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Mortgage Prepayment Scheme Not Always Best Course of Action - 2007-03-03 |
One of the more popular consumer radio shows features callers from all over the country shouting "I'm debt free!" Most of the participants have had to struggle to reach this status, and can now tell the world that they have paid off not only all their credit card bills, but their home loan as well. The host dutifully informs the callers that they have made the right choice, and that all debt is bad.
Unfortunately, I beg to differ.
While I understand the basic aversion to debt that the radio host espouses, I believe that debt is inherently neither good nor bad. Instead, it is my belief that how we use debt makes all the difference.
Let's begin with the underlying concept that your house does not care whether or not you have a mortgage balance carried on the property. The house doesn't know what your balance is, and the house will go up or down in value regardless of any existing mortgage balance.
Let's add to that the fact that tax-deductible interest costs us less than a comparable sum of non-deductible interest. So if we have to have any debt at all, it's better if that interest expense is tax deductible, as is the case with most home mortgage interest.
And finally, let's try to reach some conclusions about the nature of debt itself, and whether or not all debt is bad. May I submit for your consideration the following thoughts:
1. For most Americans, owning their own home is one of the best investments they have ever made. If everyone who bought a home had to save up enough to pay cash for their home, we would have far fewer homeowners today.
In addition, because home mortgage interest is tax deductible, the effective cost to borrow when you buy a home is extremely low.
For example, if you borrowed $100,000 today at about 6.0% on a thirty year fixed rate loan, your annual interest expense would be about $6,000. But because you can deduct all of that $6,000 from your taxable income, you save approximately one third in dollars you would otherwise be paying in state and federal taxes. Thus, your effective interest cost is closer to $4,000, or about 4 percent.
This example assumes you already itemize your income tax return, but even if you don't, you probably will begin doing so now that you own a house.
2. There is no mathematical magic in mortgage prepayment.
Prepaying your mortgage is guaranteed to earn you exactly the rate you would be paying on the loan, less any tax deduction you receive. In other words, you are effectively saving the 4 percent cost we looked at above. No more and no less.
Mortgage prepayment schemes love to play games with numbers and point out that, over the life of the loan, you can save as much as $100,000 or more by paying extra monthly payments.
The reality is that very few of us actually keep a thirty year loan until its natural conclusion. Instead, we sell the house and pay off the loan, or we refinance based on an appreciated value. Either action defeats the magical numbers of the prepayment brochures.
The truth is that prepaying your mortgage only helps you if you have extra funds available, and those funds are earning less than the interest rate you plan to prepay.
For example, if you can afford to pay an additional $100 per month on your home loan, it will cause that loan to pay off early, and interest dollars will be saved. But if you were able to put that same $100 per month into a savings account that paid the same 6 percent interest, you will arrive at the exact same point financially. And you maintain the option of having access to your savings in the event of an emergency.
3. By prepaying that $100 per month on your home loan, you experience what is called "lost opportunity" cost. In other words, you gave up the opportunity to invest that money in an alternative investment, one that might have been able to pay you more than the cost of your home loan.
So if you were able to put that $100 per month into any other investment which consistently pays more than the rate on your current mortgage, you would come out ahead. That might be a 401(k) with some matching (read that "free") employer contributions. Or that might be dollar cost averaging into a high quality stock mutual fund.
Or that alternative investment might be something as simple as buying a washer and dryer so you can avoid the weekly expense of driving to the laundromat and paying to wash and dry your clothes. In this example, we can even ignore the value of your personal time spent at the laundromat.
4. In addition to the concepts we have already examined, I recognize that there is, in many cases, great psychological value in owning your own home free and clear of any debt.
Many of our parents lived through the Great Depression, and a terrible time it was. One of the enduring lessons of that era was this: if you carried a mortgage on the farm, you might lose the farm. Those of us who are waiting for the next depression might wait more comfortably if we know we carry no debt on the house.
But the truth is this: the likelihood of an extreme economic depression like the one experienced last century is extremely low.
Instead of an irrational fear of debt, I prefer to think of debt as I would electricity.
We all live in homes with electrical wiring in the walls all around us, but most of us never think about the danger of living so close to electricity. That's because we have confidence that it is being controlled safely.
Even though we believe it to be safe, we still treat electricity with respect. For example, if we have children in the house, we don't allow them to stick their fingers in the plugs because they don't know what might happen. Likewise, if we experience a serious electrical problem, we call a professional electrician.
That being said, we all benefit from the many wonderful things electricity does for us in our daily lives. Would you consider living without electrical
service just to enhance your current level of safety?
There are constructive uses for debt and there are destructive uses for debt. So long as we use debt wisely and treat it with respect, it can be a help and not a hindrance in our lives.
In my opinion, the most constructive use of debt that most of us will ever make is the purchase of a home. If that is your situation, you have my permission to call your favorite radio host and yell "I'm in debt" and hold your head high!
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