Why it no longer makes sense for young people to pay off their mortgage early

[flu]

….The following was posted on another blog…
A person asked was whether they should pay off their mortgage early (their mortgage was a 30 year fixed 3.8%)…

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I think since these people are only 30 years oldish like me, they should consider taking on slightly higher level of risk for possibly getting higher returns than 3.875% In fact, what I would do is
1. Refinance into an even lower 30 year loan (current rates are around 3.25%)
2. Take half of there current savings and put it into some sort of more more aggressive investments than savings account (just not right now since the stock market is at an all time high, and in some parts of the US, we have reached peak housing prices (again))…

As a fiscally responsible person myself, one normally would say “pay off your debt obligations early”… However, as I have discovered recently within the past 4 years, we do live in the United States and our government and federal bank policy is to “punish” traditional “savers” at the expense of promoting moral hazard and encouraging deficit/debt spending…To solve the deficit/debt spending problems at the national, states, and personal level, our government’s solution to keep interest rates artificially low and simultaneously print more money to weaken the purchasing price of the US dollar.. In addition, our current political party has taken on a new meaning of vilifying “rich people” (defined as anyone who was responsible and “saved”) and has encouraged a propaganda/class warfare to the majority of Americans who are broke.

This environment is extremely hostile to fiscally responsible people who only “save” in a low interest account. People who are on fixed income or “save” in a traditional fixed income savings account/CD are getting (and will continue to get) slaughtered in purchasing power while other asset classes will continue to be artificially inflated….

Therefore IF you manage your money well and IF you are young and IF you have an appetite for slightly higher level of risk, take advantage of the low interest loan environment and push out as far as you can your loan obligations into the future as much as possible with the largest loan period as possible so that inflation and a weakening dollar will significantly “devalue” your loan obligation in “real dollars”. Meanwhile, use the extra money you have today to wisely invest in higher return assets that produce returns greater than the low 2-3% mortgage interest rate. For the disbeliever, let’s use real math numbers to prove this (as I posted this on another thread).. Consider the two people

1. Person A borrows $100k at a 15 year fixed rate loan of 2.5%
2. Person B borrows $100k at a 30 year fixed rate loan of 3.25%.
3. Both person can reasonably obtain a conservative 4% return YOY with extra money they have on had (people love to quote 7-8%, but that’s overly optimistic.) So let’s use 4%

Consider the following after 15 years:

Person A’s mortgage payment will be $702.67/month (8432/year) and after 15 years, the person would have paid a total of $26,480 in interest, and own his/her house free and clear.

Person B’s mortgage payment will be $435.21/month (5223/year) and after 15 years, the person would still owe $59,776 on the 30 year loan.

….But person B would have an extra 8432-5223= $3209/yr to invest at 4% during 15 years.

$3209/year compounding at 4% = (3209*1.04^15) +(3209*1.04^14)+….+(3209*1.04^1) or a total return of $66825.92044… Person B could pay off his/her outstanding 30 year loan balance of $59776 and still come out with an extra $7049 that Person A did not have by paying off his/her loan early.

So as you can see, with because mortgage rates are so low. And since achieving 4% return elsewhere is very reasonable, there really is no incentive to pay off your loan early purely from a financial gain perspective.

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BTW: Your parents probably told you otherwise..But that’s most likely because their mortgage rates were around 6-10%…In order to make that work in their case, they would have had to find a return greater than their mortgage rate. If their mortgage rate is 6% it is would be much harder for them to beat that consistently over 15 years elsewhere (possible, but hard(er)).. If their mortgage rate is 10%, then it’s extremely hard if not impossible for most of them to do better elsewhere without taking on excessive risk above most people’s comfort level.. In those high interest loan environments, it makes more sense to pay yourself a 6-10% return by paying off your mortgage early..

In this current environment, paying off your mortgage early means paying yourself a return that equals your mortgage rate, which is roughly around 3% these days. So ask yourself if you are comfortable with a 3% return over 15 years or if you would be more comfortable with trying to beat that by putting your money to work elsewhere.

