Paying a little extraBy Jonathan clements
on your mortgage payments
may make sense for the
The Wall Street Journal
MAYBE this is the year to put it on the house. Spooked by the stock market? Disenchanted with lowly bond yields? Consider taking some of your investment dollars and using them to pay down your mortgage.
Admittedly, making extra-mortgage payments won't earn you dazzling returns. If your mortgage rate is 8 percent, that's your effective pretax rate of return on every additional dollar you add to your mortgage check.
Doesn't seem like much? Sure, it can't compare with the 11 percent-a-year total return for stocks since year-end 1925, and it pales beside the 31 percent annual stock-market gain of the past three calendar years, as calculated by Chicago's Ibbotson Associates.
But making extra-mortgage payments can be a smart move for conservative investors who would otherwise buy bonds, money-market funds and certificates of deposit.
The case for making extra-mortgage payments has been bolstered by the recent drop in interest rates, which has squeezed yields on bonds and other conservative investments. In fact, interest rates have fallen so much that many folks are seizing the chance to refinance their mortgages and lock in lower rates.
"Anybody who has a mortgage rate above 8.25 percent should look at refinancing," says Keith Gumbinger, a vice president with HSH Associates, a mortgage-information provider in Butler, N.J.
What if your interest rate is 8 percent or below? "You really have to look very hard at the costs" that you would incur in a refinancing, Gumbinger says.
For those homeowners who find it's not worth refinancing, extra-mortgage payments offer an alternative way of eliminating costly mortgage debt. By adding just a few dollars to each monthly check, you can save thousands of dollars in interest over the life of your mortgage.
Suppose you just borrowed $200,000 using a 30-year, 7.5 percent fixed-rate mortgage that requires a $1,400 monthly payment. By adding only $25 to each check, for a total of $8,425 over the life of the loan, you would save $22,500 in interest and pay off your mortgage almost two years early.
Adding a few dollars to the monthly check can also make sense if you have an adjustable-rate mortgage. But with an ARM, your extra $25 won't shorten the length of the loan. Instead, the additional dollars will lead to lower required monthly payments.
"It's almost always a good time to pay down your mortgage," Gumbinger argues. "It's a solid, 100 percent-guaranteed investment."
Still, before you tack an extra $25, $50 or $100 onto the next mortgage check, make sure you have already made the most of other options that promise a higher return. For instance, instead of paying down your mortgage, you are much better off getting rid of credit-card debt. Your cards may be costing you 18 percent a year and, unlike mortgage debt, the interest isn't tax-deductible.
Similarly, before you make any extra-mortgage payments, you should invest the maximum possible in your employer's retirement-savings plan and fully fund a regular or Roth individual retirement account.
Once you have paid off high-cost debt and made full use of tax-sheltered retirement accounts, you may have additional money that you want to save. At that point, you might use the extra money to pay down your mortgage or, alternatively, you could use the cash to buy investments in a regular taxable account.
So which should it be? It all depends on what investments you would buy. If the choice is between stocks in a taxable account and paying down the mortgage, I would opt for stocks. Yeah, stocks may be richly valued. But over the long haul, you should still earn higher returns than you would with extra-mortgage payments.
That's not the case, however, with bonds or CDs. If the choice is between paying down an 8 percent mortgage or buying a bond with a 6 percent yield, I would favor making extra mortgage payments.
But what about losing all that tax-deductible mortgage interest, you cry? True, if you are in the 28 percent federal income-tax bracket, every $1 of interest is saving you 28 cents in taxes (and maybe more if the interest is deductible at the state level), so the real cost of that 8 percent mortgage is just 5.76 percent.
That's less than the 6 percent you will get on the bond. But remember, the bond is also taxable. After paying tax at 28 percent on the 6 percent interest, you will be left with just 4.32 percent -- far less than the 5.76 percent you earn with extra-mortgage payments. Unless bond prices rally, you will get much better results by paying down your mortgage.
"I would rather buy paper from myself that's costing me 7 percent or 8 percent than buy paper from the government that's paying less than 6 percent," says Michael Maloon, a financial planner in San Ramon, Calif. "As rates drop, paying down your mortgage makes more and more sense."
Moreover, making extra-mortgage payments is remarkably easy. You don't need to conduct any investment research, as you would before buying a mutual fund or a bond. Instead, to save thousands in interest, all you have to do is write a slightly larger check next time you pay your mortgage.