Investing in Your Mortgage Can Pay
Paying down a mortgage has long been viewed as a sure-fire investment. It reduces debt, helps home equity grow faster and provides a guaranteed return equal to the mortgage rate, usually more than one can make in bank savings, bonds or other comparable fixed-income investments.
But conditions change. So how does the strategy chalk up today?
Advocates say it still makes sense to put an extra $100 a month into the mortgage, or more, but it always pays to run the numbers and consider the alternatives.
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"I cannot think of any viable reason not to pay down principal," says William Flood, real estate analyst for New York-based FitSmallBusiness.com, a website for small-business owners.
"Looking at it squarely, if you are paying a 4 percent mortgage, and you pay down principal, you are getting an effective 4 percent return on that money," he says. "There are very few places where one can get 4 percent, compounded monthly, with zero volatility these days."
Among the benefits:
Guaranteed yield. With a loan charging 4 percent, reducing the balance by $100 would save $4 a year in interest charges. That's the same as earning 4 percent, which isn't bad when bank savings pay nearly nothing and a 10-year U.S. Treasury bond yields just over 2 percent.
Building equity. Equity is the home's value minus the outstanding mortgage balance, and extra principal payments increase the equity. That means more money in your pocket when you sell, or allows you to get a smaller mortgage if you see a good opportunity to refinance.
Reducing debt. Carrying less debt is almost always a good idea. Every extra dollar put into the mortgage is one dollar less hanging over you. That can make it easier to invest in the stock market or get another loan for a car or kid's college.
Snowballing effect. Required monthly payments include a sum for interest and another for paying off principal. When you reduce the outstanding loan balance, future interest charges are smaller, allowing more of each payment to go to reducing the debt, cutting future interest charges even more.
That means, however, that the borrower needs to stay in the home for a number of years for the payments to work.
"Generally, if a homeowner is not planning to remain in their home for the foreseeable future, it may not be advantageous to pay down a mortgage early," says Kristin McFarland, a financial planner with Darrow Wealth Management in Boston.
A downside. The investment return equal to the loan rate might not be as high as you could earn with something else, like the stock market. This year the Standard & Poor's 500 index is up more than 13 percent, trouncing what you'd earn paying down a 4 percent mortgage. So the question is whether you'd prefer the risk of stocks or some other alternative to the return guaranteed by paying down your mortgage.
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Carol McConkey, senior vice president of Consumer Banking at Paragon Bank in Memphis, is not a fan of paying down a mortgage, arguing that other investments might be more profitable.
"Today's low interest rates make it cheap to borrow," she says, "and with the stock market in a bullish environment, it can benefit the borrower to let that money work for them in the market."
Erika Jensen, president of Respire Wealth Management in Houston, says extra principal payments can work for many, since the homeowner is not committed to keep doing it.
"Making extra payments reduces the effective interest over time," she says. "By locking in a 30-year (mortgage) and making extra payments, borrowers can reduce their interest paid, but maintain flexibility in case they need to make a smaller payment one month."
With most mortgages, it's easy to add a little something to the regular monthly payment. Payment slips and online forms often have a place for extra principal.
For every $100,000 borrowed, a 4 percent, 30-year mortgage would charge $477 a month. Adding $100 a month would speed the process, paying off the loan in 259 months instead of 360, and saving the borrower about $22,000 in interest.
Jensen says building equity in the current home can reduce the amount one would need to borrow for the next one. That could be important if, as many experts predict, loan rates rise over the next few years and make it harder to qualify for a large mortgage.
On an adjustable-rate loan it works a little differently, since the mortgage is recalculated every year to pay the loan off on the original schedule. Instead of allowing the loan to be paid off early, extra principal on an ARM reduces the required monthly payment after the next reset, which can be nice if money gets tight. Of course, if you continue paying the original amount or more the loan will be paid off early.
Also, reducing debt will reduce future payments if the ARM adjusts to a higher rate.
Jensen says ARMs typically can rise to a maximum rate, often 6 percentage points above the starting rate, so that extra principal payments made earlier can have a big payoff if rates rise.
By making extra principal payments, your money is tied up in the home, and getting it will require selling or taking out a home equity loan or cash-out refinancing -- when you borrow more than needed to pay off the old mortgage.
A homeowner cannot be certain of getting a new loan to tap equity, says real estate agent Mark Ferguson, founder of the real estate investing website, Investfourmore.com.
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"If someone happens to lose their job, or builds up too much debt, they may not be able to refinance the house or get a line of credit," Ferguson says, leaving a sale as the only way to free up cash.
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