Consider that fact that there are a lot of high quality dividend stocks that pay a dividend above that and other investment choices that might produce returns greater than 3%… In my particular case, my primary employer offers an employee stock purchase plan (ESPP) that offers share purchases 20% discount off of fair market value on my company’s stock quarterly up to 15% of one’s gross salary. The company would withhold more each pay period and at the end of 4 months, purchase company shares at 20% discount off the fair market value during that 4 months…

Some of my peers have asked whether they should payoff their mortgage (with a 3% interest) every month, while simultaneously NOT maxing out their contributions to the ESPP plan… This is a no brainer… For our particular case in which company stock is not subject to a restricted trading window and can be sold immediately upon delivery of share…Why pay off your mortgage earlier and get a 3% return and give up a 20% return by contribution to the ESPP? Contribute to the ESPP plan first, and once you get the stock, immediately sell for a 20% gain, and then if you want pay off the mortgage earlier if you must.

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BTW: #2… As an added bonus, if you itemize your taxes, there’s also the write off your mortgage interest deduction.. I hesitate to say this, because people often over-exaggerate the virtues of a mortgage interest deduction, and claim that is the #1 reason why you want to have an outstanding mortgage when in fact, if you borrow money, interest you owe on it versus the tax benefit your get from itemizing the interest isn’t $1:$1…But I’m sure you folks already knew that..

I’m just bringing it up, for those considering the entire picture, both it AND putting your freed up money from the lower payments elsewhere…

[flyer]

Interesting analysis, and I’m sure there are pros and cons to both perspectives. I’ll leave that dissertation to the other financial experts on this board.

As someone who is now in their 50’s, I agree that young people should pursue whatever path leads them to complete financial independence at least by the time they are 50. That is the path my wife and I pursued, and it has worked out well. We have encouraged our children to do the same.

IMO, in today’s extremely volatile economy, it would seem to be even more important for young people to plan their finances well, since now, more than ever, employers seem to be replacing older workers with a newer model–unless, of course, you have union protection–and that is an entirely different conversation.

Making a lot of money is not nearly as difficult as sustaining it for the duration of your lifetime. I can’t tell you how many people I have known who “used to be millionaires.”

[spdrun]

First of all, property is still a good investment in many areas. A few West Coast cities and DC with mini-bubbles are the exception not the norm. Secondly, if paying off early helps you to qualify for financing on a “second home” that’s a rental, I say have at it.

Lastly, having a $400,000 home that you only pay taxes, utilities and repair costs, can rent out at 7-8% profit, and quit your job to bum around Thailand on the proceeds would be niiiiiice. Basically, being in the position to scream “FUCK YOU, I’M OUTTA HERE FOR A YEAR, TRY AND STOP ME, YOU DUMB DONKEY-PENIS!!!” in your boss’s face is a beautiful thing.

[flu]

[quote=spdrun]First of all, property is still a good investment in many areas. A few West Coast cities and DC with mini-bubbles are the exception not the norm. Secondly, if paying off early helps you to qualify for financing on a “second home” that’s a rental, I say have at it.

Lastly, having a $400,000 home that you only pay taxes, utilities and repair costs, can rent out at 7-8% profit, and quit your job to bum around Thailand on the proceeds would be niiiiiice. Basically, being in the position to scream “FUCK YOU, I’M OUTTA HERE FOR A YEAR, TRY AND STOP ME, YOU DUMB DONKEY-PENIS!!!” in your boss’s face is a beautiful thing.[/quote]

I agree with your first point.

Regarding your second point, I don’t think this makes sense. People who have invested with borrowed funds can confirm that the lowest loan rate is always found on the owner occupied home. Usually, investment property loans are at least .25-5% higher. Also, it can be can be harder to be qualify an investment property for a loan, because it will depend on other factors (for example, owner occupancy for an attached home in a complex). It seems like if someone has funds to pay off either their primary or rental, it would make more sense to pay off the rental first and keep the mortgage on primary, which would have the lower interest rate. Regarding taxes, I don’t think it matters which deduction you take (schedule A or C).

Also, I don’t follow your last point. I think the original person was talking about a primary home, not an investment property. For practical purposes, money sunk into your primary (until you sell it, or turn it into an investment property) doesn’t produce income. Most people aren’t interested in time-sharing their primary home with a stranger even if they aren’t occupying it full time.

[spdrun]

As far as qualifying …

There’s a local (very local, literally one 20′ wide store front) bank in my hometown that will loan on 1-4 unit investment property AS IF it were a 5+ unit or commercial property. You’ll pay 0.5% more for it, but it’s a lot easier to qualify since it’s mainly based on your credit and the building’s income, not your income. Rate fixed for 10 years, 20-25% down.

Guessing they’re keeping those loans on the books, not selling to the GSE’s 🙂

Once you’re paid off on your home, you can always still have a line of credit against it to 70-75% of value, that’s then convertible into a fixed-rate loan.

