12

So my wife and I are in the process of buying our first house. It is a nice house, and we got a smoking deal on it. However, we do not plan to live out the 30-year mortgage we are getting in this house (we think of it as a starter home). I had heard that one prudent thing to do is to pay extra on your mortgage payments every month to pay down your principal, so that you will be paying less over the long run. If we are only planning on being in this house for 5 to 7 years, is it worth the money to do this?

11

You have a loan. You can probably assume you're going to have to repay that loan, every dollar. And every dollar that's outstanding on that loan costs you interest. So assuming you're not hit by any pre-payment penalty, any dollar that you pay down on your house right now saves you a compounded R% a year, where R is your mortgage rate.

It doesn't really matter whether you're planning to sell it in a few years or not. If you pay $N, you'll save the interest + $N taken from the sale price and sent to the bank when you sell the house and move (though you might get a tax deduction on the interest).

If you have a better place to park your money and earn a decent rate of return, it would be worth it to do that instead of paying down the mortgage. If you had another loan with higher interest rates, that's probably a better loan to pay off. If you can spend some of all of it on something that's actually genuinely worth R% of its purchase price a year (plus whatever the wear and tear takes away from its value, if anything) then spend it on that instead; that'd be a better investment. (For instance, investments in the stock market may offer better returns. However, that's risky! Observe that you can't lose money paying down your mortgage, and that Safety is usually relatively expensive these days, so it's not a bad deal. But if you're talking about using it for long-term retirement savings that are tax-advantaged to boot, that's another matter.)

If you already have ample emergency funds and were just planning on putting the money into a savings account to rot at ~1.35% taxable interest, it's definitely worth it to pay down your balance now, unless you're about to sell (so the savings are slight) and it's a real inconvenience.

  • 2
    There is one scenario where you can lose money by paying down your mortgage. And that is if something happens and the home gets foreclosed on. In that case, in addition to the hit on your credit rating, you have effectively lost any extra principle payments that you have made. – KeithB Oct 19 '10 at 19:05
  • Well, if you have significant assets yet owe more than the house is worth, the bank is probably interested in coming after you for that money anyway. It's not exactly safe. If you owed less than the house was worth, you could avoid foreclosure by just selling the place yourself... – user296 Oct 19 '10 at 20:02
6

First of all, congratulations on your home purchase. The more equity you build in your house, the more of the sale price you get out of it when you move to your next house. This will enable you to consume more house in the future. Think of it as making early payments towards your next down payment.

Another option is to save up a chunk of money and recast your mortgage, paying down the principal and having the resulting amount re-amortized to provide you with a lower monthly payment. You may be able to do this at least once during your time in the house, and if you do it early enough it can potentially help your savings in other areas.

On the other hand, it is possible given today's low interest rates for mortgages that in other forms of investments (such as index funds) you could make more on the money you'd be putting towards your extra payments. Then you would have more money in savings when you go to sell this house and buy the next one that you would in equity if you didn't go that route. This is riskier than building equity in your home, but potentially has a bigger pay-off.

You do the trade-offs.

  • If we saved $50,000, we could pay off a little less than two-thirds of our principal. Does it need to be that amount, or is there a percentage we should aim for? Love the other advice, thanks! – Matthew Jones Oct 19 '10 at 15:32
  • @Matthew Jones - a broker told me $50K, but after some research I've discovered that other numbers may apply. – justkt Oct 19 '10 at 15:39
  • 1
    You only make more money from extending the term of a loan if you have the discipline (and luck) to invest the extra cash and beat the spread between loan interest and asset income. Most people just buy more junk and depreciating assets (including new cars and many home improvements). – SpecKK Oct 20 '10 at 6:28
  • Also keep in mind that you'll typically pay 5-6% of the sale price of your home to cover real estate agent commissions, too. – mpontillo Oct 30 '14 at 18:30
4

Here's one way of looking at it.

The first years of a 30-year mortgage are mostly interest payments. Even with a 4% 30-year loan -- I seem to recall seeing rates that low! -- the interest part of your payments for the first five years are double the principal part.

You will pay less in interest if you throw extra money at the mortgage. How much extra?

Let's say you have a loan of $100,000 for 30 years at 4.5%. The monthly payment is $506.69. After five years, you've paid $8,842.43 toward principal and $21,558.97 toward interest.

Let's bump that payment up $200 per month to $706.69. Now, after five years, you've paid $22,284.24 toward principal and $20,128.56 toward interest. You've saved yourself from paying $1,430.41 in interest.

