With bonds paying next to nothing, where can you turn for a respectable yield, guaranteed?
Well, how about your home?
Many homeowners look upon the homestead as a valuable asset they can tap for retirement through downsizing or a loan. They typically count on building equity the old-fashioned way, by gradually paying off the debt and enjoying some price appreciation.
There's another option: making extra principal payments on the mortgage to reduce the debt faster. Every dollar used to pay down the loan earns a "yield" equal to the loan rate, since it saves you from having to pay that amount of interest. If your loan charges 4 percent, prepayments earn 4 percent, a lot more than you'd get in bank savings or a 10-year Treasury note, now yielding a paltry 1.8 percent.
"The advantage to paying off a mortgage over buying bonds depends on the cash flow created," says Wyatt A. Moerdyk of Evidence Advisors in Boerne, Texas. "If the cash flow created by paying off a mortgage is greater than the yield of a bond investment, paying off the mortgage may be a wise move."
"A very conservative investor who is averse to debt may find paying off his or her mortgage is the right choice," says Eric Meermann, a planner with Palisades Hudson Financial Group in Scarsdale, New York. "If the alternative is sticking your money in a money market or savings account, you're better off paying (the mortgage off) early."
He adds, though, that prepaying a mortgage is not a good alternative to investments such as stocks that could be more profitable in the long run.
Mortgage payments involve various charges, often including sums for property taxes and homeowner's insurance, but the key parts are the interest charge on the remaining debt and the principal payment that gradually reduces the debt over the years.
You have a right to pay extra principal, every month or in lump sums, and the payment slip you send with your check probably has a space for recording the amount.
Paying down a mortgage has a snowballing effect, since it reduces interest charges going forward. On a fixed-rate loan, that allows more of each month's payment to go to principal rather than interest, and the loan is paid off early. With an adjustable-rate mortgage, extra payments reduce the required payment after the next annual reset, which applies the new interest rate to the remaining debt. After that, you can either pay less or pay what you have been, with more going to principal.
Prepayments can substantially reduce your interest charges over time, since less interest is required each month as the debt gets smaller. They also allow you to build equity faster.
A homeowner with a $300,000 mortgage for 30 years at 4 percent would pay $1,432 a month in principal and interest. By adding about $150 a month in prepayments, the loan could be paid off five years early, reducing total interest charges by about $40,500. Without the prepayments, the homeowner would still owe nearly $78,000 after 25 years.
"Many people like to have paid off their mortgage before they retire, and making extra payments on your mortgage can be part of that strategy," says David Reiss, who teaches about residential real estate at Brooklyn Law School in New York City.
But although today's low bond yields make mortgage prepayments appealing, stocks returns could beat prepayment yields substantially. Index funds tracking the Standard & Poor's 500 index are up nearly 8 percent this year, and averaged 6.7 percent a year over the past decade. That's a lot better than you're likely to do with a mortgage prepayment, though the prepayment yield is guaranteed while a fund's return is not.
Probably the most severe drawback to investing in the home is a lack of liquidity. To tap that additional equity, you'd have to take out a loan or sell the property.
"The downside of paying down the mortgage is that it doesn't serve as an emergency fund the same way that a portfolio of low-risk investments does," says Joshua Wilson, chief investment officer of WorthPointe Wealth Management in Plano, Texas.
So investing in the home should be limited to money you can afford to tie up for the long term.
While Americans have traditionally thought of the home as a rock-solid investment, many homeowners suffered deeply from the home-price plunge in the Great Recession, when millions ended up owing more than their home was worth. So you can lose money investing in your home, though there's less chance of ending up underwater if prepayments have trimmed the debt.
In most of the country, housing markets are a lot stronger than they were in the years after the financial crisis. But although a nationwide price collapse is very rare, they do occur here and there from time to time, so assess your local market before committing more money to your home.
"The idea that home equity is safe was addressed in 2008," says Kyle Winkfield, managing partner of O'Dell, Winkfield, Roseman and Shipp, a District of Columbia firm that specializes in retirement planning. While investing in home equity is probably safer than stocks and commodities it is not safer than bank savings or a life insurance policy, he says.
Aside from assessing risks, the homeowner considering prepayments should think about how to get equity out of the home when the time comes. You could sell and move to a cheaper place, pocketing leftover cash. Or you could borrow. But to qualify for a home equity loan or cash out refinancing you'd need enough income to make loan payments.
Increasingly, homeowners older than 62 are turning to reverse mortgages, which are loans with no payments. The principal and accumulated interest charges are instead paid after the home is sold, usually after the owner's death. Scott Vance, an advisor with Trisuli Financial Advising in Raleigh, North Carolina, helped a client obtain a reverse mortgage line of credit, which is similar to a home equity line of credit that would require regular payments.
"The benefit of using the reverse mortgage type versus a straight (home equity line of credit) is that the owner never repays it," Vance says. "He draws on the funds if and when he needs them and when he passes the home is taken as payment for those funds."
After the sale, any equity not needed to repay the debt would go to heirs.
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