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Mortgage Prepayment question

Posted by sonopoly (My Page) on
Mon, May 12, 08 at 16:49

Hi,

As I've stated before, I'd like to pay my mortgage off around the time I retire which means I'd have to prepay a bit. Is there a difference between paying a little extra monthly (let's say $100) rather than an annual extra payment of $1,200? I'd rather do the annual payment unless it's much more advantageous paying monthly.

Thanks in advance to anyone who can give me advice!

Sonopoly


Follow-Up Postings:

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RE: Mortgage Prepayment question

Yes, there is a difference.
The $100 you pay each month does not accumulate the interest charges it would accrue between then and December (assuming your annual payment would be made then).
The net difference would depend on what, if any, income that $100 would be generating for you by holding on to it until December.
With an 8% mortgage, you would avoid about $40 in interest yearly by making $100 additional principle payments monthly instead of annually.


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RE: Mortgage Prepayment question

It depends. If you start making your annual $1200 payment on June 1 of this year and continue on making annual June 1 $1200 payments, you'll probably pay off your mortgage a few months earlier than if your start with $100 extra monthly payments on June 1 of this year and continue them each month.

But if you wait and start your $1200 annual extra payment on Dec 1 of this year and continue to make them on Dec 1 of each year, you'll pay off the loan on the same date in both cases, but the final payment will be a few hundred dollars less if you stick to the monthly schedule.


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RE: Mortgage Prepayment question

Hi Sonopoly,

As I've stated before, I'd like to pay my mortgage off around the time I retire which means I'd have to prepay a bit. Is there a difference between paying a little extra monthly (let's say $100) rather than an annual extra payment of $1,200? I'd rather do the annual payment unless it's much more advantageous paying monthly.

Assuming you are accumulating the payoff funds in the best relatively safe growth account while you are waiting, the only significant difference is in your financial safety. Your accrued interest received, especially when compounding, will offset most or all (and sometimes even more) of the after-tax mortgage interest.

The longer you retain the funds seperately for the eventual payoff, the safer and more secure you will be financially. If you are accumulating them in a manner that provides compounding interest, you may very well accumulate your funds larger & faster, allowing you to retire your debt not only faster but in a safer fashion.

Remember; Cash is oxygen.

Nobody has ever gone bankrupt or into surprise foreclosure when they had more than enough cash...
(Even when they had paper debt equal to or beyond the cash itself.)

Cash in hand is far safer than cash in home.

Cheers,
Dave Donhoff
Leverage Planner


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RE: Mortgage Prepayment question

Rather than paying a fixed amount every month (or annually) how about getting a copy of your amortization schedule. Your lender may have included one with the loan documents or you can print one via the internet if you have the relevant information. Instead of paying a fixed amount, pay off a specific payment. Then you'll see exactly how much money you're saving (the interest for that payment). If you're early into your loan, the principal payments are usually pretty small and the interest pretty high. The money you can save is staggering.

Good luck!


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RE: Mortgage Prepayment question

Thanks, Randy, FF, Dave, and Mike! All of this info is extremely helpful. I will research all my options. This mortgage stuff is so complex...

Sonopoly


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RE: Mortgage Prepayment question

Wouldn't the OP be better off keeping the mortgage and paying on time...in increasingly less valuable dollars? (Assuming the mortgage is at a low interest rate.)


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RE: Mortgage Prepayment question

Isn't it better to pay off mortgage completely by retirement? Or is it okay to pay off on time (rather than early) a few years into retirement? I'm just trying to do the financially wise thing since it is new to me (mortgage) and somewhat perplexing. I don't want to wait 10 years and then find out I should have done something else.....

Thanks again!
Sonopoly


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RE: Mortgage Prepayment question

Isn't it better to pay off your mortgage completely by retirement? In general, the answer is no--so long as the money is invested in a way that earns more than the interest rate of the mortgage.


