Pre-pay for today? The pros and cons of mortgage prepayment
Posted by Lise on 30 Oct 2008 at 12:00 pm | Tagged as: personal finance
Yesterday I talked about Money magazine’s retirement benchmarks, circa 2007. I explored the fact that I would need $72,000 at age 35 by these standards, or that I would need to be putting away $316 every paycheck for the next six years to reach that goal. I also hinted at why I’m not – because my husband and I are putting $500 a month towards our mortgage instead.
The Advantages of Prepaying a Mortgage
Recall that my house is financed in the “piggyback” route, with two mortgages. The second of those is the one we pre-pay. It is the smaller debt ($75,000), but it has the higher rate of 8.9%. We have currently paid off $15,000 of that debt in the first two years of ownership, for a current balance of ~$60,000.
Functionally, putting money into that is equivalent to investing in a product that pays 8.9% interest. Given the current financial state, this is a much higher rate than we would see anywhere else. We have been doing this since we bought the house, but it makes especially good sense right now.
There’s also the fact that the second mortgage balloons at 15 years (~13 years from now) – meaning that it will be need to paid in full at that time. This is another compelling reason to prepay. Admittedly, we could refinance at any point before then, but that’s just shuffling debt around. Paying $500 extra a month, we are on track to pay this off in less than 10 years.
Once the second mortgage is paid off, we will turn our attention to the first ($302,000). It has a fixed rate of 6.6%, but the payment amount increases at 10 years – at which point we will have paid off the second.
But the biggest advantage, to my mind, of prepaying the mortgage is decreasing the period of your life you spend paying for housing. If retirement is as difficult as it seems, then the freedom of owning one’s house outright is immense. With both mortgages paid off, that frees up ~$3,200/month for us – about half of our current income. Yes, there will be maintenance; and we would still have to pay for oil and electricity, but that is manageable on a more limited income. This would give us the freedom to be more mobile. I could, for example, spend three months of the year working at my mother’s tax business, pulling down about $20,000, and then go spend six weeks in Argentina learning intensive Spanish (one of my many dreams!).
This lifestyle would lend itself easily to mini-retirements, rather than the typically depicted Orlando-dwelling, shuffleboard-playing Retirement with a capital “R.” I could live with that!
I just need to stop telling myself this would be even more feasible if I had never bought a house to begin with… that train has sailed, to quote the immortal Austin Powers, and I’m not about to sell my house at a loss.
The Disadvantages of Prepaying a Mortgage
Well, really, there’s one big one: If we suddenly weren’t able to make our monthly payments, all the money we prepaid wouldn’t make much of a difference. The primary way this would happen would be a job loss.
This is why it’s so key to build oneself a safety net: an emergency fund and appropriate insurance coverage.
This is still something I’m working on. I’m building an emergency fund, but I worry I’m not building it fast enough. The figure to aim for is three to six months living expenses, which for us is $15,000-$30,000, on the generous side – but more like $8,000-$15,000 if we just want to cover the mortgage.
… I currently have $1,600 in there. I contribute about $150 a month, but it seems like every time it gets to a decent value, we have an emergency. Oh, only little disasters – car repairs, or vet bills – but it does continually deplete the fund.
As for insurance, I tend to hold the minimum coverage in just about everything. I have only liability insurance on the Tercel (admittedly, it’s almost 15 years old). I have what life insurance comes free at work (which won’t help a lot if I leave my job). Matt and I have the health policy that’s available to him at his job. We have whatever homeowner’s insurance is required by law. It may be time to reexamine this particular way of doing things, for maximum emergency preparedness.
In conclusion: we’re choosing to pay down our mortgage rather than contribute more to our retirement. I believe it’s the best choice for us right now, but I need to construct a better safety net for the “somedays” as well as the now.
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A few random comments, if I may.
First, why is your 300k loan going to increase its payment size in ten years? 300k at 6.6% works out to be right about a $2k/month payment, which I think is what you are doing. Did you get some sort of 10/20 loan where the interest rate jumps up after 10 years? If that’s the case, you might consider trying to refinance once the credit markets calm down a little; a 6.6% rate isn’t that great, and if it is going to increase later, you can almost certainly do better.
I’m not sure that paying off your mortgage early is exactly the same as an 8.9% investment due to how the taxes work out, assuming you are itemizing your deductions. And I think that generally speaking, people say it is better to invest your money and hope for better returns than to pay down your mortgage quickly. That said, I’m putting extra against my mortgage as well, and for you, it certainly seems like the right choice.
I think you are overestimating the effect that paying off your house will have, however. Since the home loan is a debt with fixed size payments, inflation works in your favor here, which in return reduces the effective savings in paying it off.
