A lot of people think that mortgages are bad and that you should use them sparingly, putting down as much cash as possible or taking every opportunity to pay off your mortgage early. The idea of owing that much money and having to make a payment every month makes them really nervous. My parents were in that camp. They didn’t buy bigger houses until they could pay cash for them – and they scrimped and saved every penny in order to make that possible.
At some level it sort of makes sense – the smaller your mortgage either the sooner you won’t have to pay anything or the smaller your monthly payment will be. But it turns out that that logic is really too simplistic. What it really comes down to is whether or not you have a better use for that money.
[Before I go any further let me stop for a second and cover my ass. I am not giving financial advice. I am merely pointing out some of the considerations in deciding if you should pay off your mortgage early or make a huge down payment. Before making a decision regarding paying off a mortgae early you should seek the advice of a qualified financial adviser.]
About a month ago Sharon Epperson, one of the CNBC correspondents, put together a nice video and article on Why You Shouldn’t Pay Off Your Mortgage Before You Retire. Her basic thesis is that you should first look at better alternate uses of your money before trying to put more money towards reducing your mortgage – which is what I said above. At the top of the list is paying down high interest credit card debt, maxing out your retirement savings, and building your emergency fund.
In analyzing your alternate uses of cash consider the true cost of your mortgage. It’s not your monthly payment. A big chunk of that goes towards paying down principal. It’s not a cost but rather forced savings – and it comes from the same pocket that you would have used to pay down your mortgage early. The balance of your mortgage payment, the interest component, is your pretax cost but then you get a tax deduction on that, which further reduces your cost. If your interest rate is 4% and your marginal tax bracket is 25% then you are really paying only 3% to borrow that money on an after tax basis. When you pay down your mortgage early you are basically investing at a 3% after tax rate – but it is a very conservative investment. It’s not like your mortgage balance is going to fluctuate with the market.
Now contrast that 3% after tax rate with the interest rate on your credit cards (not tax deductible) or what you can earn tax free in a retirement account or even what you can earn on an investment in stocks, considering the tax favored treatment of capital gains and dividends. It quickly becomes clear that excess funds may be better deployed towards those other uses. In the case of investing in stocks it depends upon your risk profile.
In principle, I personally want the biggest mortgage I can get without kicking the rate up. But when we bought our house I had run out of investment ideas in a low interest rate environment so putting a little additional cash towards the down payment made sense. But I still took out a fairly large mortgage and with a 30 year amortization schedule.
There is a supplementary video (below) that goes with that CNBC article (not the video in the article) that was rather interesting in that two of their other correspondents fessed up to having 15 year mortgages. Presumably these guys are pretty sophisticated so I was a bit surprised by this, though one of them indicated he had other personal considerations.
What is even more surprising though is Diana Olick’s comment at around 1:48 where she says something to the effect that people want smaller mortgages now because they are afraid home prices will fall?!?!?!?!? Uh…what exactly does that mean? It sounds like she’s saying that if home prices go down you are better off having made a large down payment. Nonsense.
Having a smaller down payment will not impact how much money you lose if your home goes down in value. You always lose dollar for dollar – except if you have a small down payment you may be able to limit your losses to that small down payment if you let the bank foreclose or you do a short sale.
I suspect that she is falling victim to a common source of confusion – that being underwater on your mortgage makes the loss on your house worse. Yeah, you might have to bring cash to closing but losing 25% of your home’s value with 30% down is economically equivalent to losing 25% with 20% down.
#Mortgage #RealEstate #MortgagePayoff
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