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RE: Mortgage Prepayment question

If you have a mortgage payment when retired, then you'll need to set aside a fairly large portion of your nestegg just to generate enough return to meet the payments. And this portion will need to be invested pretty conservatively because it'll have to provide you with a steady income stream -- your mortgage payments don't stop just because the market has crashed. That means your rate of return on this portion of your nestegg will be on the lower end -- and may even be less than your mortgage rate, depending on financial conditions.

OTOH, if you don't have those mortgage payments to make, you'll have much more flexibility with your investments to respond to changing financial conditions..


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RE: Mortgage Prepayment question

If you have a mortgage payment when retired, then you'll need to set aside a fairly large portion of your nestegg just to generate enough return to meet the payments.

feedingfrenzy-- it sounds to me that you suggesting you need to "set aside" a large enough amount of money such that the earnings from this chunk of money are sufficient to make your mortgage payments? Do I understand you correctly? And if so, may I ask why?

Once you retire, do you not just start "cashing out" your retirement savings to meet your living expenses? (with the idea of not hitting zero before you die, of course). Why would you treat a mortgage any differently than other expenses? Yes, I understand if you have a mortgage in addition to food and heat and blood pressure medicine, you have to "cash out" a larger amount each month, but if you have been putting more into savings all along as the alternative to prepaying your mortgage you are also starting off with a bigger pot from which to dip. Which is better i imagine would depend on specifics, but I don't understand the concept of treating the money needed for a mortgage any differently that money needed for other living expenses.

(((Although it is entirely possible I totally just misunderstood what you were saying, in which case, never mind))) :-)


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RE: Mortgage Prepayment question

Hi Sonopoly,

Isn't it better to pay off mortgage completely by retirement?

Not necessarily. Retirement occurs either voluntarily (when you've accumulated enough passive/safe investments to support the rest of your days,) or involuntarily (when you are no longer able to be gainfully employed, regardless of your financial readiness.)

For voluntary retirement, you are generally better of having more capital growing, especially in compounding-return tax-sheltered accounts... even if you also have some leverage (asset-married debt) remaining at non-compounding costs of interest.

Compounding growth outperforms non-compounding costs over time... so starving your growth accounts of dollars in order to send extra money prematurely to retire asset leverage (mortgages, for example) only hurts your safety and delays your ultimate freedom from debt (rather than accelerating it.)

This is counterintuitive, because most people don't understand the mathematic effect of compounding returns, and how a 6% interest cost can be outperformed by a 5% compounding interest payment (by quite a bit) when left alone over the years. Your growth accounts don't have to necessarily have a FACE return higher than your mortgage costs... they simply need to be compounding (interest paid on top of accumulated interest.)

Mathematically, paying principal on a mortgage before it is demanded repaid makes no monetary sense UNTIL it can be done as a "luxury" because overall growth, and protection of the cash position of your net worth in the home, is no longer an important issue (perhaps because you have by then achieved sufficient wealth that the value of the home could be lost, and the income from the leveraged growth accounts could be forfeited, with no detrimental effect on your lifestyle.)

Or is it okay to pay off on time (rather than early) a few years into retirement?

Sure, it's "OK." Just be aware of the full ramifications.

I'm just trying to do the financially wise thing since it is new to me (mortgage) and somewhat perplexing. I don't want to wait 10 years and then find out I should have done something else.....

The fear of future regret is a powerful motivator, to be sure!

Hi FF,

If you have a mortgage payment when retired, then you'll need to set aside a fairly large portion of your nestegg just to generate enough return to meet the payments.

Not true UNLESS you wish to keep the accumulated growth accounts growing to your advantage. If you don't care about the growth performance any longer, you can transfer your equity from your growth accounts into your real estate, effectively surrendering your leverage at that time.

And this portion will need to be invested pretty conservatively because it'll have to provide you with a steady income stream -- your mortgage payments don't stop just because the market has crashed. That means your rate of return on this portion of your nestegg will be on the lower end -- and may even be less than your mortgage rate, depending on financial conditions.

