Should you pay off your mortgage early?

In today’s low interest rate environment, whether or not to pay off a mortgage early is a question which is often asked and debated.  Oftentimes one could benefit more by paying off a loan over a longer time frame, as inflation will tend to degrade the real value of the loan principal over time.  In the current low interest rate environment the carrying costs of the debt are minimal.  Because a mortgage is a long term obligation, the additional funds can instead be invested in a diversified portfolio of equities and bonds, preferably in a ROTH IRA or ROTH 401k.

Many of the arguments for early mortgage payoff were valid in prior decades, when interest rates were much higher.  Take, as an example, the 1990’s when the 30 year rate hovered between 7% and 10%.  In these years, it was usually advisable to pay off a loan early, as significant savings could be realized by doing so.  As an example, consider a $500,000 30 year mortgage at an 8% rate, which was a typical situation in the 1990’s.  By paying off such a mortgage 10 years early, savings of over $300,000, or 60% of the loan principal, could be realized.

Contrast this with a $500,000 30 year loan at a 3% rate, which is more typical in today’s environment.  Paying off this mortgage 10 years ahead of schedule would result in savings of less than $100,000, or about 20% of the loan principal.  An argument could be made to pay off such a mortgage later rather than sooner, as one could more easily afford to carry the principal and invest the additional funds elsewhere.  Meanwhile, inflation will tend to reduce the real value of the loan principal over the 30 year period.

 

Home equity line of credit and loan

Owners of real estate, including home owners, are able to access the equity in their property in several ways, including reverse mortgages, liquidation of the underlying real asset, and using the property as collateral for a loan.  A home equity line of credit or loan is a way to use the equity in a piece of real estate as collateral for a loan or line of credit.  The loan or line of credit places a lien on the real estate that is used as collateral, which has the effect of reducing the amount of equity in the real property.  Here we will discuss the situation where a homeowner uses their primary residence as the collateral for this credit.  In this scenario, the interest on the loan or line of credit is typically tax deductible.

Home equity loan versus line of credit

A home equity line of credit (frequently known as “HELOC”) is a facility which can be accessed or drawn upon by the borrower.  Funds can be drawn during the draw period, and the payment amount during the draw period is usually based upon the amount drawn and the interest rate on the loan.  Oftentimes it is only required to make interest payments during this period, and in some situations no payment is required.  The length and terms of the draw period vary.  Once the draw period ends, the repayment period usually begins, and the required payments during the repayment period are typically higher than during the draw period.  In some cases, a single lump sum payment, known as a “balloon payment”, is due at the end of the draw period, which can expose the borrower to significant risk.  Interest rates on a HELOC are usually variable.

A home equity loan is a lump sum loan amount, secured by the equity in the home, which must be paid according to a fixed term or schedule.  Unlike with a HELOC, which usually has a variable interest rate, the interest rate on a home equity loan is typically fixed.

Any home equity loan or line of credit contract or agreement should be understood carefully and in detail before executing or signing.  Careful attention should be paid to interest rates and repayment periods and terms.  Keep in mind that you typically have the right to cancel any home equity loan or line of credit contract within three days of signing.

Owning versus renting

Owning versus renting: which is better?  We will provide a basic comparison between owning and renting a home.  Oftentimes a home is thought of as an investment, however we believe that it is more of a consumption item than an investment item, with the added benefit of serving as an inflation hedge for the owner.

As an example of this, consider a 30 year fixed mortgage note which is paid exactly as agreed.  Over this 30 year period, rents and wages will rise, however the mortgage payment will remain constant.  There may be times when housing prices rise at a substantial rate however research has shown that in the long run housing has merely kept pace with inflation since 1890.

A large part of this is due to the large transaction costs incurred during purchase and sale of real estate.  These costs are much higher for a typical consumer purchasing a home than they are for typical professional real estate investors, who purchase real estate regularly and thus enjoy an economy of scale due to their expertise and the volume of transactions which they engage in.  Owning a home also results in additional time which must be spent by the homeowner in maintaining the home, while renting will typically require less time and expense on maintenance.

Mortgage financing

For many individuals and families the purchase of a home is the largest purchase they will make in their lifetime, and determining how much to spend is therefore very important.  How much of a house you can afford  will depend on the amount of your income as well as the stability of your income.  The lender or originator of the mortgage will be happy to tell you how much home you can afford according to their standards, but these standards are designed to manage their risk, not yours.  Although oftentimes your interests happen to be aligned, it is important to do your own careful analysis of your financial situation before purchasing a home.  In this article we will discuss ways to determine how much home you can purchase using an analysis of your income, cash flow, assets and liabilities, and financial objectives and goals.

Bank/lender underwriting standards

The bank, lender or originator of the mortgage has certain guidelines which they use to determine whether or not you meet their criteria.  The two most important metrics which they use are the “front end ratio”, which is designed to measure the house payment in relation to your gross income, and the “back-end ratio”, which is designed to measure your total long term liabilities in relation to your gross income.  Other factors are used as well, but these two metrics are the ones which are most easily quantifiable.  A standard which is frequently used for a good credit score is a 28% front-end ratio and a 38% back-end ratio.  In other words, if your gross monthly income is $10,000 your principal, interest, taxes and insurance can not exceed $2,800 per month.  Similarly, your principal, interest, taxes, insurance, installment loan payments, credit card payments, and student loan payments combined can not exceed $3,800 per month.  Note that loans which are scheduled to be paid off within the next 12 months are considered a current, not long term liability and are thus not included when calculating the back-end ratio.