, and now, along with 25 percent of the other mortgage payers in this state, we are nailed into an investment that is worth nothing like what we bargained for. Because you don’t realize a loss until you sell, we’re hanging on and hoping values will turn around. But realistically: it’s going to take a long, long time to break even on that place, and we certainly will never make a profit.

Meanwhile, he would like to go to graduate school (can’t, as long as he has to make that mortgage payment) and he would like to go back to San Francisco (can’t, as long as we have an albatross tied around our necks). Because we can’t rent the house for what we’re paying on it, our options are very limited.

What Else Can We Do?

There’s really only one option if he wants or needs to leave: I sell my house, use the proceeds to pay off the mortgage on that house, and move in there.

It’s a pretty little house, and the truth is, it’s a better size for me. It has no pool, so that would be one fewer cost and lots less work. It’s more centrally located—within walking distance (sort of) of the light rail line and my favorite upscale grocer (where I no longer can afford to shop…).

On the other hand, the summer utility bills are much higher than mine, and the neighborhood is not the best. Although my neighborhood also has some dangerous slums nearby, it at least doesn’t have a Walmart around the corner jacking up the crime rates, and I do have a very pleasant park less than two blocks from the front door.

Really, in terms of living conditions it probably would be a toss-up. I certainly could stand to live there. If that’s what we have to do to make it possible for him to get on to the next stage of his life, the world won’t end.