9-7-18: Should we pay extra on our mortgage?

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Question of the week:  Should we pay extra on our mortgage?

 

 Answer:  This is a question we answer every few years and it has come up a few times over the past few weeks with different clients as they consider paying extra on their mortgage every month or year to pay it off faster. It is natural to want to pay off debt, get rid of the monthly payment and quit paying a lender interest are the main two reasons.

 

But is paying off your mortgage early the best financial move for you? Here are several items to consider before you commit to paying off your mortgage ahead of schedule.

 

Are you maxing out your contributions to your retirement account? Most Americans are underfunded for their retirement, many of whom own homes. Instead of paying additional principal down on your mortgage I suggest putting it into your retirement account instead for several reasons. First, the money you put into retirement is usually deducted from your taxes (an exception can be if you contribute to a Roth IRA account), whereas the money you pay down on your mortgage is not. Most homeowners in California will have combined state and federal tax rates around 33% of adjusted gross income. If you contribute the $18,500 maximum to a 401(k) ($24,500 if over 50) that is a tax savings of about $6000, pay the same amount down on your mortgage and there is zero tax savings—in fact you will have negative tax savings because…

 

The government pays for part of your mortgage due to the mortgage deduction allowed on state and federal income taxes. You can deduct the amount you pay on your mortgage interest directly from your income for both federal and California state income taxes (there are limits, for married couple $1 million if mortgage used to purchase home was put in place prior to 12/16/17 or you were in contract to purchase home prior to that day; if your current mortgage was a refinance or put in place after 12/16/17 the new limit is interest up to a $850,000 balance). So if you have a $500,000 mortgage with an interest rate of 4% you can deduct $20,000 from your income, saving approximately $6500 in taxes. If you pay down $18,500 on your mortgage you lose approximately $250 in tax savings since your interest payments are lower. Paying down $18,500 on your mortgage instead of putting it into your 401(k) can cost you over $6000 in tax savings.

 

If you are maxing out your retirement contributions, how are you on saving for your children’s college education? As the parent of college freshman and a future college freshman, and someone who has looked at thousands of clients financial statements, I can attest that college expenses have far outpaced most families abilities to save for those expenses. Having gone on several college tours the last few years one common theme from the financial aid offices was that the general threshold for receiving direct aid (i.e. tuition reduction in form of grant from school) is income around $70-80,000, which is great if you live in some parts of the country but not too far above the median income in most parts of California. So unless your children have exceptional talents in some endeavor plan on needing quite a bit of money if you wish to contribute to your children’s college finances. Putting additional money into a 529 College Savings account or other savings instead of paying down your mortgage might be a better allocation of funds. By doing this you are essentially “borrowing” at whatever your mortgage rate is today for use in the future instead of potentially borrowing in the future at what may/probably will be a higher rate.

 

Speaking of your mortgage’s interest rate, is it lower than other debt you have? Credit card debt, auto loans, your own student loans? If you are maxing out your retirement contributions, you do not have to worry about future college expenses but have consumer debt it makes more sense to pay off that higher interest, non-tax deductible debt before paying off your mortgage. It not only makes more sense but it is very good math.

 

Are you planning on selling your home in the future, before the current term of your mortgage is completed and before your over-payment plan would pay off the mortgage? If so you should consider putting the additional funds into savings, investments, even cash. Your home is not worth more, or less, depending on your mortgage balance. Your home’s value is determined by location, size, condition, etc, not by the amount of debt secured by the home. Paying $40,000 down on your mortgage over say five years and then selling it with a $400,000 mortgage balance was a loss of opportunity for those funds to work for you with compound interest and/or dividend reinvestment. There is no compound equity or equity reinvestment in your personal residence, it will be worth what the market dictates when it comes time to sell. Yes, your net proceeds from the sale will be $40,000 more than if you have not paid down the mortgage. At a 4% return on the extra $666 per month you pay on the mortgage over five years would result in over $44,000, 10% more than your net proceeds gain from paying that money into the mortgage.

 

One final consideration, it costs money to get money back out of your home. If you have $100,000 equity and want to access some of it you will either need to refinance, obtain 2nd loan or HELOC, or sell the property, each of which has costs. What if you pay down your mortgage and need money in the future for home improvements, medical emergency or other unexpected life event?

 

All these are factors, and there are more, that you should consider before paying extra down on your mortgage. There are some factors that more strongly support paying off your mortgage early than other, primarily looking at your current income, your projected retirement date and your projected income during retirement. Or you have a property that is a rental with a low enough balance that you can use rental income to accelerate the payoff of the mortgage, again looking at some of the factors above, to have a free and clear investment that gives you more options in the future, such as selling and carrying a large mortgage to defer capital gains and continue to receive income.

 

As with most/all of our questions of the week, before we can answer the question we need answers to more questions—and this particularly the case this week. If you are considering accelerating the principal reduction on your mortgage, please do not hesitate to contact me to discuss your options.

 

Have a question? Ask me!

 

With the center of the news universe seemingly being in the Senate Judiciary Committee hearing room this week, you may need to look a few pages into your daily paper tomorrow to find the employment data released today, or any other news for that matter. The Labor Department announced today that 201,000 jobs were created in August, 204,000 in the private sector. The front-line unemployment rate remained at 3.9%. These pieces of data are positive, but not a big impact on rates as the news was in-line with expectations. What did have a strong impact on rates was the average hourly earnings data which showed an increase of 0.4% in August following the 0.3% gain in July. This puts the annual rate of pay increases at 2.9%, up from 2.7%, the highest rate of increase since June 2009, the month the recession ended. With the consumer price index measuring inflation at 2.9% the average American worker’s income is keeping pace with inflation. The wage data puts upward pressure on rates and more than reinforces future rate hikes from the Fed.

 

Rates for Friday September 7, 2018: After holding on last week following the strong GDP data, rates could not continue to hold following today’s labor market news. More workers getting more pay leads to more spending leads to higher prices which leads to higher interest rates. Today rates popped up on the labor news after remaining flat from Friday to Friday for the past three weeks. Not surprising, the surprise to me is they had not increased sooner. Lock your rate when you can as higher rates are lot more likely in the future.

 

FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS:

30 year conforming                                            4.50%             Up 0.125%

30 year high-balance conforming                      4.75%      Up 0.125%

 

Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.

 

With age comes experience and practicality. When our fifteen year old refrigerator decided to quit last Wednesday, Leslie and I looked at each other and said, “happy anniversary,” knowing a new fridge was going to be our 24th wedding anniversary present to each other. And sure enough this Tuesday, our anniversary date, a new one was delivered. Not to be completely unromantic I placed a bottle of nice vodka inside the present for her to enjoy. Somehow I don’t think I get away with a kitchen appliance and bottle of vodka for number twenty-five next year….

 

Have a great week,

 

Dennis

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