Question about my mortgage

[Matt (Semper Fi)]

Hello friends.  About 11 years ago, my wife and I bought a house with an ARM (not knowing at the time quite what we were doing).  The opening interest rate was around 6%, and was locked in for 3 years (or thereabouts).  After that, it could only adjust up to one full point per year.  Well, since that time, the rate has only gone down, and for the past two years, our rate has sat at 2.25%.  Our current minimum payment is about $412.00, and we have been pumping anywhere from $500 to $1,000 extra a month towards the payments for a few years now.  We now owe only $35,000.00 on the loan.  A little more info: I am a school teacher (11 years under my belt), and my wife is an area supervisor for Maverik Country Stores.  Together, we net about 80k, sometimes closer to 95k with bonuses.

My question is this: should we keep up what we are doing and have the house paid off in a couple of years, or should we pay the minimum ($412) on the mortgage and invest the extra that we have been paying?  I ask, because all the extra money we are paying is only getting us a 2.25% return (if I understand MMM's math correctly), while I could get a better return if I invest the money in other ways.  One of my concerns is that there is the chance that the mortgage interest rate could increase by one point this year, and another point next year, etc.  Paying off the loan early will help me avoid potentially higher interest rates.  I also am the type of person that would supremely enjoy having a paid-off house.  I would like to get into owning a rental property, but I would not be comfortable investing in a rental until I have the primary residence paid off.  Anyway, now I am babbling.  Back to the question:  should we keep up what we are doing and have the house paid off in a couple of years, or should we pay the minimum ($412) on the mortgage and invest the extra that we have been paying?

Thanks for any forthcoming advice!

[ShoulderThingThatGoesUp]

When the rate goes up, it seems like you'll be able to crush it, right? It's $35,000 and it'll keep going down every month even while you pay the minimum. 2.25% is great to pay the minimum on; when it goes up beyond a level you're comfortable with, start putting more in every month - clearly you have the free cash flow to do it. You'll have ample warning of a coming hike by checking in on current rates a few times a year. Even in three years it can only get to 5.25%, at which point I would want to pay it off, but 5.25% isn't horrible.

Are you maxing out your tax-deferred retirement accounts? That's an easy win with that money every month - even if you're in the 15% bracket I can't imagine the rate on your loan will ever be anywhere near that in its remaining lifetime.

[Matt (Semper Fi)]

Thanks for the reply, Mr. Shoulder!  It's hard to shake the "brainwashing" (probably too harsh a term) that I have received from the Dave Ramsey program of having the "paid-off home mortgage".  The man's program did help us get out from under a mountain of debt, but as I study other forums and blogs, I am finding that there are definitely different opinions.  I completely understand the comfort and peace of mind of having a paid-off house, but I also like the idea of growing my 'stache more quickly with better returns, rather than quickly paying off a 35k loan with 2.25% interest.

As far as our investments, my wife's 401K contributions are up to the 8% match, and my Roth IRA is maxed out.  We could definitely put some of the freed up funds into maxing out my wife's Roth IRA contributions.  Regarding my own 401K:  The school district does not offer a match, but it does automatically put in a certain percentage each month (something like 1.7% of my salary) regardless of whether I contribute or not.  Would it be advisable to go ahead and max out my 401K as well, even without a match?

[ShoulderThingThatGoesUp]

Thanks for the reply, Mr. Shoulder!  It's hard to shake the "brainwashing" (probably too harsh a term) that I have received from the Dave Ramsey program of having the "paid-off home mortgage".  The man's program did help us get out from under a mountain of debt, but as I study other forums and blogs, I am finding that there are definitely different opinions.  I completely understand the comfort and peace of mind of having a paid-off house, but I also like the idea of growing my 'stache more quickly with better returns, rather than quickly paying off a 35k loan with 2.25% interest.

As far as our investments, my wife's 401K contributions are up to the 8% match, and my Roth IRA is maxed out.  We could definitely put some of the freed up funds into maxing out my wife's Roth IRA contributions.  Regarding my own 401K:  The school district does not offer a match, but it does automatically put in a certain percentage each month (something like 1.7% of my salary) regardless of whether I contribute or not.  Would it be advisable to go ahead and max out my 401K as well, even without a match?

Almost certainly - but are you sure you have a 401k from a school district, and not a pension? It's not unheard of and it's probably way better for the taxpayers to have a public 401k, but most teachers seem to have pensions.

What tax bracket are you in?

[Matt (Semper Fi)]

My 401K is through URS (Utah Retirement Services), same as my pension plan, and they seem to be two separate accounts.  As far as tax brackets, with my limited knowledge, I believe we are in the 25% tax bracket, since our combined gross income (married filing jointly) is between $74,901 - $151,200.   I hope I understand tax brackets correctly, but please correct me if I am wrong.   

[frugaliknowit]

A couple of things to consider:

1.  Your mortgage terms are crappy, plain and simple.  You would not be able to refinance on good terms, because the amount is too small (unless you took some cash out).  You've been very lucky up until now.
2.  Your mortgage probably provides no tax benefit, since the balance is so low.
3.  Getting rid of it would give you more flexibility going forward, relieve yourself of its administration, and diversify your investing (kind of like buying a bond or an annuity...).
4.  The risk level of prepaying mortgage versus buying VTMAX is NOT the same.  I wouldn't consider the prepaying as a 2.25% return, since the rate is floating.
5.  How would you feel if rates went up, while stocks went down?