[HLS]

“It seems like if someone has funds to pay off either their primary or rental, it would make more sense to pay off the rental first and keep the mortgage on primary, which would have the lower interest rate. Regarding taxes, I don’t think it matters which deduction you take (schedule A or C)”
*********************************
1. If rates are similar, I think that it is much better to pay down balance on primary first. Can make a big difference.
2. Various factors go into qualifying for an investment property loan. In many cases it is only .25% higher for this, but there is ALWAYS an option to pay up front an get the same rate as owner occupied.(With at least 25% equity, paying 1.75% of loan amount gets you same rate as OO)
3. Many people convert their primary into a rental and have owner occupied financing in place.

There are many strategies to use that may not seem like a big deal up front but have a huge impact on the bottom line over many years.

[HLS]

[quote=spdrun]that will loan on 1-4 unit investment property AS IF it were a 5+ unit or commercial property. You’ll pay 0.5% more for it, Rate fixed for 10 years, 20-25% down.[/quote]

I’m sure that this is possible but I question that it is only .5% more than 10yr fixed FNMA pricing.
There is a big difference on GSE loans on a rental between 20% and 25% equity.
There’s a risk factor with the rate only fixed for 10 yrs.

They are DEFINITELY not selling that loan to GSE’s.
It’s their money, probably being kept as a portfolio loan and they can do whatever they want.

(A fully amortized GSE 10yr loan on an investment property today is 2.75% with no points)

[matt]

I am 36 (i consider that young :), currently working overseas with my former NCC primary home now rented. I still owe 400K on the property which likely appraises today at 950K or so. I bought in 2010 and have struggled to refi as it is very difficult to close a loan when you work for a non-US company overseas (despite having verifiable tax returns, pay stubs, etc)… so my current loan is 4.75% and payment 2600 / month, renting at 4K / month. I am thinking about paying this off to #1 assure my family a roof over our heads should we ever need it, #2 call me conservative but a guranteed 4.75% for me is a decent return. With the property paid off worst case i have an asset cash flowing me almost $3K / month and the security of a beautiful home in a great schol district to live in should we ever need it, with the sole pressure of generating enough income to pay for property taxes, bills, and food to provide a decent life for my family. This for me is compelling as I know life throws punches and i may not be able to generate the cash i can today in the future.

[CA renter]

[quote=matt]I am 36 (i consider that young :), currently working overseas with my former NCC primary home now rented. I still owe 400K on the property which likely appraises today at 950K or so. I bought in 2010 and have struggled to refi as it is very difficult to close a loan when you work for a non-US company overseas (despite having verifiable tax returns, pay stubs, etc)… so my current loan is 4.75% and payment 2600 / month, renting at 4K / month. I am thinking about paying this off to #1 assure my family a roof over our heads should we ever need it, #2 call me conservative but a guranteed 4.75% for me is a decent return. With the property paid off worst case i have an asset cash flowing me almost $3K / month and the security of a beautiful home in a great schol district to live in should we ever need it, with the sole pressure of generating enough income to pay for property taxes, bills, and food to provide a decent life for my family. This for me is compelling as I know life throws punches and i may not be able to generate the cash i can today in the future.[/quote]

Totally agree with this.

[HLS]

[quote=matt] I am thinking about paying this off to #1 assure my family a roof over our heads should we ever need it, #2 call me conservative but a guranteed 4.75% for me is a decent return. [/quote]

Nothing wrong with being conservative. Don’t ever let anybody talk you into taking risks that you aren’t comfortable with.

Due to your circumstances, just realize that equity in your home is trapped if you cannot qualify to refi.
Weigh giving up cash vs. having a huge cash cushion. Paying off debt comes at a cost.

Many seniors are house rich but cash poor.
Even with a $1 million dollar home owned outright they may not qualify for a $200K loan. The system is broken.
They may have the option of a reverse mortgage to be able to get some cash, but I am not a huge fan of this loan. It’s another govt creation.

*I may be able to help you with a refi if you’d like to contact me privately. Your situation is unusual and I need more details.

[spdrun]

I suspect you can always find SOMEONE to give you a portfolio loan even if you don’t qualify for normal financing. I can’t speak to SD, but one lender in NY/NJ does 65% ltv stated income in 2013, cash out or purchase. Stated income can be no more than 4x of funds available after closing. This is for owner occupied sfr, duplex, or condo.

Another lender does non-occupied, treated as a commercial mortgage as I described earlier.

