Author Topic: Atypical Mortgage Paydown Strategy  (Read 6872 times)

RoseRelish

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Atypical Mortgage Paydown Strategy
« on: June 06, 2012, 10:29:27 AM »
Please help me find holes in this strategy!

We can all agree that paying down the mortgage is prudent - not if there are better potential returns to be had - just that reducing debt is a good move. Anyhow, the gist of my mortgage paydown strategy is that paying small regular amounts to reduce principal is not the best choice because all it does is eliminate payments at the end of the loan life while providing no near-term cashflow benefit. If the money that would have been allocated to reducing principal were instead put into a savings account, you could still "feel" like you are reducing debt while having a massive liquidity/cash cushion in case something unexpected happens. Once this savings account's value exceeds the loan amount, pay it off! Instantly, your cash flow improves for giving up the cash.

Making an extra $500/month payment on a $200k mortgage from day 1 eliminates ~175 monthly payments (at a 4% rate) but you get no access to this cash or benefit of reduced monthly payments. (Unless you get a HELOC or something, but there are fees etc. associated vs. no fees with a savings account.)

Is this clear enough? Again, instead of ACTUALLY making the extra payment to the bank - just put the money in a savings account until the value is more than the loan. You get access to the money if needed and still attack debt with the same vigor.

fiveoh

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Re: Atypical Mortgage Paydown Strategy
« Reply #1 on: June 06, 2012, 10:35:10 AM »
I believe by paying down the mortgage you are paying down the principal and thus reducing the amount of interest you are paying.  I.e. if you have a 100k mortgage @ 4% and pay 1k extra towards the principal, now next month you are paying interest on 99k instead of 100k.  Use an amortization calculator and you can see how much you will save in interest by paying it down early. 

AJ

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Re: Atypical Mortgage Paydown Strategy
« Reply #2 on: June 06, 2012, 10:53:22 AM »
It probably goes without saying, but the cost of this strategy is the difference in interest between your savings account and your mortgage. If you pay 4% and make 1%, you are coming out behind. If you invest elsewhere to increase your return, you increase risk and the funds aren't exactly liquid (market may be in a downturn when you need them).

That doesn't mean it isn't a good strategy, but there is a cost-benefit analysis everyone has to go through when deciding on saving vs. investing vs. debt pay-down.

In other countries, I have heard they have a savings account/mortgage hybrid that sounds appealing. I hope it makes its way here...

twinge

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Re: Atypical Mortgage Paydown Strategy
« Reply #3 on: June 06, 2012, 10:56:08 AM »
I agree that it's less risky to set aside cash to pay off your mortgage in a lump sum rather than dripping it in all along.  If you have an emergency, that cash is more flexible than a HELOC.  Also, if down the road your mortgage interest rate seems ridiculously low relative to the interest rates you can earn on cash you'll happily drag out the mortgage as long as you can.  And cash can be readily used if you find an opportunity more promising to invest in than paying off the mortgage in the future.   To be sure, at this moment in time, interest rates on no-risk savings are less than mortgage rates, but if you even invested just 20% of those savings in equities (or whatever else you research that is higher risk) you'd probably come off better than paying off a lower than 4% tax deductible interest rate and still keep liquidity.

This is what I do:
With my rate (recent no-cost re-fi to 3.875  for 20 yr fixed loan, about 275K left on a loan for a house appraised at about 450K) I'm  reluctant to pre-pay my mortgage, but I have a conscious awareness of a "bucket" of investments I will use to either cash flow or pay off this mortgage in ER.  While this bucket is currently invested in a balance of stocks/bonds, as I get closer to ER, I will likely shift enough into safe investments to cash flow the mortgage if the the interest rate I can receive on cash is higher than 4% or to pay off the mortgage if it is not. So far, I have consistently been able to make far above 4%, and I can comfortably pay my mortgage on my income if these investments were to tank. Plus, we plan to sell and move to a lower COL area in retirement.

« Last Edit: June 06, 2012, 11:40:33 AM by twinge »

smedleyb

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Re: Atypical Mortgage Paydown Strategy
« Reply #4 on: June 06, 2012, 10:58:22 AM »
Is this clear enough? Again, instead of ACTUALLY making the extra payment to the bank - just put the money in a savings account until the value is more than the loan. You get access to the money if needed and still attack debt with the same vigor.

It's exactly what I do.  No incentive/rush to retire multi-year, sub 4%, tax deductible debt at the expense of ever greater levels of liquidity.  I don't have a specific account where I deposit hypothetical pre-payments into, but at a certain point -- likely 5 years from now -- I'll be able to retire my mortgage using about  10% of my available liquid assets.  In other words, I don't even want to feel it when I cut that last, big check to my bank and retire the mortgage 5-6 years early.  And I definitely don't ever want to be in a position where I have to have the bank's permission to access the equity in my home.   

skyrefuge

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Re: Atypical Mortgage Paydown Strategy
« Reply #5 on: June 06, 2012, 11:01:00 AM »
If you truly need that amount of cash saved on-hand, then sure.  Or, if you can get a return greater than your mortgage rate in a "savings account".  But in general, if you intend to pay of your mortgage early anyway, it's a bad idea to delay.

If you put $500/month into a 0% savings account, it will take approximately 18 years before you've saved enough to pay off the remaining principal on the mortgage.  Over those 18 years, you'll pay $115,300 in interest.

If you put the $500/month into extra principal payments on the mortgage, you'll have it paid off in 15.3 years and have paid a total of $67,877 in interest.

velocistar237

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Re: Atypical Mortgage Paydown Strategy
« Reply #6 on: June 06, 2012, 11:09:37 AM »
We can all agree that paying down the mortgage is prudent - not if there are better potential returns to be had - just that reducing debt is a good move.