In other words, if you pay $3200 every month, using the extra to first pay off the 75k loan, you’d pay that off in 8 years. If you then continued to pay $3200 every month, putting all of it against the other loan (which would then have $270k left), it would take you about 10 more years. If we assume that during that 18 years, inflation averaged 2.5%, then that $3200 extra you’ll have each month 18 years from now is only about $2000 in today’s dollars. Which is still nice, but…
If you are not stockpiling money for house upkeep, then building up your emergency fund as quickly as possible certainly sounds like a good idea. I’ve read (somewhere, but can’t find the reference) that as a rule of thumb, you can expect to pay an average 1% of the cost of your house per year to maintain it. Problem is, those costs tends to be very random and bursty. My limited home ownership has shown that to be true so far, paying almost nothing for several years, then getting hit with $5k to replace a furnace and two emergency plumbing bills of over $2k in total just a few months apart. Minimal data points, obviously, so your mileage may vary.
Good luck.
Thanks for commenting, MathMatters. I have been moderating so much spam lately that it’s a relief to see a real comment! Here’s hoping I can answer your questions.
First, why is your 300k loan going to increase its payment size in ten years?
It’s interest-only for the first ten years. According to the mortgage document, the payment amount adjusts (by a set amount) but the interest rate does not. Yes, refinancing before then would be ideal, once the credit markets look less sea-sick.
I’m not sure that paying off your mortgage early is exactly the same as an 8.9% investment due to how the taxes work out, assuming you are itemizing your deductions.
We do itemize, and we get a large refund every year (which is hard to eradicate entirely because on the state level it doesn’t provide as hefty a deduction). I tend to think people overestimate the amount the deduction saves them, however, but I don’t have the numbers to prove that off hand.
Since the home loan is a debt with fixed size payments, inflation works in your favor here, which in return reduces the effective savings in paying it off…
That’s a good point about inflation, and I thank you for taking the time to do the math. I guess that’s the good thing about being heavily leveraged; if a loaf of bread starts costing $100, suddenly my debt doesn’t seem so bad!
One number that keeps me motivated to pay off early is the fact that over the course of the loan (if allowed to run the whole 30 years), the house will cost me $700k (not including maintenance!). Of course, with inflation calculated in, that may mean a lot less…
With the gas prices going down, I have “hedged” an extra $40 a month that I’m not spending on gas into my emergency fund, just to build that up quicker. I would be happy having at least three months’ mortgage payments in there.
How puzzling. 300k @6.6% (well, I’m assuming 6.625%), interest only, should be about $1670/month, and your evil second loan is $600 a month, which is well short of $2666. I read over your earlier posts where you listed out your monthly finances (you are braver than I in that regard, although it was what drove me to comment, as it is always interesting seeing others financial details). It is possible that those posts were not accurate… oh! Escrow! Does the $2666 minimum include escrow payments? That would be about $380 per month in escrow. That could be about right for an escrow — property taxes and insurance vary to much for me to make a guess.
You know you can get rid of your escrow once you get a decent loan to value, right? I find them offensive… the mortgage company assuming that I can’t manage to pay my own taxes and insurance without their help is mildly infuriating.
Anyway, let’s see… if I am understanding things correctly now, then really, paying down that second loan as fast as possible is really your only possible move, right? If you hit the ten year mark, your monthly payments will jump by just over $600/month, which will severely crimp your ability to pay off the 15 year loan before it ballons. That would be a really nasty trap if you were not on top of it the way you obviously are.
In regards to tax deductions, I am very much not an expert on the subject, and I can’t speak for what people in general think. But I’ve always thought is is fairly straightforward. Your marginal tax rate is 25%, so if you pay $XX in interest, you thus save that 25% tax on an equivalent $XX of income. I think it gets more complicated if you earn a lot of money (it starts to phase out or something) but up until then, it effectively lowers the interest rate you are paying on your loan to 3/4 of the actual rate. At least, that is how I think of it.
In regards to refunds, if haven’t stumbled over it before, take a look on the irs.gov site — they have a withholding calculator that I have found to be VERY accurate. Each year, about 3/4 of the way through the year, I punch everything into the calculator and modify my withholdings so that I end up owing about $1000 in taxes each April. It has worked out exactly, every time. Much better than giving the government an interest free loan, I figure.
And yes, I think the $700k number is somewhat misleading — I’d consider it a scare tactic, almost, except it doesn’t ever seem to scare people. That said, I think it is more than $700k… The $300k loan costs you $200k (first 10 years) plus $240k (last 20 years). So $740k total right there. The $75k loan costs about $60k in interest, so about $875k in all. Still, once you knock $100k off due to taxes, and another 30% or so due to averaged net inflation, and figure it is over the course of 30 years, it… well, it’s still too big a number to really be meaningful, isn’t it? Gotta love houses…
Yes, that does include escrow as well. It’s possible we can switch out of having that; I’m not sure on the details. Definitely something to check up on.
The problem with the tax witholding is that my company withholds state and federal tax the same based off a single W-4, but if I cut back on my withholding such that I don’t have a federal refund, I’ll end up owing money on the state side. It’s frustrating, to say the least.
[...] the average U.S. savings rate is below 1%, my personal rate is only around 7% (higher if you count pre-paying the mortgage). If you believe David Bach’s Automatic Millionaire books, one needs about a 10% savings rate [...]