But if you can swing $706.69, can you swing $752.28? That's the payment on a fifteen year mortgage at 4.25%. After five years you'll have paid $26,562.31 on principal and $18,574.49 in interest: $1,500 less in interest than even paying an extra $200/month on your 30-year.

Now, another way of looking at it.

If you're getting a 30-year, get one. Pay only the minimum, and save what you would have paid toward your mortgage to fund a down payment for your next house, since you're planning to get out in 5-7 years. Rather than try to sell your current house, rent it out. Rents go up, but your mortgage payment won't. Fixed-rate mortgages are a great protection against inflation.

3

justkt's answer lays out the opportunity costs aspect of your question pretty well. But if I were in your position, extra payments on principal for a home I wasn't planning to retire in isn't the way I'd invest the money. Housing prices are awful (hence the great deal on what you just bought), and given the number of foreclosures outstanding and the existing uncertainty over the legality of some of them, they're likely to remain awful for years. Depending on the size of your monthly mortgage payment, if you've got that much free cash after expenses each month, I'd consider the following options instead:

  • cash emergency fund (3-6 months living expenses)
  • max out 401(k)
  • max out IRA

You could go with a non-qualified (no tax-deferral benefit) account for the cash emergency fund so you could put any amount above and beyond 3-6 months of living expenses into stocks, index funds, mutual funds, etc.

All of these options have the advantage of being more likely to provide a positive return in the 5-7 year time frame. The cash emergency fund option has the additional advantage of being more liquid than housing--regardless of the current economic environment.

1

Matthew - I'll start with the premise you put enough down that you won't default on an upsidedown mortgage.

There's an order I recommend when considering prepayment:

  1. Deposit to your 401(k) accounts to get the match, if your companies offer.
  2. Pay off any higher interest debt. Obviously any credit card debt you carry month to month.
  3. Be sure your emergency account is funded. In a bad job market, this means having cash to pay all bills and survive until you get work.
  4. Understand your own long term investing plans, do you feel you are disciplined enough to see your investments grow long term, and not panic at every drop?

Prepaying a mortgage is a guaranteed return for a fixed investment for the life of the mortgage or ownership of the house. If you have a rate of 5%, and that rate is good for you to invest at, then prepaying is fine. The presumed long term market gain is 8% or higher (12% if you are a disciple of Dave Ramsey, but I digress) and at the 15% cap gain rate, a 6.8% post tax return. Your 5% rate after tax (if it's all taken on Sch A) is about 3.75% if you are in the 25% bracket.

This difference of 3% or so is not guaranteed year to year, not even for the long term. For some, the desire to pay off the mortgage is enough to focus on it. Others see the 3% compounding over time, and likely to occur over the coming decades.

0

Paying down your mortgage now will decrease the total cost of your home loan and the time period for which your loan lasts. Even if you trade up in that time period, you will be that much closer to being free of house payments.

Owning your home outright gives you a significant amount of freedom to consider less lucrative and more personally fulfilling career options- especially if your work environment becomes unpleasant. It can also help you weather the storm of a job loss more easily (though you should also build an emergency fund).

Homes are depreciating, illiquid assets with significant transaction fees. It is wise to get a starter home that meets your current needs and move up to a home that better meets your needs as you mature. However, getting on the status treadmill and buying large showy homes that generally exceed the utility that you get out of them is expensive, a poor investment, and often impairs the ability to generate long term wealth.

  • @SpeKK - I would disagree that it is a good idea to get a starter home. I think, as you mention in your earlier post "Only buy as much home as you will need in the next decade or so, in a place that you will like living over that time period, and don't consider it much of an investment." The key phrase there is buy as much home as you need. As you yourself point out, homes have significant transaction fees - you're better off buying a home once and never buying one again then "trading up" and paying 10% in transaction fees by doing so. – CrimsonX Oct 27 '10 at 21:24
  • People didn't care about transaction fees when home appreciation was bubbling away. Housing stagnation has resulted in market pressure to make transactions more efficient (look for discount realtors). More importantly I believe real property is an essential part of any portfolio, and now appears to be a great time to get some. It's hard to plan for the future. Most socioeconomically mobile people will move a few times in their life, so I think it's unreasonable to expect the average reader here to only own 1 home in their life. Work and kids can play a large factor in what a person wants. – SpecKK Oct 28 '10 at 0:11

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.