To pre-pay (your mortgage) or not to pre-pay . . . that is the question.

 

Most people would agree that living without a mortgage payment would be a nice thing . . . but is it worth pre-paying your mortgage to try and get the balance paid off? 

The answer: Yes . . . but probably, No.

A lot of people are overly consumed with the idea of paying off their mortgage.  Many sending in an extra few dollars each month, rounding up their total payment to the nearest hundredth or even adding $100 or $200 to their payment, hoping to make a dent in what is most probably their largest debt.  Investors, keying in on the consumer’s drive to do this, have come up with ways to “help” (and I use that term very loosely) by offering bi-weekly payments — sometimes called “Equity Power Program” or something of the like — selling the payment plan as a smart-fix to paying off your mortgage early. 

Essentially, making payments every 2 weeks is the equivalent to making 26 half-payments per year, which is the same as make 13 payments per year.  So, if you want to avoid the “administrative fee” of signing up for the “Equity Power Program” (usually $50 to $295 — ouch!) and if you want to avoid the transaction fee usually associated with this type of plan and charged at each half-payment (usually $1 or $5 per period), you can accomplish the EXACT same thing by sending in one extra payment per year or by sending in an additional 1/12th principal-and-interest-payment each month.  But . . . you probably shouldn’t even do that.

So . . . back to the question at hand.  Should you pre-pay your mortgage?  The answer depends on a few things.

# 1.  Do you have any other debt (credit cards, student loans, car loans, a home equity line of credit)?  If you do, you should pay those off completely before adding $$ to your mortgage payment.

# 2.  Do you have cash in the bank?  Most financial experts would advise you to have four to six months worth of living expenses saved in some type of liquid asset account (checking, savings, money market, etc).  If you do not have this type of reserve account, you should save for this first.

# 3.  Are your 401K contributions at work maxed-out?  If you have numbers 1 and 2 under control, money growing in your 401K should pay a better return than the tax-deductible cost of your mortgage.

# 4.  Are your other retirement and college saving plans being utilized fully?  If not, put more money here to make sure you are on track to meeting your goals, more so than paying down your mortgage.

# 5.  Assuming that 1 through 4 are in order (and even if you don’t have them in order, but you are just dying to pre-pay your mortgage), then the final question is possibly the most important.  Do you have a fixed rate mortgage or an adjustable rate mortgage (ARM)?  And if you have an adjustable rate mortgage, does it have an automatic recast option (most interest-only ARMs do have this options; most others do not).

Here is why this is important:

On a fixed rate mortgage, pre-paying the mortgage does not change next month’s payment — it does not “save” you interest in the same sense as it would if you prepaid a credit card or car loan (most credit cards and car loans have interest calculated daily based on the outstanding balance).  On a fixed rate mortgage, the amortization schedule is set the day that you close on your loan, so additional payments that you make towards the principal save you interest simply because you are saving yourself having to make the 360th or 359th payments (for example). 

On an interest-only adjustable rate mortgage (for most investors) the amount of monthly interest charged recalculates based on the outstanding balance.  This feature is called re-casting, or automatic re-casting – so, as you pay down the principal balance of the mortgage, the interest charged is reduced.  So, prepaying the mortgage really DOES “save” you interest.

Here is an example.  You and I both buy houses and mortgage $200,000.  You get a 30 year fixed at 6.5% and I get a 10/1 interest-only ARM at 6.375%.  Because of the lower interest rate and the interest-only payment, my payment is $202 less than yours (yours, though, includes a principle and interest payment).  If I take the additional $202 per month and pay down the mortgage (assuming that it is automatically recasting each month) who will pay more interest over 5 years?  10 years?

Hmmm . . . I’m working on a spreadsheet to calculate the savings.  Check back soon to find out the answer.  

Adjustable Rate Mortgages . . . OOOOhhhhhhh . . . . AAAAhhhhh

“click, click, click, click, click, click, click . . . click, click, click”

Adjustable rate mortgages (ARMs) have become increasingly popular over the past few years . . . and not so much in the past six months. With mortgage rates hitting historic lows a few years ago, some adjustable rate mortgages (with rates in the high 3% and low 4%) were just too good for consumers to pass up. Just think (or remember, if you were one of them), if you owed $200,000 on your mortgage at 7%, you could refinance and drop your payment by $500, $600 or even $700 per month. Good idea? or too good to be true?

