Paying Off Your Mortgage
It's Not as Attractive as It Sounds
Dec 2006
The holidays are upon us and the season of giving is
now in full swing. But when you're making your holiday
gift list, don't forget that you need to take care of
the person writing the checks as well, namely you!
Federal Reserve Chairman, Ben Bernanke, recently spoke
of the need for all Americans to save more today in
order to prevent significant financial consequences in
future decades.
Save, Save, Save
A critical component for developing future security is
the practice of "paying yourself first". One popular
way to accomplish this objective is to pre-pay your
mortgage, reducing the total interest owed and
eliminating future payments.
If you have a home loan, you'll inevitably be
offered an opportunity to "save money" by enrolling in
a bi-weekly payment program. In one recent example, a
borrower could save nearly $31,000 by eliminating five
years and five months of payments on a loan amount of
$197,500.
The logic behind this savings program is simple.
Many people get paid every other week. Based on this
schedule, each time a paycheck is received, half of
the mortgage payment would be paid on the borrower's
behalf. During the two months when three paychecks are
received, two extra half payments would be made,
equating to one extra mortgage payment each year.
Others may choose to pre-pay their mortgage in
different ways, but the benefit is basically the same.
Some individuals make lump sum pre-payments when they
get a bonus or a tax refund check, while others simply
add a little extra to their payment each month.
Another option is to take a shorter term loan such as
a 15-Year Fixed Rate. Regardless of the method chosen,
prepayment does appear to save the homeowner money.
The question is, do prepayments make the most of your
investment dollars?
Hold That Check
The Federal Reserve Bank of Chicago recently released
a paper,
The Tradeoff between Mortgage Prepayments and
Tax-Deferred Retirement Savings, which
demonstrates the benefits of not prepaying your
mortgage but choosing to fund your retirement instead.
Many homeowners may think they're already making
progress towards retirement by paying down their
mortgage at a faster rate. After all, a penny saved is
a penny earned, regardless of where it's placed.
Besides, the objective is to pay off your mortgage as
soon as possible so mortgage payments don't have to be
made during retirement.
The key factor to keep in mind though is something
called arbitrage. The Merriam-Webster Dictionary
defines arbitrage as "the nearly simultaneous purchase
and sale of securities or foreign exchange in
different markets in order to profit from price
discrepancies." While we're not discussing securities
here, we are talking about money. So, here's an
example to help clarify things. If you were to borrow
money at 4.00% and invest it at a return of 12.00%,
this would be considered arbitrage. Banks do this
every day.
How is this relevant to you? Well, the IRS allows
you to contribute a portion of your earnings each year
into a Tax-Deferred Account (TDA), such as a 401K or
Individual Retirement Account. The benefit of doing so
is that you forgo taxation today, when you're most
likely being taxed at a higher rate. When you withdraw
the funds in later years, your earnings and your tax
rate will probably be lower. In addition, you'll
benefit from having a compounded rate of return on the
non-taxed funds, allowing them to grow to a higher
balance until the time comes to draw on the account.
Analyzing the Difference
In the report by the Federal Reserve, the authors
stated that by choosing to accelerate mortgage
payments in lieu of funding a TDA, American homeowners
may cost themselves as much as $1.5 billion a year!
This doesn't even take into account the money that
many homeowners withhold from their company-matching
401K plans.
Furthermore, by choosing to fund a TDA, the
resulting savings to the individual homeowner could
yield 11 to 17 cents per dollar, depending upon the
choice of assets in the TDA. While the reasons for
choosing to pay off a home loan early can vary from
person to person, it is estimated that about 38% of
U.S. households are costing themselves a lot of money
simply by making the wrong choice of where to direct
their money.
What to Do Now
If your company offers a 401K program and you aren't
participating, then enroll yourself as quickly as
possible. If you're unable to enroll this year, plan
on doing so next year. Contribute the maximum amount
you can without causing financial hardship. If your
company offers a matching plan, take advantage of the
full amount available. This is a 100% return on your
money! If you don't have the ability to participate in
a 401K program, consult with a Financial Advisor about
starting an IRA. For those of you who are
self-employed or employed by a small business, there
are several programs you can investigate. A call to
your Financial Advisor would definitely be worthwhile.
If you're participating in a bi-weekly mortgage
program or making advance principal payments against
your home loan while not fully funding your retirement
accounts, STOP doing so. In addition, if your current
home loan is set at a term of less than 30 years, you
may want to consider restructuring your loan to allow
for higher retirement fund contributions.
For a simple analysis of which options may be best
for you, place a quick call to your Mortgage
Professional or Financial Advisor. These experts will
help you to achieve financial security in the years
ahead. With home loan rates approaching their lowest
point of the year, this is a great time to investigate
how you can make your home, and home loan, work for
you.
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