Besides, $42,750/yr guaranteed income ain’t bad. You can always find some job that nets an additional $30-40k/yr, rent the house, and move into smaller digs. 2-3 bedroom apt for $1500/mo, let’s say.

[UCGal]

[quote=HLS][quote=matt] I am thinking about paying this off to #1 assure my family a roof over our heads should we ever need it, #2 call me conservative but a guranteed 4.75% for me is a decent return. [/quote]

Nothing wrong with being conservative. Don’t ever let anybody talk you into taking risks that you aren’t comfortable with.

Due to your circumstances, just realize that equity in your home is trapped if you cannot qualify to refi.
Weigh giving up cash vs. having a huge cash cushion. Paying off debt comes at a cost.

Many seniors are house rich but cash poor.
Even with a $1 million dollar home owned outright they may not qualify for a $200K loan. The system is broken.
They may have the option of a reverse mortgage to be able to get some cash, but I am not a huge fan of this loan. It’s another govt creation.

*I may be able to help you with a refi if you’d like to contact me privately. Your situation is unusual and I need more details.[/quote]

Many lenders will lend if you can show an income stream from your investments. If the senior has investments in IRAs – and sets up systematic (monthly, annually, some automatic period) withdrawals – that can be used to qualify.

There is a lot of talk about this on the website http://www.early-retirement.org/forums/

For younger folks – consider if you want to continue to pay a mortgage after you retire. I’m not in the younger age category – but not retired (yet). I know my projected retirement budget works a LOT better without the mortgage P&I in it. So we’ll be paying off the mortgage in the near term. I don’t understand how people expect to pay large mortgages on limited retirement income streams. But folks seem to be doing that. I’ve done my retirement projections both ways – and I can retire younger if I don’t have a mortgage (with a smaller nest egg).

[HLS]

The lenders who lend based on ‘projected’ income stream usually do not lend fixed for 30yrs AND rates are considerably higher than ‘real’ 30yr fixed rates today. What are the rates & term ?
When it’s adjustable or short term the risk is on the borrower.

5% vs 3.50% is 43% higher which is a HUGE margin.
With $200K of debt, you have to give up $200K of cash to pay it off.

This is not a simple matter of right/wrong but what an individual is comfortable with. There is always some risk involved.

Having no mortgage comes at a cost. The lost opportunity of that cash. It’s foolish to think otherwise.

I have seen too many older people who have lots of equity but very little cash. They are NOT enjoying their lives. Reverse mortgages are expensive.

There is nothing wrong with manageable debt.
I have had responsible people tell me that they sleep much better with money in the bank than they did when they had a high mortgage payment and no cash cushion.

Having cash gives you options. Having lots of equity limits your options. The system makes me sick. It’s broken & manipulated.
It’s ridiculous/idiotic that people with $1 million dollar homes cannot qualify for $200K GSE loans at 3.50%

Obviously not available today, but what if CD rates were 6%+ and the interest stream paid the full payment on an amortized mortgage ?

[dumbrenter]

[quote=flyer]Interesting analysis, and I’m sure there are pros and cons to both perspectives. I’ll leave that dissertation to the other financial experts on this board.

As someone who is now in their 50’s, I agree that young people should pursue whatever path leads them to complete financial independence at least by the time they are 50. That is the path my wife and I pursued, and it has worked out well. We have encouraged our children to do the same.

IMO, in today’s extremely volatile economy, it would seem to be even more important for young people to plan their finances well, since now, more than ever, employers seem to be replacing older workers with a newer model–unless, of course, you have union protection–and that is an entirely different conversation.

Making a lot of money is not nearly as difficult as sustaining it for the duration of your lifetime. I can’t tell you how many people I have known who “used to be millionaires.”[/quote]

Second that. And very good point about how hard it is to sustain than making the money.

[livinincali]

[quote=HLS]
Obviously not available today, but what if CD rates were 6%+ and the interest stream paid the full payment on an amortized mortgage ?[/quote]

Banks aren’t in the business of losing money. How would a condition where 30 year fixed mortgages are 3.5% and CD rates are 6% ever exist? Banks would be losing money like crazy if that condition ever came to pass.

Individually someone might be able to borrow at 3.5% and invest to earn a return at 7% but that can’t be the case at the macro level because the math doesn’t work. Almost everybody thinks that somehow they can win at this game of borrow low and earn a spread on the return. Of course plenty of people end up rich doing that and plenty of people end up in bankruptcy doing that.

[Author]

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