For a lot of consumers, ARMs were (and in some few cases still are) a good tool to help manage their monthly payment. Because the average homeowner stays in a house for 6 to 7 years (and in Atlanta, I would guess that timeframe to be even lower), the need for a 30 year mortgage is not entirely practical. This of course, flies in the face of our parent’s advice and life-experience . . . “I remember when Jimmy Carter was President, we had a 15% rate on our mortgage and it was an adjustable rate loan!”

The issue lies in how people use the tool. A lot of consumers used interest-only adjustable rate mortgages (specifically the first type of interest-only ARM introduced to the market which was a one-month adjustable rate loan) to purchase more house than they could typically afford. With hopes of upward mobility and/or a steady increase in salary at work, some of those people now find themselves in a pinch to make their payment. This one-month ARM mortgage, and now most adjustable rate mortgages, are based on the LIBOR index which is loosely tied to Prime rate. Prime rate, follows the Federal Funding rate (see previous post), so, basically, as the Feds have raised the Federal funding rate (now 17 times in a row), people with one-month LIBOR arms have watched their rate go up more than 4.0% in the past year and a half. Hopefully, most have not watched the whole time and have at some point refinanced out of that one month LIBOR ARM and into something a little longer-term. If you have not yet refinanced, stop reading and call me . . . seriously, that’s enough . . . stop reading and pick up the phone.

If you leveraged this type of loan as a tool to save cash, and if you “got-in” and “got-out” at the right times (even with the cost of refinancing your mortgage twice — once to “get-in” and once to “get-out”), you probably saved a few thousand dollars. And depending on how long you stay in your house (since the last time you refinance) will determine if you made the best decision . . . or if you would have been better off locking-in for 30 years at 4.875%.

Despite the bad-press that ARM’s are now getting (hey, I’d be angry if my payment went up by $600 over the course of two years), certainly they can’t be that bad, right? In 2004, Fed Chief Alan Greenspan had this to say about adjustable rate mortgages: “”Homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade.” Realizing that many consumers have gotten over their heads, and as the state of the economy has changed, I think the past Fed Chief would urge people to use caution when considering an adjustable rate mortgage (and specifically ones with an interest-only option).

Just as a piece of historical/common sense/mortgage-trivia . . . by looking at the graph above, when do you think that the one-month-interest-only adjustable rate mortgages became most popular (remember, the rate is based on the LIBOR index)? You guessed it . . . 2003.

Since the time of the introduction of the 1 month and 6 month ARMs, investors now offer intermediate adjustable rate mortgages (sometimes called “fixed-term adjustable rate mortgages”) that have a period of time in which the rate is fixed — usually 3, 5, 7 or 10 years. These types of loans give consumers the benefit of an interest-only payment (and a slightly lower rate compared to a 30 year fixed) with the security of a fixed interest rate for a certain time-period — 3 years, 5 years, etc. Unfortunately, with the Feds movement in short-term rates (and the subsequent movement in the LIBOR index) these types of loan rates have become squeezed closer to the fixed rate loan to where the savings, and benefit, of these types of loans have become less and less appealing. Because the monthly payment also increases to a principle and interest payment at the time of the first rate adjustment, consumers should be careful to weigh the benefits of a lower payment with the risk of still being in the house at the time the payment adjusts.

There are certainly some advantages to having an interest-only ARM. The interest-only payment allows flexibility in cash-flow, allowing consumers to put money other places (consumer debt, car payments, retirement savings, education savings, etc).

What would happen if we both purchased identical houses in the same neighborhood and mortgaged $200,000. (The reason I say the “identical house in the same neighborhood” is to take the variable of appreciation out of the argument). You obtained a 30 year fixed-rate mortgage at 6.5% and I got a 10/1 interest-only ARM at 6.375%. My total monthly payment (interest only) would be $202 less than yours, but your payment would include a principle and interest payment. If I invested the $202 per month in a mutual-fund account, who would end up ahead after 5 years? 10 years? What if I took the additional $202 and pre-paid the mortgage? Who would be ahead?

The answer to these questions and my advice to ONLY prepay a loan that re-casts, next time.