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To
Prepay or Not to Prepay
By Ruth Simon
In
these troubling times for investors, there's no place like home.
That's the thinking of Adam Eisenson, a fourth-grade teacher who
lives in Hillsborough, N.C. This summer, Mr. Eisenson stopped making
contributions to the 403(b) retirement savings plan offered by his
school. He's now applying the extra $700 a month to pay down his
30-year mortgage, which carries a 7-1/8% interest rate.
"Even though I love the market and have an online trading account,
I was getting really disappointed," says Mr. Eisenson, whose
mortgage payment would normally total $1,065 a month. Mr. Eisenson
says he plans to continue making the extra payments "until
after this whole war thing calms down and we start seeing a rebound."
With stock prices plummeting and the 10-year Treasury note (which
calls the tune for mortgage rates) currently yielding just under
4.6% some investors have decided that prepaying their mortgage is
the way to go. The basic premise is simple: Prepaying a mortgage
offers a return equivalent to the interest rate on your mortgage
minus any tax benefit. Thus, spending $10,000 to prepay an 8% mortgage
will save you $800 a year, the same guaranteed yield as an 8% Treasury
bond.
Taxes are what make the calculation more complicated. If
you're in the 27% tax bracket, losing the deduction on $800 of interest
will reduce your net savings to $584 a year, or a 5.84% yield. But
even that thrashes the current yields on bonds and bank accounts,
most of which are taxable.
"You get a higher return paying off an 8% mortgage than investing
in a 5% Treasury," says Robert Van Order, chief economist for
Freddie Mac, the government-sponsored mortgage finance company.
Because of lower tax rates and limits on itemized deductions, the
tax advantage of a mortgage isn't what it used to be," he adds.
So far, any increase in prepayments hasn't shown up in mortgage
statistics. The most recent data, from the second quarter, showed
many people were doing exactly the opposite: opting for cash out
refinancings that increased their mortgage payments.
Indeed, many financial planners say that now isn't a good time to
prepay mortgages, especially when stocks already have tumbled to
more attractive valuations. They say investors over the long run
will be better off plowing any extra money into the stock market,
which historically has produced average annual returns of 10% or
better.
"I can't in good conscience suggest that clients pay down"
6.5% and 7.5% mortgages, says Linda Lubitz, a financial planner
in Miami.
Ross Levin, a financial planner in Minneapolis, says he had been
recommending that clients invest in their mortgages as a way to
"reposition some assets." But Mr. Levin adds that he's
more reticent to do it now because mortgage rates have become "so
cheap."
But in a time of political and economic turmoil, many people want
the sure thing. Last week, Mark and Nancy Xander of Albuquerque,
N.M., paid down about $135,000 of their $265,000 mortgage and refinanced
the balance to reduce the monthly payments. "It was a peace
of mind thing," says Mr. Xander, 39 years old, a medical equipment
salesman who sold some stock to raise cash.
Falling share prices played a key role in the couple's thinking,
says Mr. Xander. "We're not even breaking even if the market
is losing money." By refinancing, the Xanders also sliced their
monthly payments to $1,200 from $2,300 and reduced the interest
rate on their loan by more than a percentage point. "If things
get really bad, we've got a real manageable expense," Mr. Xander
says.
To see how paying down a mortgage stacks up against a taxable fixed-income
investment, you simply compare the interest rate on the mortgage
with the yield on the investment. "It's a straight comparison
because both are subject to the same tax," says Tom Ochsenschlager,
a partner in the national tax office of Grant Thornton LLP.
Mr. Ochsenschlager is paying down about two-thirds of the balance
on his 6.25% adjustable rate mortgage because he's earning just
3.85% on his money-market account. "I was trying to sit out
the market even before the terror attack," he says.
The comparison is trickier if the alternative to prepaying your
mortgage is buying stocks. That's because stocks held more
than one year are subject to a lower capital gains tax. The
accompanying chart to this article shows the break-even point for
investors weighing a stock-market investment against paying off
their mortgage. Someone who has an 8% mortgage and is in the 35%
tax bracket, for instance, would be better off paying down their
mortgage if they expect stocks to earn less than 6.5% a year. The
calculations from Grant Thornton don't include state and local taxes
and assume all stock-market earnings are taxed at the 20% capital-gains
rate.
Prepayments shorten the time it takes to pay off a loan.
A one-time, $5,000 prepayment made in the 13th month of an 8%, 30-year
mortgage can cut 56 months off the term of the loan and produce
roughly $36,000 in savings, according to HSH Associates, financial
publishers in Butler, N.J.
Two big caveats. If you have a 15-year or 30-year fixed-rate
mortgage, prepaying your mortgage generally won't reduce your monthly
payment, which is fixed at the time you take out your loan. Likewise,
prepaying your mortgage won't allow you to skip payments when times
are tough.
The exception is homeowners with adjustable-rate mortgages, who
will see reductions in their monthly payments if they prepay. That's
because the monthly payments on ARMs are typically adjusted once
a year based on the outstanding balance and the current interest
rate. If you have an ARM, it's best to prepay about two months before
the loan readjusts, says Keith Gumbinger, vice president of HSH.
"Otherwise, the real savings on your monthly payment won't
show up" until the next readjustment.
There are many ways of prepaying your mortgage beside a lump payment.
You can replace a 30-year mortgage with a 15-year mortgage, adding
a few hundred dollars to each monthly payment. Or you can simply
include a few extra dollars when you send in the mortgage payment
each month.
However, homeowners should be wary of so-called "biweekly"
mortgage payments, says Nancy Castleman, a partner in goodadvicepress.com,
a Web site that covers how to manage debt. Biweekly plans allow
homeowners to make 26 biweekly payments, or the equivalent of one
extra monthly payment a year. But they generally carry a one-time
set-up fee and sometimes include a monthly charge. "It's a
waste of money," says Ms. Castleman. "You end up paying
for services you don't need."
Before prepaying your mortgage, make sure that you have enough spare
cash to cover emergency expenses or the loss of a job. It's also
best to pay down credit-card debt, car loans and other forms of
consumer debt first because the interest on these loans isn't deductible
and the rates are generally higher.
Keep in mind, too, that if you do need cash in the future, you're
going to have to do some shuffling to get money back out of your
house after prepaying. Donna Skeels Cygan, the Xanders' financial
planner, says she advised the couple against paying off their entire
mortgage because "I wouldn't want that money tied up where
it's not accessible.
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