I received an interesting reader question last week about a scenario where you are very sure that you’re going to sell your house in a few years. In that case, would paying down your mortgage principal create an opportunity for a relatively high return with minimal risk? The e-mail:
Your blog is very insightful. I had an idea that I wanted to run by you. I plan to list my condo for sale in about 14 months. Currently I have a 2nd mortgage with an 8.875% rate. I want to have the most net cash at the time of sale, so I’m thinking the safest investment I can make over the next 14 months is to pay down this mortgage. If my math is correct, I would get a 4.9% return on the avoided interest (less what I would have gotten back from deductions). Am I crazy, or does it seem like I’ve found a good place to put my cash until I leave?
I’m not a mortgage professional, but it would seem to me that in theory this should work. When you make the additional principal payments, every future mortgage payment will also include less interest and more towards paying the loan balance down even faster. When you sell the house, you’ll get your “return” from this lower loan balance.
The annul return from paying down your principal should be roughly equal to the annual interest rate of your loan. The reader had an 8.875% second mortgage, which would seem like a pretty great short-term return over 14 months. The exact return might be a little off to the amortization schedule, it should be close. The mortgage interest may be tax-deductible, but remember that interest from a bank CD outside an IRA is also fully taxable. Check out these related posts:
- Amortization Schedules and Principal Prepayment, Part 1: Shortening a 30-Year Mortgage Into 15
- Amortization Schedules and Principal Prepayment, Part 2: Verification of Returns
Within the posts above, based on the amortization schedule of a 30-year fixed mortgage at a 5% interest rate, I plotted both the effective interest rate paid and the annual investment return from prepaying below:
I suppose that one big risk in doing this is that you don’t end up selling the house, so your cash is now stuck in the home’s equity and will be more difficult to access. So you’ll have to be fairly confident that you will be selling the house, or at least be okay with the possibility of just having a smaller mortgage balance.
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I’ve considered this idea too, but decided not to based on the potential that the house may not sell quickly and my savings is locked in a place I can’t get to if need be. Also there’s no telling what you’ll get for your house.
The only thing I would add/discuss with the emailer is that it may be more prudent to use the extra cash to reduce reoccurring bills as your debt to income ratio may be more of a factor in getting a ‘better’ mortgage.
If this is a second home, wouldn’t the gains (principal in extra payments) be taxable? and hence the returns reduced?
I think there are more cost associated with house other than interest. You need to consider how much money market you would loose on your principal (since that money could have been in bank account instead of in your house principal). You also need to consider inflation rate vs appreciation rate. (especially when house value is going down).
It’s got to depend on your personal financial details.
From my perspective, liquid cash would be worth quite a bit more at closing time than a smaller mortgage balance. Depending on the size of those pre-payments, the difference in interest paid can’t be much more than $1000 or $2000.
Now if you’ve already got a big pool of cash to draw from, to either facilitate closing (make negotiated repairs, pay agent fees, transfer tax, etc), supplement a down payment on your next property or pay first/last/deposit if you’re moving back to a rental, then I could see going ahead with pre-payments.
In this housing market, I’m not confident that prices have bottomed out. That condo might be less 18 months from now.
Ummm I think your convoluted math is taking you down a strange path. If you owe $100 at 8% it is costing you 8% per year. If you pay back $100 you owe nothing and it costs you nothing. I think ANY paydown of an 8.875% loan is the equivalent of earning you the annual rate of 8.875%.
If they have a sufficient emergency fund and don’t have any other debts with higher % interest then I’d say go for it. 8% is a relatively high rate for a mortgage loan so paying that off is a good priority. But I wouldn’t put money towards paying down a mortgage if I don’t have a good emergency fund. If they have other debts like credit cards at a higher interest rate then I’d pay those off first of course.
I got a big pay increase and have been able to save as much as $10k/month over the past year. I paid down my $100K
home equity line of credit over the past year. Now, I’m wondering if I should have paid off my mortgage first instead of the home equity loan. The home equity line of credit was charging 2% less interest than the home mortgage interest rate.
My spouse’s job is relocating within the next year and the move will be paid for by her employer. Our 1st mortgage loan rate is 6.625%. With a house sale looming so soon, it hasn’t made sense to refinance our $120K loan. The Alternative Minimum Tax is hitting me such I don’t get about $8-9K of my interest deduction anymore. So I’ve been trying to pay my principal down beneath $100K, then I’m considering paying off the mortgage loan with my home equity line of credit which has been charging about 4.5% interest lately. I should be able to pay off the $100K over the next year regardless of whether I pay off the home loan or the home equity line of credit. Thus, it doesn’t make sense for me to start putting my excess cash flow into savings when the interest rates are so much lower than what I’m paying in interest on borrowed money.
Let’s assume you will close your house in 18 months and you have $10k cash that don’t need until you close.
Then making $10k payment toward second mortgage has the same effect as investing in a 18month CD at 8.875%. The tax effects wash out each other if you itemize.
Any change in the value of your house would not affect the return you’d getting from paying down your mortgage loan.
If your mortgage interest is not tax-deductible somehow, that would actually make it even MORE attractive to pay it down and reduce the interest paid.
I actually ended up doing this… and using a 0% interest card to make up the difference so I could pay it down quicker… IE the mortgage esentially got shifted onto a CC.
Two results:
1) I had a condo as well with a second that I paid down (seems similar here)…….. the fact that I had the 2nd paid off made it easier to sell (no short sell by missing a $1K or two after commission)
2) I did indeed save money! 8.875% times a large balance can be close to $2-3K on a modest 2nd.
I would do it all over again…
This seems like a clever method to get ahead a bit and would certainly work, but as many here have already pointed out it depends on your own situation. It’s important to look at the big picture of your finances as a whole before making a decision like this.
“I suppose that one big risk in doing this is that you don’t end up selling the house, so your cash is now stuck in the home’s equity and will be more difficult to access.” — While the cash is stuck in the home’s equity, it’s earning 8.875%. It’s stuck in a good way.
Thanks Jonathan. Now, I see.