Fiscally Fit Terry Cullen

Wall Street Journal Online - April 10 03
from The Wall Street Journal.

April 9, 2003

Some homeowners are wondering whether savings in CDs and money market accounts might be better used to reduce or eliminate mortgage payments. But there are downsides to paying down, or paying off, your mortgage.


 Debating the Pros and Cons Of Paying Off Your Mortgage

With four years of calculus under his belt, electrical engineer John Roberts figured he'd easily be able to compute the financial benefits and drawbacks to paying down his mortgage. He figured wrong.

"I'm stumped," Mr. Roberts says. The Lexington, Ky., homeowner and his wife want to refinance and use a large chunk of their roughly $80,000 in savings to pay down their mortgage and lock in the benefit of not having to pay 7% interest on their remaining $110,000 loan. But his financial planner argues that it's better to use the cash to put the money in long-term investments like stocks or bonds.

With the stock market still struggling to find its footing, and interest rates hovering near 50-year lows (and quite possibly headed lower) investors looking to make their money work harder have been pouring it into what has been the one sure bet: real estate. Now some homeowners, like Mr. Roberts, are wondering whether savings stagnating in CDs and money market accounts might be better employed by paying down -- or paying off -- their mortgages.

By paying down your mortgage, you lower the amount of principal you have outstanding on your loan, which in turn sharply reduces the amount of interest you'll pay over time. And if you're able to pay off the mortgage in full, you'll eliminate what for most Americans is their largest single expense.

But the decision isn't the no-brainer it appears to be. There are drawbacks to offloading that monthly nut.

Real Estate Debt vs. Other Investments

It's hard to be bullish about the outlook for the stock market after three years of enduring a bruising bear, but history shows downtrodden stock indexes invariably bounce back and march higher.

By locking up your savings in your home, you may miss out on future stock-market gains, says Michael S. Rubin, director of client tax services at Bessemer Trust Co. in New York. "In the current environment it's unwise to be paying down mortgages at these historically low rates," he says.

 The rate on a 30-year fixed mortgage rate is now about 6%, but for a taxpayer in the 28% federal tax bracket and a 7% state tax rate, that rate is just 3.95% when you count the tax deduction you receive for homeownership, Mr. Rubin says. (If you choose to take the standard deduction, rather than itemize, your home provides no after-tax benefit.)

 At rates this low, with no sign of a near-term uptick, it makes more sense for homeowners to invest long-term savings in stocks or bonds. Despite the recent three-year slump, the Standard & Poor's 500-stock index historically has returned an average of 10.2%, and the five-to-10 year Treasury note has returned an annual 5.4%, according to Ibbotson Associates in Chicago. Even after your mortgage payment, you'd still come out ahead with those returns.

To be sure, thanks to recent tax reforms, many homeowners will be able to avoid paying taxes on their homes when they finally decide to sell, whereas stocks and bonds are subject to capital-gains taxes. But investors can minimize the impact of capital gains taxes with tax-efficient bond and stock funds.

Bottom line, if your investment horizon stretches more than, say, 10 years, reconsider paying off your mortgage and look into more aggressive investments for your long-term savings.

Home Appreciation

Sure, home prices have appreciated significantly over the last few years. Home values rose an average 6.2% in the year ended Sept. 30, 2002, up sharply from the annual average of 4.6% since 1980, according to the Office of Federal Housing Enterprise Oversight ( in Washington, D.C. Since 2000, home prices have risen 15.4% on average, with regions such as New York, San Diego and Washington D.C. seeing home prices rise 75% or more.

 But contrary to some perceptions, appreciation should not affect your decision to pay off your mortgage.

 Too often people think paying down their mortgage now makes their home more valuable later, says Stephen A. Taylor, a financial planner with MassMutual Financial Group in Coral Gables, Fla. "Whether you pay down a mortgage or not, it does not affect the fair market value of your house," he says. "If you overpaid for your house, when you go to sell -- even if you've paid down your mortgage -- you may walk away with little or no money at the closing."

 Homeowners who anticipate selling their homes in a few years also should look to other investments, rather than prepaying their mortgages, since the real benefit of prepayment is the substantial interest savings overtime. By prepaying now only to sell a few years down the road, you're crimping your monthly cash flow while gaining very little in interest savings.

 That said, there is one instance where paying off your mortgage early can provide a substantial financial boost: when you retire. Often homeowners will downsize to cheaper homes, or move to locations where comparable homes are far less expensive. If you've paid off your mortgage, that sale can free up a considerable amount of equity at a time you may need it most.

Consider Your Long-Term Goals

Most people who pay off their mortgages early do so for a sense of security, says Mr. Taylor says.

"The question becomes whether the person can 'stand to live with debt,' " he says. The boomer generation and those that followed are much more comfortable carrying heavy debt than the World War II generation, "where you had to scrimp and save for everything you wanted, and you tried not to go beyond your means. Some people just aren't accustomed to living in debt," he says.

But that security may be jeopardized by tying up so much of your savings in one, very illiquid investment, says Terence D. Condren, director of financial planning at FleetBoston Financial in Boston.

"Paying down a mortgage, regardless of the interest-rate issue, might prevent [homeowners] from reaching a much more important goal, such as starting their own business," he says. "They may also have teenagers who will soon be going to college, which of course will demand quite a lot of liquidity."

Paying off the mortgage now will simply force them to borrow to pay college costs later on, when rates may be significantly higher. Remember, as recently as 1995 mortgage rates were north of 8%. Also, in certain instances with a home equity loan, the interest may not be tax deductible.

On the other hand, homeowners may feel uncomfortable with the impact of the mortgage on their cashflow. If the money available for paying down the mortgage is likely to be held in low-yield investments anyway (e.g., cash, growth stocks, short-term bond fund) for the foreseeable future, paying down the mortgage will improve their cashflow and let them sleep better at night. In this case, it's a question of personal preference rather than mathematics.

 Deciding, and Acting on It

 If you're on the fence about whether to pay down or pay off your mortgage, rather than invest the cash in stocks or other securities, approach the decision as you would any other investment. Get a current appraisal of the property, which will let you know how much your house has appreciated -- or not -- since you bought it. Then, making a rough estimate of how long you're likely to remain in your home, and plug your information in this home-price appreciation projection tool offered by real-estate Web site Now compare the rate of return with the rates of return on stocks and bonds I quoted above, and decide whether your home's location and amenities make it a more desirable investment over time than equities or bonds.

If you do decide to go ahead and prepay, rather than pay off the loan entirely, you will need to decide how best to go about making the payments. The easiest way to prepay your mortgage -- without busting the bank -- is to raise your regular monthly payment.

Don't waste your time with biweekly mortgage-payment services. The fees are outrageous -- most charge an upfront fee ranging from $195 to $300, as well as an administrative fee (ranging from 79 cents to as much as $3.95 for each payment!). Essentially, all bi-monthly plans do is trick you into making the equivalent of one additional monthly payment each year. So trick yourself instead and save the fees.

Divide your monthly payment into 12 equal parts, then increase the amount of money paid to your mortgage company each month by that amount. For example, say your monthly mortgage payment is $1,200. Divide $1,200 by 12 months and you get $100. Bump your monthly mortgage payment up by $100, to $1,300 a month, and you're painlessly on your way to repaying your loan early, thereby saving thousands in interest. Be sure to inform your lender that the additional monthly cash is meant to be applied to your principal, and not future interest -- this is important step, so don't skip it. And check first to ensure your lender doesn't charge any prepayment penalties before making any additional monthly payments.