Should we pay extra on our mortgage?

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 recently from a few clients. The main reasons people say they want to pay down their mortgages are to get rid of the monthly payment, reduce the amount of interest they pay, and payoff the mortgage sooner.

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 those funds into your retirement account instead. Consider that 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 19,500 maximum to a 401(k) ($26,000 if over 50) that is a tax savings of about $6400, 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 (note depending on when you funded the loan your interest deduction may be capped on the interest up to a $750,000 balance). So, if you have a $500,000 mortgage with an interest rate of 3% you can deduct $15,000 from your income, saving approximately $5000 in taxes. If you pay down $15,000 on your mortgage you lose approximately $150 in tax savings since your interest payments are lower. Paying down $15,000 on your mortgage instead of putting it into your 401(k) can cost you over $5000 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 senior and a 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. 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. As well, with today’s very low mortgage rates, the rate to “borrow” by not paying down your mortgage will likely be lower than the return on the funds you are investing for future college costs over the long run.

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!

Retail sales are not leading economic growth. For the second time in three months retail sales dropped month over month, down 1.1% in July from June. While still up 16% from last July, the decline has many opinions coming forth as to why. Are consumers “spent out,” having gorged themselves at malls and Main Street shops when the local economies first opened back up? Did on-line retailers like Amazon, Walmart and Target create new buying habits that pulled even more shoppers out of stores and onto websites?

Pushing retail numbers down is the continuing stagnation of auto sales, or rather decline. Shortages in computer chips continue to slow production of new cars, pushing inventories down and prices up. Auto sales, which have already been sluggish, dropped 3.97% from June to July; removing auto sales from the overall retail sales data and the dip is .4% for the month instead of 1.1%.

What should concern retailers, besides the reduction in foot traffic and ringing registers, is that retail sales are calculated on dollars spent, not units moved. Those dollars spent are inflated around 4% from 2020, and up 0.5% from June. Sales dropped 0.4% while prices increased 0.5%.

Minutes released from the meeting of the Federal Reserve’s meeting in July show a shift in its view of inflation. Previously the Fed had maintained the stance that the spike in inflation is “transitional,” as the economy went from closed to open. The minutes show many feel that inflation will continue into 2022 due to shortages in labor and materials. It feels like the Fed is ready to announce in the near future a tapering of the Quantitative Easing policy to keep its rates near zero.

Rates for Friday August 20, 2021: The economic news is a bit choppy, higher prices, less consumption. The Fed seems poised to change course on rates. Uncertainty is typically not good for markets. This week we saw mortgages fairly flat, and conforming rates are flat Friday to Friday yet again. However, lenders are hedging a bit on high-balance rates and we see a bit of an uptick in those programs from last week.

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

30 year conforming                                         2.625%  Flat

30 year high-balance conforming                   2.875%  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.

As many of you know I grew up moving around. When we moved from Tulsa to outside Philadelphia, my first friend became my best friend for our time there (leaving for New York after a little over five years). Greg and I spent a lot of time together, and thankfully for me his dad had season tickets to the Eagles and I was able to go to a few games each season.

Greg still lives in the same area and yesterday he contacted me that he is in San Diego visiting his daughter. “Come down, let’s see the Phillies play!” was the message I received.

Two tickets on the third baseline for the Phillies and Padres at PetCo Park for tomorrow night will get us together in person for the first time since sometime in the late 1970’s. Go Phillies! Ring the Bell!

Have a great week,

Dennis

Past Weekly Rate & Market Updates can be found on my blog page at my website www.DennisCSmith.com/my-blog