That degree of safety is very doable, and the face rate of return doesn't have to be higher, as long as the compounded growth during the planned period outperforms the non-compounding costs of the tax-deductible mortgage interest.

OTOH, if you don't have those mortgage payments to make, you'll have much more flexibility with your investments to respond to changing financial conditions..

A very nice choice that people get to make when they've kept their funds carefully seperated from their real estate & balanced for optimum safety, tax efficiency & growth.

Hi Quirk,

Although it is entirely possible I totally just misunderstood what you were saying...

NAH.... you sniffed right through the BS! Good job!

Cheers,
Dave Donhoff
Leverage Planner


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RE: Mortgage Prepayment question

quirk

I think I probably didn't express myself well enough.

It's understood that most retirees don't live off just the return on their investments, but gradually cash out the principal as well. But that doesn't really alter the fact that having a mortgage payment means you'll need a larger nestegg to generate the income stream necessary to meet the mortgage payments.

It's certainly true that, over enough time, you're very likely to be better off investing the extra money instead of using it to pay off your mortgage early. If you've followed that strategy for 20 or 30 years before retirement, you're fairly likely to have increased your investment portfolio by more than enough to meet the mortgage payments. This could be a good strategy if you're sufficiently financially disciplined to actually make that monthly investment.

However, for people who have five or ten years before retirement, this strategy is much more risky because market fluctuations may result in much poorer than expected return on investments. It's quite possible you may even lose money, and that means you'll have to dip into your other savings just to meet your mortgage payment.

Yes, the near retiree could make very conservative and "safe" investments, but this means they'll get a low rate of return. Unless their mortgage rate is lower than the rate of return they get on these types of investments (and under current conditions, that wouldn't be true for most mortgagors), the strategy will have backfired on them.


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RE: Mortgage Prepayment question

It seems like another aspect of this is that because of inflation, the mortgage payment becomes a smaller and smaller percentage of one's expenses over time.

For example, my parents bought our family house in 1955 for around $20,000. Their mortgage payment was about $38 a month. By the 1970s, when they paid off the mortgage (around the time my father retired), that $38 was a pretty small deal to them, although initially, it was a lot of money!


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RE: Mortgage Prepayment question

What I am curious about in regards to the inflation aspect is how does that compare to the total amount you have given to the bank. If at the end of my mortgage, I have paid double the price of the house, what is truly the better way to go even if 30 years from now $1550 will seem like chum change. I have no earthly idea how to do the math on this one so does somebody care to help enlighten me?

I am certainly learning many new things with regards to money. leverage, etc that I have never considered but could certainly use many more lessons.


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RE: Mortgage Prepayment question

So another question which I hope wasn't already answered and by the way -- thank you all for your replies -- very helpful and informative indeed! My company matches the first 5% of my 401K, so I am contributing 5% now because it has been all I can handle with the mortgage and a hefty car payment ($555). My last car payment was in April so now I have a bit more money to put into my 401K. SO, would it be better to put another 5 or so percent instead of paying the extra annual mortgage payment?

Thank you again!

Sonopoly


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RE: Mortgage Prepayment question

Greetings son o' poly,

I'm a foreigner, so some of my assumptions may be erroneous.

In the early years of your mortgage, as the outstanding loan is large, the proportion of your regular payment that must be paid monthly in order to pay the interest on that loan is large ... which leaves only a pittance to pay toward principal. In those years, if you can make one extra payment annually, going entirely to pay down principal, you may reduce the amount of principal owing by as much or more than was accomplished by all of those small payments through that year. That means that the principal amount being smaller as you enter the next period, the proportion of the regular payment that needs to be used to pay the interest on the current principal owing is smaller ... which means that more is left over each month to pay down principal, retiring it more in that next year. Which leads many to feel that paying down mortgage on occasion like that makes sense.

