By Jack Guttentag
One of the vexing features of the post-crisis financial system is the dearth of riskless investments paying a decent return. The rates on federal government securities and insured CDs are not much greater than zero. Yet every homeowner with a mortgage has the opportunity to earn a return equal to the interest rate on the mortgage, with no risk, simply by making extra payments.
The only downside to using mortgage repayment as an investment is that it has no liquidity — once you make the payment, you can’t take it back if you have an unexpected need for funds. But most homeowners with mortgages who place their savings in bank deposits or money market funds paying less than 1 percent, rather than earning 3 to 6 percent by paying down their mortgage, do it for reasons other than a need for liquidity. The main reason is confusion about one or another feature of loan repayment.
Some borrowers have trouble viewing mortgage repayment as equivalent to buying a bond or a CD. Yet in both cases, you pay out money now and receive a stream of income in the future based on the contracted interest rate. The only difference is that the income received from a mortgage repayment is cancellation of interest that you would have had to pay otherwise. The difference between receiving $1,000 of interest, and eliminating the payment of $1,000 of interest, is one of form but not of substance.
Those with a mortgage can actually earn a little more than the interest rate on their mortgage by taking advantage of the 10- to 15-day payment grace period that is found in all mortgage contracts. By adding the extra payment to the scheduled payment, the borrower will save interest for the entire month, even though they do not provide the funds until 10 or 15 days into the month.
Note: If borrowers make a separate payment after the grace period, their loan balance may not be reduced until the following month, which would reduce their return on investment.
Some borrowers who itemize their tax deductions don’t want to repay their mortgage because it entails the loss of a deduction. But the loss is exactly the same as that on a taxable investment. For example, a borrower in the 33 percent tax bracket who repays a 3 percent mortgage earns 2 percent after tax. If instead the borrower purchased a CD paying 1 percent, the after-tax return is 0.5 percent. If the before-tax rate on the repaid mortgage is above the before-tax rate on the alternative investment, the same will be the case after taxes.
Some borrowers believe that they missed the boat on loan repayment because they didn’t do it in the early years of their mortgage when the regular payment went largely to interest, rather than later, when most of it goes to principal. But the rate of return on mortgage investment is not affected by where the mortgage is in its life cycle. While the allocation of scheduled payments between principal and interest changes over the life of the mortgage, extra payments go entirely to principal, no matter what stage of its life cycle the mortgage is in.
Some borrowers are immobilized by plans to sell the home, as if somehow this would prevent their obtaining the expected benefit from making extra payments. But it wouldn’t. In fact, the benefit would become glaringly evident in the smaller loan balance they have to pay off out of the sale proceeds. A similar point applies to those planning to retire with reduced income. If and when they need a reverse mortgage in the future, they will have to pay off their existing mortgage in the process, and the lower the balance, the more they will be able to draw on the reverse mortgage.
I have also heard the concern that the lender won’t credit a borrower’s account until the end of the term. This is not true; the account is credited immediately or even a few days early.
A variant is that the lender will use the extra payments for some purpose other than reducing the loan balance. The only substance to this concern is that the lender will indeed apply extra payments to any unpaid obligations, of which the most likely is an underfunded tax/insurance escrow account. Aside from that, the only thing the lender can do with extra payments, other than credit them to the loan balance, is to steal them, which they never do.
With one exception, borrowers making extra payments need not provide special instructions as to how the payments should be applied. The exception applies when the extra payment is an exact multiple of the scheduled payment — the payment the borrower is obliged to make each month. If the scheduled payment is $600 and the borrower sends in a check for $1200, the lender does not know whether the borrower wants to apply the extra $600 to principal, or is paying for two months. To avoid this problem, do not make extra payments an exact multiple of the scheduled payment.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.
©2013 Jack Guttentag
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