Thursday, July 22, 2010

To Amort or Not to Amort

Amort is defined as “lifeless” in my University owned edition of Webster’s Dictionary (circa 1958).  It is also the root word for amortize, defined in that dictionary as “the gradual extinction of a future obligation”.  This is what occurs when we repay our mortgage through our monthly payments.  It is also my question of the week, as I have had two people ask me if they should take money from their accounts and repay their mortgage.  What are the considerations in making this decision?


When you should consider paying off your mortgage:

·         When you have no other debts, such as credit card debt, at greater rates of interest.  If you are paying an APR of 18% on your credit card debt and 5% on your mortgage, pay your credit card debt first.  ALWAYS repay the highest APR loan first, if you have extra money to pay toward your debts.

·         When you have maximized your retirement savings, particularly up to the limit that your employer matches your contributions to your 401k, 403b, or other retirement plan.  If your employer matches 50% your contributions up to a limit, then making a contribution up to the limit is like an immediate 50% return on your money.  Besides, you don’t have to pay taxes on your contributions until you receive payments in retirement.  The Federal Reserve has estimated that approximately 38% of households making extra payments on their mortgage are making the wrong choice and underfunding their retirement savings as a result.

·         When you have established an emergency fund of three to six months living expenses.  This is one of the key steps in financial planning, as it enables you to face life head-on and handle those little and, sometimes, big things that come your way.  Importantly, an emergency fund allows you raise your deductibles on your property insurances, thus freeing more money for investing, as well as paying toward your mortgage.

·         When you do not believe you can earn rates of return greater than the rate of interest on your mortgage from your investments.  (I think this is what created this question to be so popular this week.  Yet, today (Thursday) as I write this markets are up about 2%.  I bet no one asks me this question today.)  As the recession eventually ends, rates of return will exceed current mortgage rates.  When that occurs, the money you spend on your house, could have been earning money for your child’s education, your retirement, or another life’s financial goals.

·         When the only reason you itemize your deductions for federal taxes is due to your mortgage.  Everyone receives the standard deduction of $5,700/$11,400 (single/married filing jointly).   Two-thirds of households take the standard deduction, rather than itemizing their deductions, as the standard deduction is the greater of the two for their circumstances.  If this is you, there is no tax benefit to itemizing your mortgage interest.   For those of you that really believe that tax deductions save you money, remember that they work this way: You pay $1 of interest and the federal tax deduction saves you $0.25 (assuming a 25% tax rate, more if you have state income taxes).  I’ll tell you what, you give me $1 and I’ll give you $0.40 for as many dollars as you want to give me.  That’s a 60% better deal than the one you get from the IRS.  I doubt I have many takers.

·         When you have already established an adequate insurance program; life, medical, disability-income are all particularly important if you have financial dependents.

·         When you are not already “underwater” with your mortgage.  It makes little financial sense to prepay, if there is a chance you may face foreclosure.  Besides, if you are one of these homeowners it is probably best to put your money in an emergency fund – which you may not have – in order to help you with your transition to a new life.

·         When you have a burning desire to be debt free.  I have no problem with people who want the sure “return” of not paying mortgage interest, as opposed to taking on the risk of investment markets.  Please, however, make the best decision for your circumstances, not the “one size fits all” answers of the radio talk-show hosts.

·         As it is a math problem and this is coming from a major university to you, consider the following.  We’ll assume a $100,000 mortgage with either a 30 or 15 year amortization period and either a 5.25% or 7.5% rate of mortgage interest, to illustrate the point.  For each of the four combinations, we’ll see how adding $200 per month to your mortgage payment will reduce your total interest paid, as well as reduce the time until your mortgage is repaid.

o    Regular Payment 15 year mortgage (repay in 180 months):

§  5.75% interest; $830.41 per month

§  7.25% interest; $912.86 per month

o   Regular Payment 30 year mortgage (repay in 360 months):

§  5.75% interest; $583.57 per month

§  7.25% interest; $699.21 per month

·         Savings from adding $200 per month to the payment for each of the above

o   15 year mortgage:

§  $14,490 interest saved and repaid in 131 months for the 5.75% mortgage

§  $19,643 interest saved and repaid in 130 months for the 7.25% mortgage

o   30 year mortgage:

§  $49,896 interest saved and repaid in 198 months for the 5.75% mortgage

§  $79,967 interest saved and repaid in 191 months for the 7.25% mortgage

o   Conclusion: A similar prepayment of mortgage principal is more advantageous the greater your mortgage rate of interest and the longer the amortization period of the loan.

·         Let’s do one more example, although it is a different problem.  Should you pay $100,000 cash for a house or borrow $100,000 at 5.75% to finance the house.  (This is similar to repaying a mortgage in full.)  The answer will depend on the rate of return you can earn on your money.

o   Option 1: Invest the $100,000 at 7%.  In 15 years the $100,000 would grow to $275,903

o   Option 2: Pay off the mortgage in full and faithfully invest the mortgage payment you would have paid at 7%.  In 15 years, the 180 deposits of $830.41 would be worth $263,208.  Thus, you are better off with the mortgage and keeping the $100,000 invested at 7%.

o   However, if you can only earn 5% on your $100,000 it would be worth $207,892 in 15 years, while the $830.41 deposits would be worth $221,959.  See, the answer depends on what you can earn on your money, as compared to the mortgage rate of interest.

·         As always, consult a qualified financial professional (or learn how to use a financial calculator) to address your particular situation with additional clarity, as an aid to your financial success.



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