I assume that you can deduct you mortgage interest. That means that, on about $100,000. loan at 8%, you'll have to pay about $8,000. interest and if your marginal tax rate (i.e. tax rate on your highest level of income) is 25%, that means that your real cost is $8,000. minus tax saving of $2,000. leaves a net cost to you of $6,000. If marginal tax rate 20%, $8,000. less $1,600. leaves net cost to you of $6,400.

Here's a very serious question ... if you don't make those extra payments on the mortgage, will you without fail invest every one of those dollars? Or will some, even most of them, get frittered away?

Suppose you do invest every one of those dollars, without fail.

What kind of investment will you choose? If you put it into the bank, even if you could earn 8%, you'll have to pay tax on that income, so you'll have the same amounts in hand as mentioned earlier regarding after-tax deduction.

I think that your possibility of earning 8% on a bank account, these days, is rather remote.

If you buy a stock directly, or via a mutual fund, some pay a modest amount annually ... in the case of a stock, it's a dividend. You'll have to pay tax on that income ... I don't know whether such income in your hands would be tax-advantaged, or at top marginal rate. I like that kind of income on local stocks in Canada, for the tax rate was lower and recently became lower yet. In the case of an equity-based (i.e. stock market based) mutual fund, usually part of it is in dividends and part may be interest or capital gain that they earned on stock sold for a profit/(loss).

In a number of years, there may be some growth in value of the stocks that are still held, whether in the mutual fund or that you own yourself. That increase in value that was developed as of the end of the year, but not realized, does not need to be reported for income tax. In Canada, you don't have to answer to the income tax people for that until either you or the mutual fund manager sells those stocks, for a profit or loss, which is added to or deducted from that kind of income, for tax-reporting purposes.

Do you have funds on hand to use for emergencies? Suppose your car blows up and you need to buy a new one ... can you handle that? Or your furnace quits and isn't repairable ... or a cyclone blows part of your roof off?

Suppose you get laid off (whether temporarily or permanently) ... do you have enough reasonably liquidateable assets on hand to be still operational after three months? Six months? A year?

Do you have balances owing on credit cards that you don't pay off in full each month?

Do you have any idea what rate of interest that you're paying on those unpaid balances? For regular cards, it's usually 15 - 20% and on store-issued cards, it's often up around 25 - 28%.

That means that you'd be wiser to pay off those balances rather than paying down your mortgage principal!

I'm nearly 80, and I don't have such a cushion on hand quite a bit of the time.

Why not? I receive 3 pensions, which are almost guaranteed income, for all that I must do in order to continue to receive them is stay alive. Also, a payment from a tax-deferred retirement account, from which I am required to withdraw an increasing percentage of its total value annually.

I have about 80% of my assets (which do not include a home) in stocks or equity-based mutual funds. Why such large proportion of total assets? I do not expect to need to liquidate more than 20% of my assets over a period of 5 - 10 years. And have felt that I should plan to fund my life's expenses till age 100, as I prefer to run out of life before I run out of money rather than the other way around.

I have had a number of the stock and mutual fund certificates issued, which I have used as collateral at my bank to set up a fully secured Line of Credit, which cost no set-up fees (no evaluation of a home, title search, lawyer's fees, etc.) which I use on occasion, but much of the time sits there unused ... with no inactivity fees to pay.

I use my credit card for (infrequent) emergency use, then draw on the line of credit to pay off the full credit card balance owing when I receive the account. Interest paid is not deductible.

So I have set up a separate fully-secured Line of Credit that I may use to purchase more stocks, when I feel it justified and lack savings on hand to use. Interest paid on such loans is deductible.

Also ... it's been my experience that, after a couple of years of dropping stock markets, usually they advance quite rapidly for the first couple of years of recovery.

Were I to need emergency money when I felt that markets were much too low, I'd probably draw on my emergency line of credit for ongoing living costs for a year or so rather than selling stocks at distressed prices, trusting that after recovery I could probably sell them for probably 50% (or even 100%) more than now.

Hope all of this is helpful. If some of it wasn't understood, please ask for further explanation.

ole joyful ... enjoying good health at advanced age


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