Some of us think that a mortgage is the safest kind of leverage out there for a Mustachian, and that paying it off as slowly as possible (never would be the best case) would give you the best expected return.

Secret Stache

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Re: Atypical Mortgage Paydown Strategy
« Reply #7 on: June 06, 2012, 11:14:35 AM »
I make 1 or 2 lump principal payments a year.  I was doing the monthly thing but recently switched to the less frequent payments.  It really depends on how soon you are looking at paying it off.  I am scheduled to be done at the end of 2014 regardless if I pay monthly or yearly and the difference in intrest is not very much. 

RoseRelish

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Re: Atypical Mortgage Paydown Strategy
« Reply #8 on: June 06, 2012, 11:40:57 AM »
If you truly need that amount of cash saved on-hand, then sure.  Or, if you can get a return greater than your mortgage rate in a "savings account".  But in general, if you intend to pay of your mortgage early anyway, it's a bad idea to delay.

If you put $500/month into a 0% savings account, it will take approximately 18 years before you've saved enough to pay off the remaining principal on the mortgage.  Over those 18 years, you'll pay $115,300 in interest.

If you put the $500/month into extra principal payments on the mortgage, you'll have it paid off in 15.3 years and have paid a total of $67,877 in interest.

Thanks for the actual numbers. I guess I didn't run them - just thought about how it would work. My head's calculator didn't carry a zero! (joking). So the "normal" way of paying down a mortgage - in more normal amounts rather than all at the end probably does make the most sense - assuming the liquidity isn't needed...unless the "savings account" gets a return above the mortgage rate. I really appreciate this help!

gooki

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Re: Atypical Mortgage Paydown Strategy
« Reply #9 on: June 06, 2012, 02:59:13 PM »
At 3% and below it's a great strategy provided you invest the spare money and not succumb to lifestyle inflation.

You do have to ask yourself, if one could guarantee a return better than the rate the mortgage lender is offering you, then why would they offer you the money and not invest it themselves?

Making an extra $500/month payment on a $200k mortgage from day 1 eliminates ~175 monthly payments (at a 4% rate) but you get no access to this cash or benefit of reduced monthly payments.

If you ever have to refinance you instantly get the benefit of reduced monthly payment if you have been paying down additional capital. And since you've paid less interest, the reduced monthly repayment will be less than if you had hoarded your spare cash.

In my personal situation I have no regrets about additional mortgage repayments. Fixed rate was 7.45% for five years, we increased our monthly repayments by $800, and made semi regular $10,000 bulk repayments. And a final repayment of $80,000 by semi timing the market in Feb 2011 and selling up all our shares (Share were purchased via company stock purchase plan at 15% reduced rate - i.e. better than my mortgage rate).


pca

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Re: Atypical Mortgage Paydown Strategy
« Reply #10 on: June 06, 2012, 04:17:12 PM »
This is what I do:
With my rate (recent no-cost re-fi to 3.875  for 20 yr fixed loan, about 275K left on a loan for a house appraised at about 450K) I'm  reluctant to pre-pay my mortgage, but I have a conscious awareness of a "bucket" of investments I will use to either cash flow or pay off this mortgage in ER.

I like that plan, but I think your 20 year fixed is too conservative: you're paying out the nose for rate security you don't need. You have a bunch of investments that can be put towards the mortgage at any time, so you already have security. Why pay for it twice?

Take advantage of lower rates! Say you refinanced to a 5/1 at 2.5%. That would save you over $10 A DAY in interest.

Our story is we refi'd from a 30 year fixed at 5% to a 5/1 ARM at 2.5%. This saved us $27 per day (!). When it resets in five years, if rates are still low we'll refi again; if they've gone up, we'll put what we've saved towards the mortgage, and that reduced principal ought to prevent our total payment from going up.

Note that ARMs typically have a lifetime rate cap (in our case, I think it's around 8%), so the worst-case is still totally manageable.

sol

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Re: Atypical Mortgage Paydown Strategy
« Reply #11 on: June 06, 2012, 05:27:41 PM »
You do have to ask yourself, if one could guarantee a return better than the rate the mortgage lender is offering you, then why would they offer you the money and not invest it themselves?

This is the lynchpin in the whole operation.  Banks have a lot of very smart people spending 40 hours/week trying their hardest to figure out how to maximize the return on their investments.  If they thought they could do much better than your mortgage, they would have put their money somewhere else instead.

It's exactly the same argument you hear about trying to time the market, only in reverse.  Lots of other people who are smarter than you are already trying to price in future returns, and if you bet against them you're swimming upstream. 

Which is fine, as long as you think you know something they don't.

Mr Mark

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Re: Atypical Mortgage Paydown Strategy
« Reply #12 on: June 06, 2012, 06:32:31 PM »
You do have to ask yourself, if one could guarantee a return better than the rate the mortgage lender is offering you, then why would they offer you the money and not invest it themselves?

This is the lynchpin in the whole operation.  Banks have a lot of very smart people spending 40 hours/week trying their hardest to figure out how to maximize the return on their investments.  If they thought they could do much better than your mortgage, they would have put their money somewhere else instead.

It's exactly the same argument you hear about trying to time the market, only in reverse.  Lots of other people who are smarter than you are already trying to price in future returns, and if you bet against them you're swimming upstream. 

Which is fine, as long as you think you know something they don't.




Except it's not a free market. The Fed and almost everyone else (Freddie et al) are keeping rates low. A 30 year fixed at, what, 3.7% or so? Yes please. Remember that's nominal. It includes inflation.

If we can't beat 1% real return long term I'd think a lot of plans are in trouble...