There's no correct answer here, though I lean towards blowing it to smithereans...

[ShoulderThingThatGoesUp]

If you're putting money into (non-Roth) retirement accounts, you might easily get in to the 15% bracket. We have a slightly higher income than you guys and maxing out my 401(k) puts us in the 15% bracket. Especially since you need to take the ~$10,000 standard deduction off of your gross income, or more if you have enough to itemize deductions.

Either way 401(k)s are a pretty great deal in this income range.

If you find the investment options in your 401(k) confusing, which they usually are, people in the Investor Alley subforum would be happy to help you pick which is the best deal.

[chad]

My vote would be to max out your 401k accounts and your Roth IRAs. If my math is correct, that should take about 47k. That should leave at least enough to live on if you're mustachian about your expenses. Depending on how much you're making, you might be able to also take a bite out of the mortgage. If I were making 100k and had your options, I'd be really hoping to max out all accounts and take down the mortgage within three years.

[Matt (Semper Fi)]

Frugal, those are some great points to consider!  Thank you.  And shoulder, I had not considered that increasing my 401K contributions, even without a match from the employer, may put me in a lower tax bracket, which would be very awesome.  I can't really go off of a flat salary, since my wife bonuses a couple of times per year (and they are irregular amounts), and I may pick up a stipend here and there over the course of a year.  But maybe we could err on the high side.  I'll run a few numbers and see what shakes out.  Chad, I like the way you think - nuts and bolts of the matter! A huge thanks to the three of you that have chimed in so far.

[ShoulderThingThatGoesUp]

Since it sounds like you've recently started paying attention to where your money goes - and we've all been there - you might want to do a full case study by following the instructions in this topic. It sounds like you're doing a great job but there's always good suggestions.

[Jack]

A couple of things to consider:

1.  Your mortgage terms are crappy, plain and simple.  You would not be able to refinance on good terms, because the amount is too small (unless you took some cash out).  You've been very lucky up until now.
2.  Your mortgage probably provides no tax benefit, since the balance is so low.
3.  Getting rid of it would give you more flexibility going forward, relieve yourself of its administration, and diversify your investing (kind of like buying a bond or an annuity...).
4.  The risk level of prepaying mortgage versus buying VTMAX is NOT the same.  I wouldn't consider the prepaying as a 2.25% return, since the rate is floating.
5.  How would you feel if rates went up, while stocks went down?

There's no correct answer here, though I lean towards blowing it to smithereans...

I agree with frugalknowit that the fact that your mortgage is adjustable instead of fixed makes a difference. I've been vociferously arguing against paying off fixed-rate mortgages early in another thread, but having one that floats with inflation removes one of the primary advantages to keeping it around.

If I were in your situation, I would do one of the following:

• Refinance to a 30-year fixed with at least enough cash out to get the best rate, then max out all tax-deferred accounts and invest whatever's left in taxable (and yes, that means investing all future surplus cash flow and the entire lump sum from the refi)
• Stop paying the mortgage ahead and invest the money in a taxable account instead, to pay off the mortgage all at once if and only if the interest rate rises above 4-5%.

Option #1 is better, but (I assume) harder for a recovering Dave Ramsey-ite to accept.

[tweezers]

I agree with frugalknowit that the fact that your mortgage is adjustable instead of fixed makes a difference. I've been vociferously arguing against paying off fixed-rate mortgages early in another thread, but having one that floats with inflation removes one of the primary advantages to keeping it around.

If I were in your situation, I would do one of the following:

• Refinance to a 30-year fixed with at least enough cash out to get the best rate, then max out all tax-deferred accounts and invest whatever's left in taxable (and yes, that means investing all future surplus cash flow and the entire lump sum from the refi)
• Stop paying the mortgage ahead and invest the money in a taxable account instead, to pay off the mortgage all at once if and only if the interest rate rises above 4-5%.

Option #1 is better, but (I assume) harder for a recovering Dave Ramsey-ite to accept.

Number 2 is great advice.  You're going to have a really hard time getting a mortgage for $35K, but I think you can feel reassured that rates are unlikely to raise significantly any time soon.

[Matt (Semper Fi)]

I do like the sound of the second option over the first.  I don't know what interest rates will do in the near future, but I DO know that every year, they have adjusted down almost a full point.  Even if it does go up one point next year, it's still at a killer rate.  Assuming two years of full point growth on the interest rate, that would give me two years of pumping some serious cash into my savings before I start getting alarmed by the interest rate (would be at 4.25% by that time).  Then all engines stop, and pay that hag off.

[kendallf]

I agree with frugalknowit that the fact that your mortgage is adjustable instead of fixed makes a difference. I've been vociferously arguing against paying off fixed-rate mortgages early in another thread, but having one that floats with inflation removes one of the primary advantages to keeping it around.

