NORTH
PALM BEACH, Fla. -- Oct. 23, 2006
-- Think it's a raw deal that you
pay far more interest on your
mortgage than you receive on your
savings?
There's
a quick way to wipe out that gap
and get the same earnings -- in
some cases even higher -- that you
pay out: Take the amount of money
you would put into a savings
account and pay extra principal on
your mortgage, instead.
In
other words, if you have a 6.5
percent mortgage and you make an
extra payment against principal,
you have an investment that yields
6.5 percent.
While
prepaying isn't for everyone,
financial advisers say it's often
a smart savings strategy. Among
the advantages: low risk,
flexibility and easily measured
savings. Plus, there's a reward at
the end.
Such
payments, directly reducing
outstanding debt, have long ranked
as a popular technique to
accelerate the journey to owning a
home outright by shortening the
life span of a mortgage.
"You
get to actually own your house --
which is a lot more comfortable
position to be in than a stock
certificate or bond if times get
tough," says Marc Eisenson,
co-founder of Good Advice Press, a
publisher of debt reduction books.
"Also, your savings are
liquid. You can get a home equity
line of credit or loan if you need
it."
Calculated
over many years, small payments
add up to substantial savings. A
homeowner with a 30-year mortgage
for $200,000 at 6.5 percent
interest, for example, could save
$56,000 in interest costs over the
life of the loan by forking over
just $100 extra every month. While
prepayment amounts vary, a common
approach is to pay the equivalent
about one extra monthly payment
each year. Doing this annually
would allow someone to pay off a
30-year mortgage in 25 years.
Consider
it an investment
The
best way to determine if prepaying
is a wise financial move is to
compare it to all other investment
options.
That's
the advice of Jack Guttentag,
professor of finance emeritus at
the Wharton School of Business and
founder of the Mortgage
Professor's Web site. He tells
homeowners to view prepayments as
investments bearing interest
equivalent to their mortgage rate
-- a prepayment on a 6-percent
mortgage is the same as an
investment that yields 6 percent.
"If
you can earn 6 percent, and it's a
sure 6 percent, and there's no
risk involved, then the question
is whether you can do better
somewhere else," Guttentag
says. "For most people, the
answer is no."
But
there are exceptions. Younger
homeowners might be better off
funneling savings into a
diversified stock portfolio. While
that's risky in the short run,
over the long term it's likely to
prove to be more lucrative,
Guttentag says.
Donna
Wood, a CPA and financial planner
in Haymarket, Va., advises clients
often to put money into 401(k)
plans before prepaying on a
mortgage. In many cases,
employers' will match 401(k)
contributions up to a certain
limit. Wood tells clients to
contribute at least to that limit
and secure the money in a
diversified portfolio before
exploring others savings
strategies, such as prepaying.
Eisenson also advises homeowners
with outstanding credit card
balances to concentrate on
eliminating their high
interest-bearing debts before
paying off mortgage principal.
Prepay
options on nontraditional loans
Today,
fewer homeowners hold only
traditional 15-year and 30-year
mortgages. Alternate debt
instruments, such as
adjustable-rate mortgages, or ARMs,
home equity credit lines, and
interest-only loans, have
proliferated. As use of these
alternate loans grow, so do
homeowners' prepayment options.
If
you have more than one outstanding
mortgage or loan on your house,
it's logical to prepay the one
with the higher interest rate. But
determining which loan is
costliest can be tricky with ARMs,
where interest rates fluctuate.
Guttentag
advises ARM-holders to consider
both their present and future
interest rates when deciding
whether to prepay. If today's
interest rate is 5 percent,
prepaying might not seem
imperative. But if it's likely to
rise to 10 percent in the next
several years, reducing
outstanding debt becomes far more
appealing. Every dollar of
principal that you pay off today
may be earning the rate you may
have to pay in the future. The
same is true for home equity lines
of credit, says Wood. By paying
down a loan, borrowers help ensure
that future interest charges will
be smaller. As for interest-only
loans, Wood says, prepaying is
wise because it allows homeowners
to build equity.
But
before sending in that extra
check, it's important to make sure
it won't cost you. Some lenders,
particularly those who market to
borrowers with damaged credit,
charge penalties for prepayment.
Prepayment
penalties are exceedingly rare for
conventional or government-backed
loans, says David Reed, president
of CD Reed Mortgage Bankers in
Austin, Texas. In the subprime
loan market, however, Reed
estimates that around one in four
mortgages contain some sort of
prepayment penalty.
On
the flip side, prepaying may also
be less desirable for homeowners
fortunate enough to have locked in
low fixed interest rates. If one
is paying 4 percent interest on a
mortgage, for example, purchasing
a government bond yielding 5
percent interest would be a more
lucrative move than prepaying.
Do
it yourself
Prepaying
on a mortgage should save you
money. But paying someone else to
handle the payments could reduce
or eliminate those savings.
That's
why Reed tells homeowners to be
wary of many heavily marketed
prepayment programs. Most charge a
fee, commonly $300 or $400, to set
up payments.
"I
say prepay all you want, just make
sure you're not in one of those
goofy biweekly programs you have
to pay money for," he says.
"Just do it yourself."
Before
sending in more than the minimum
mortgage payment, Reed advises
contacting one's lender about how
best to go about making a
prepayment. Loan origination
documents should also include
prepayment information, including
any possible penalties. Some
mortgage bills include a box to
check off if extra principal
payment is included. In other
cases, homeowners may write a
separate check, marked
"principal only."
There's
no hard-and-fast rule about how
much to prepay. Determining the
right sum involves analyzing such
factors as one's living expenses,
other outstanding debts, risk
tolerance and alternate investment
options.
There's
also no set way to schedule
prepayments. Homeowners who get
paid every two weeks may feel
comfortable with a biweekly
payment plan. This involves paying
half of the monthly mortgage bill
every two weeks, which effectively
adds up to paying an extra month's
mortgage each year. Another common
approach is to tack on an extra 10
percent to the regular payment.
Ultimately,
it's a personal decision, says
Eisenson.
"The
amount to allocate between debts
and more traditional investments
is an individual matter, with each
of us having to decide how much of
a risk we are willing to take, how
much comfort we require and what
our priorities are," he says.
"Mine would be to have a
house I can afford to live in and
isn't likely to be taken away from
me, should times get
tougher."
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2006 Bankrate.com. All rights
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