Pay Off Your Mortgage Early And Save Big!
Lately, I have seen several solicitations from friendly mortgage lenders offering homeowners the chance to pay off their mortgages early. Note that these are not new lenders offering a refinance -- rather these are the homeowners' own lenders offering an accelerated repayment schedule, with the promise of saving you tens of thousands of dollars in interest over time.
Now, I’m always a little wary when a mortgage lender proposes to reduce the amount of interest I will pay them. Isn't that how they make their money?
Is this a smart deal for consumers? Probably not. ....
First, there is the opportunity cost. What else could you do with the extra money? It (almost) goes without saying that you should first pay down your higher interest debts, such as credit cards. (Caveat: If you are on the brink -- then instead pay your secured debts first.) Once those bases are covered, consider saving or investing the surplus. Remember that your mortgage interest payments are tax-deductible, which means that the real interest rate is 10-35% lower (depending on your tax bracket) than the APR listed on your statement. Can you beat that in the stock or bond market over the long term, based on your risk profile? Quit possibly yes, especially if you have a fixed rate mortgage that you locked in while rates were low, and you are young enough to invest somewhat aggressively. At the very least, in a conservative money market or CD, you might match the cost of money in your mortgage, and thereby create an emergency cushion for yourself.
Second, are the transaction costs. Of course the idea of sending an extra mortgage payment now and then has been around for ages. Indeed, that familiarity is what the mortgage lenders are now trying to capitalize on. But that was too simple. Now paying extra is a “service” that the lenders want to charge big bucks for. I’ve seen two different versions of this appeal. In one, Citimortgage wants $375 to sign you up and then charges $.075 every two weeks. In another offer, a lender wants a $9.00 service charge with each payment!
Third, there is the fine print. Check out the back of one of these mailers. The one on my desk has a Clause 7 which includes, “.... I understand that you [the lender] will have interest-free use of the biweekly amounts from the date they are drafted until the date these amounts are used to make a mortgage payment. ...” And when does that happen? Clause 8 suggests that only after paying 26 of these bi-weekly payments (equaling one year). So, the money is doing nothing for you during this time – only further enriching your lender. (I’ll blog more extensively on the suspense account shenanigans at a later date.)
It gets worse. Clause 8 includes, “I understand that under the terms of my mortgage, my loan may be subject to a prepayment penalty to the extent allowed by law.” That’s right, your friendly lender is soliciting you to do something which they will later penalize you for doing. Prepayment penalties are endemic in the sub-prime lending market. (PDF) Depending on the fine print in your mortgage, that could cost you 4-5% of the original loan amount.
Once again, you have to "admire" the lending industry's ability to take a good idea and make money off of it in a potentially unfair and deceptive way.
Here's a link to an article about some reasons why you might want to do something else with the money anyway - such as funding a retirement account, or building up an emergency fund
http://articles.moneycentral.msn.com/Banking/HomeFinancing/DontRushToPayOffThatMortgage.aspx
It is usually something where you have to consider a lot of factors, but the sales pitch from the lender highlights the "savings" in a way that obscures or distracts the customer.
January 4, 2007 1:21 PM | Reply | Permalink
One thing I've learned about finance, as a finance major in college, is that you can really play shell games with numbers. Banks do this expertly. They can charge extra fees for helping you save money by paying off a mortgage early, but they will still make the same income or more off that money when they re-lend it. It is the same principle as inventory turnover. The faster the turnover, the less profit margin needed. However, they can make a higher margin by turning inventory of loans over faster and reduce default risk at the same time.
The best way to save money paying off your mortgage early is to make extra payments, but you have to be sure those tricky early payment penalties are not in your mortgage note when you take out the loan. If they are in your loan, you either need to refinance into a loan without one, or bite the bullet. It is better to pay the early payment fees, than to be enslaved by a loan. If a bank insists on penalizing you for paying off early, make it a policy to never do business with them again, and inform them of your decision in writing to the president of the bank. It is simply robbery, and encourages enslavement to debt, which is contrary to our founding father's values found in the Constitution of the United States.
(a note on the tax effect: Why pay $1 to get 35 cents back? It is still better to keep the $1. The tax break is great, but it is still a shell game that makes banks richer and consumers poorer. If you want a tax break from real estate, take it in depreciation on investment property. Borrowing increases your financial risk, and makes banks richer at little or no risk, at your expense.)
Jim Anderson
The Truth About Credit
January 5, 2007 8:29 AM | Reply | Permalink
Jim asks: "Why pay $1 to get 35 cents back? It is still better to keep the $1."
As I explain above, the problem is the opportunity cost. If you have to spend $100,000 cash to pay off your mortgage so as to avoid paying $1 in interest and getting 35 cents back (= paying $.65), then you have to ask what else you could be doing with that $100,000 dollars. As I suggest above, it may make sense to put it in an investment that will earn you more than the $.65 you'll continue paying the bank.
-ctr
January 5, 2007 9:32 AM | Reply | Permalink
Nice justification. However, If you pay off the mortgage, you don't have risk of default on a loan for the place you live. You also don't have to pay rent, so your monthly cash flow for living doesn't need to be nearly as high. That is usually the largest chunk of a household budget.
If you use the $100,000 you mention to invest at a higher return than the bank is charging. You only make a profit on the margin. Is that margin worth the risk? Probably not. You are effectively borrowing money to invest. If your investment is at risk of loss of principle, you are doubling your risk of loss. If things go bad, which they usually do at some point. You won't have money to service the loan and your investment principle won't cover it either, and you stand to lose a place to live when you need it most.
If you have a home with a $900 payment, and say the interest portion is $830 each month, you will have paid around $10,000 in interest that year. That creates a tax deduction. If you are in a 30% tax bracket you will save $3,000 in taxes. Why pay $10,000 to the bank so we can avoid paying $3,000 to the IRS? If my home is paid off, I keep the $10,000, and find other ways to avoid paying the $3,000 in taxes. If you think it creates a money making opportunity for you to pay $10,000 to save $3,000 then I'll send you a check for $3,000 as soon as your check for $10,000 arrives.
I will admit that it is probably smart to start saving for retirement before you pay off your home, but I think it is wise to have substantial equity in the home first so you can always sell the home to pay off the loan regardless of market conditions.
Jim Anderson
The Truth About Credit
January 6, 2007 9:21 AM | Reply | Permalink
To pay or save is a dilemma I could use some advice on. I have an additional $300 I can pay against my mortgage loan each month. As a first time home owner with a 30 year, fixed rate mortgage loan, I would like to know if it’s wiser in the long run to make extra monthly payments to the bank, or instead, invest it into a safe investment vehicle until enough is saved to pay off the entire principle. My goal is to pay off the mortgage as fast as possible, but financial experts such as Suze Orman always advise to make extra payments and no other alternatives. But to me, investing in CDs or Money Market Accounts for example is the wiser choice because CDs or MMAs are making interest rather than sitting in equity doing nothing. In my opinion, making extra payments on a fixed rate mortgage is dead money and should be avoided until we save enough to pay off the entire principle. Am I off base or are financial experts not giving us all our options? I would be very interested to hear opinions on the subject since I am no expert in this field.
Joe D.
January 19, 2007 2:50 PM | Reply | Permalink