If I were in your situation, I would do one of the following:

• Refinance to a 30-year fixed with at least enough cash out to get the best rate, then max out all tax-deferred accounts and invest whatever's left in taxable (and yes, that means investing all future surplus cash flow and the entire lump sum from the refi)
• Stop paying the mortgage ahead and invest the money in a taxable account instead, to pay off the mortgage all at once if and only if the interest rate rises above 4-5%.

Option #1 is better, but (I assume) harder for a recovering Dave Ramsey-ite to accept.

Number 2 is great advice.  You're going to have a really hard time getting a mortgage for $35K, but I think you can feel reassured that rates are unlikely to raise significantly any time soon.

What I believe Jack is advocating is not to get a mortgage for $35k, but some higher number, up to 80% of the value of the house (leaving 20% equity to avoid PMI and the like).  Then you invest the cash out, pay your new low rate fixed interest mortgage, and invest all extra monthly cash.  Now you have a fixed rate mortgage as an inflation hedge and you are earning stock market returns on the invested cash out, as well as pouring future income into investments rather than pre-paying a variable rate loan.

This option is better mathematically but it may be hard to get there from a Ramsey "no debt" mindset.

[Matt (Semper Fi)]

Thank you, Kendall, I appreciate the clarification.  And you're right -- my debt-paranoia runs VERY deep indeed, haha. 

[Jack]

I agree with frugalknowit that the fact that your mortgage is adjustable instead of fixed makes a difference. I've been vociferously arguing against paying off fixed-rate mortgages early in another thread, but having one that floats with inflation removes one of the primary advantages to keeping it around.

If I were in your situation, I would do one of the following:

• Refinance to a 30-year fixed with at least enough cash out to get the best rate, then max out all tax-deferred accounts and invest whatever's left in taxable (and yes, that means investing all future surplus cash flow and the entire lump sum from the refi)
• Stop paying the mortgage ahead and invest the money in a taxable account instead, to pay off the mortgage all at once if and only if the interest rate rises above 4-5%.

Option #1 is better, but (I assume) harder for a recovering Dave Ramsey-ite to accept.

Number 2 is great advice.  You're going to have a really hard time getting a mortgage for $35K, but I think you can feel reassured that rates are unlikely to raise significantly any time soon.

What I believe Jack is advocating is not to get a mortgage for $35k, but some higher number, up to 80% of the value of the house (leaving 20% equity to avoid PMI and the like).  Then you invest the cash out, pay your new low rate fixed interest mortgage, and invest all extra monthly cash.  Now you have a fixed rate mortgage as an inflation hedge and you are earning stock market returns on the invested cash out, as well as pouring future income into investments rather than pre-paying a variable rate loan.

This option is better mathematically but it may be hard to get there from a Ramsey "no debt" mindset.

Yep. Getting a mortgage for $35k would be hard, but getting one for anywhere between $50K or so and 80% LTV should be fine. It has a couple of important advantages compared to option 2:

• You get a lump sum to invest now. This is the least important benefit.
• Even though the rate would be maybe 1-1.5% more than your ARM in the short term, that rate is locked in for 30 years! Besides, the extra return from the lump sum in the previous point very likely compensates for the extra interest on day 1 anyway.
• Here's the most important part: since you don't have to worry about suddenly withdrawing your investments to pay off the thing due to interest rate fluctuations, you can invest in your retirement accounts instead of taxable. At $75-$150k gross income you're paying a lot of taxes, plus you're in the area where extra 401k contributions can mean the difference between making the cutoff to deduct your IRA contributions or not. So not only do you save 25% in the current year, you also save taxes on the growth for all the years between now and when you withdraw, and you can make those tax savings compound by making more income eligible for them!

[Matt (Semper Fi)]

I'll do my homework on that, Jack; you make some damned provocative points there!  I would not classify myself as a risk-taker -- I had two small businesses go teats up, mainly because I got cold feet and lacked confidence in my abilities.  However, that being said, at this point in my life and career, I'm serious enough about leaving the rat race sooner than later, that I am willing to push out of my comfort zone.  Thanks again.

[Shor]

Naturally, if you consider yourself to tend more to the conservative side, being free from the mortgage is absolutely a worthwhile goal.

Thing about pulling a reverse mortgage is that you're leveraging future earnings to pay it off. Now, that might be 'easily' gained from stock market growth, sure. But it might not, and if it's not, it will have to be covered by income, and if that unsettles you, you definitely need to think longer on that one.

That being said, not prepaying the mortgage any further at the current rate sounds like a great plan. If rates start rising above 4 go ahead and slay the beast. No one will tell you it was a mistake to pay off that rising interest debt, Especially if it fits nicely in with your goals.

[Matt (Semper Fi)]

Thank you, Shor.  I am definitely leaning more towards either:

A) Pay off the mortgage as quickly as possible, within 18 months, and be rid of it, and then supercharge my savings, or

B) Take my time paying it off, and divert that extra cash (that has been going towards double and triple payments) into other savings vehicles. 

My sister is a realtor, and the company for which she works sells commercial REITs.  She will be sending me some information on those.  From what I have read, they can be a pretty nice addition to a portfolio.  Again, I thank everybody for their input.