March 19, 2010
When Not to Pay Down a Mortgage
By RON LIEBER

This week, the Federal Reserve reaffirmed its intention to stop buying mortgage-backed securities, signaling the likelihood that the mortgage rates you can get today are as good as they’re going to be for a long while. Once the Fed stops buying, after all, rates are likely to go up.

And current rates are quite good. At about 5 percent, in fact, they’re so good that they’ve helped change the age-old debate over whether homeowners should make extra mortgage payments to pay off their debt well before their loan periods are up.

Back when rates ran at 7 or 8 percent, making extra payments offered what amounted to a guaranteed return on your money. When you’re ridding yourself of debt that costs you much less, however, it’s easier to imagine a future when you could more easily earn a higher return by investing those potential extra mortgage payments someplace else.

Meanwhile, at a time when just about everyone knows someone who is unemployed or who owes more on a home loan than the house is worth, keeping extra cash someplace more liquid than a mortgage seems like a safer approach.

So is the case against extra payments closed for good, given that so many people have locked in rock-bottom mortgage rates for the long haul?

The answer depends on two things: how likely you are to leave the extra money in savings and how good it would feel to wipe your debt out years earlier than your mortgage requires.

THE BASICS First, let’s dispense with the standard boilerplate. Don’t even think about making extra mortgage payments unless you’ve paid off higher-interest debt. Credit card debt is the easiest win here.

Also, if you’re not saving enough to get the full match from your employer in a 401(k) or similar account, increase your savings there first. And don’t make extra mortgage payments if you don’t already have a decent emergency fund set aside.

YOUR REAL INTEREST RATE Now, take a look at the interest rate on your mortgage. That 5 percent? It’s not your real rate if you get some of the interest back each year in the form of a tax deduction.

Let’s say you have a household income of $175,000 and are paying 35 percent of that in total to the state and federal tax collectors. If you pay $20,000 in mortgage interest each year on a loan that charges 5 percent, the deduction effectively brings your taxable income down to $155,000.

As a result, you’re paying $7,500 (35 percent of $20,000) less in taxes than you would have without the deduction. So ultimately, you’re not really paying $20,000 in interest at all; your net cost is $12,500 after you subtract the $7,500 tax savings.

And that makes your effective, after-tax interest rate on your loan just 3.25 percent, which is simply 35 percent (your tax rate) less than the original 5 percent.

BETTER RETURNS? So any money you set aside in lieu of making extra mortgage payments would need to earn more than 3.25 percent annually. That seems like a reasonable possibility in the future.

In fact, you could have done that well during the supposedly lost decade we just finished. Vanguard Wellington, for instance, a popular low-cost mutual fund that holds about 65 percent stocks and 35 percent bonds and other short-term securities, earned an average annual return of 6.15 percent in the 10 years ended Dec. 31, 2009.

The Vanguard Balanced Index Fund would not have outperformed our 3.25 percent benchmark, however, as it only returned 2.64 percent over the same 10-year period.

STORING THE SAVINGS Wouldn’t taxes eat into the returns from the money you’d save instead of making extra mortgage payments? Not if you place it into an account shielded from taxes. A Roth individual retirement account would fit the bill here, as would a 529 college savings account or health savings account.

Bruce Primeau, whose note to his financial planning clients at Wide Financial Group in Minneapolis on this topic inspired me to re-examine it, adds that this isn’t simply about keeping more assets under his watch so he can earn a better living. “I’m not telling them that the money has to come to me,” he said. “A 401(k) match beats the return on paying a mortgage off automatically. There’s real estate and buying employer stock through a purchase plan at a 15 percent discount and all kinds of things.”

Then you need to preserve those savings. When extra money goes toward a mortgage, it’s hard to get at it when the urge strikes to flee to an Asian beach for a few weeks of playtime. If the money is not locked up in retirement or college savings, however, you may be tempted to spend it.

THE LIQUIDITY PROBLEM Capital-gains taxes might eventually come due with some of these investments, and the rate could well rise above the current 15 percent long-term rate before too long. Still, having some of your savings in a taxable account makes sense for several reasons.

If you hit a stretch of long-term unemployment after having plowed most of your extra cash into paying down your mortgage, your bank probably won’t pat you on the back for being a good saver and give the money back to you. Nor is it likely to let you borrow it through a home equity loan if you have no income with which to repay it.

Elaine Scoggins, who had the mortgage department chief reporting to her at a bank before she became a financial planner, suggests imagining a situation where you need to move quickly but can’t sell your home or extract equity to use as a down payment in your new town. Given that possibility, why create more home equity through extra mortgage payments than you have to?

“The whole housing debacle has reminded us all, including me, that real estate is not liquid,” said Ms. Scoggins, who is the client experience director for Merriman, a planning firm in Seattle. “And it takes cash to support it.”

Those who have used their cash in an attempt to be conscientious have learned some tough lessons, meanwhile. Imagine people who scraped together a 5 percent down payment and bought a home in Florida or Arizona in 2005 and then made extra mortgage payments the first two years to try to increase their equity. Now, post-collapse, they owe, say, 30 percent more than their homes are worth and need to seriously consider walking away from the loan — and all of those extra payments.

REASON AND EMOTION So the reasoned case for making no extra payments is very strong. But there’s one counterpoint that almost always carries the day, even when there’s only a mild risk with the financial strategy of putting extra money elsewhere.

And it’s this: I need to be able to sleep at night.

Even Mr. Primeau concedes here. “Emotionally, you’re right, and financially I’m right, and emotionally, you win,” he said. “If emotionally, people want to pay down their debt, then that’s what I help them to do.”

If you’ve just started paying down your mortgage, any extra payments should go toward principal (make sure your mortgage company is applying it properly). That will have the effect of shortening the term of your loan from, say, 30 to 25 years, depending on how many extra payments you make. The extra payments won’t lower your monthly payment, but they will reduce your balance.

Many people who are years into their mortgages — and perhaps paying less in interest and getting less of a tax break as a result — tend to develop stronger feelings about making extra payments. Those feelings are often even more acute as retirement approaches and homeowners become determined to quit work with no debt to their names.

Those who do retire their debt rarely regret it or wring their hands over the big gains they might have scored by investing the money elsewhere. Tim Maurer, a financial planner and co-author of “The Financial Crossroads,” describes the feeling that washes over people who have paid their last mortgage bill as “beholden to no one.”

So he doesn’t feel as if it’s his business to separate people from their emotions if they feel strongly about working toward a debt-free existence. “The whole point of planning is to make life better,” he said. “It’s not to have more dollars at the end of the day.”