My previous article about how to pay off your mortgage more quickly by pre-paying a portion of the principal balance of the loan generated several follow-up questions, here are a couple of them:
Q: I have been struggling with this question for some time now. My mom says to do one thing, yet I think maybe it’s not the “best option” financially for me. I sold some property in California last year and now have about $170,000.00 in cash in the bank, free and clear. I have a new mortgage here in Washington of $232,000.00 at 5.875% interest. This is a 30 year loan. I make $65K a year. Due to the mortgage interest deduction I take at the end of the year to bring my taxes down, I think it’s better to pay-down the loan with each payment vs. taking the cash out and paying down the mortgage with the entire $170,000.00 right now. If I don’t have anything to write off, it seems that I just give it all to Uncle Sam at the end of the year. AND, I won’t have any money to invest in stocks or real estate where I could make more than not having the extra cash. My mom thinks it’s always better to pay off your loan. What do you think?
A: I’m not a big fan of carrying a mortgage just for the tax deduction. You are probably in the 15 percent income tax bracket, which means that you have spend 85 cents in real money for every 15 cents that you save in taxes. The mortgage interest deduction is definitely a benefit to consider, but it should not be your only reason for carrying a mortgage. Be sure you are looking at the big picture.
Let’s analyze your situation: If we assume that inflation will run about 3 percent per year, you can deduct that from your interest rate to give you an inflation-adjusted interest rate of 2.875 percent (5.875 – 3). Now, if we also factor in your income tax deduction of 15 per cent of the interest expense, that further reduces the real cost of the mortgage by 0.88 percent (15 percent of 5.875), which gives you an effective interest rate of just over 2 percent. Any way you look at it, that’s pretty inexpensive money. If you pay down your mortgage with the cash you have on hand you would be essentially earning 2 percent on that money. That’s not much of a return. If you have any stock market or real estate investing skills at all, you should be able to earn a much better return with that money than 2 percent per year. So I would be inclined to agree with you and tell you to hang onto the cash for investing. However, there is no “right” answer to this question. Many people like the peace of mind that comes with owning their home free and clear. That is more of a psychological benefit than a financial benefit, but there is nothing wrong with that as long as you realize what you are doing.
Q: My father borrowed in the old days and interest was taken off each payment as the principal decreased. Known as simple interest. Now they divide the principal and interest into equal payments over the borrowed amount. That makes it a compound interest, right? You are paying 5 percent interest, but if you pay the same each month for full term it is 10 percent. Is that correct?
A: Real estate loans are always based on simple interest, not compound interest. The interest expense is calculated by multiplying the interest rate by the amount of the loan. For example, if you borrow $200,000 at 5 percent interest, you would pay $10,000 per year in interest, or $833.33 per month. That would be an “interest only” loan. But most people get an amortized loan, which means that each month you pay the interest expense plus a portion of the principal balance so that at the end of the loan term the entire balance is paid off. If you borrow $200,000 at 5 percent interest on a 30-year amortization schedule, the loan is divided into 360 equal payments of $1073.64 In order to keep the payments equal, a large percentage of the monthly payment in the early years pays the interest expense with a very small portion of each payment going toward reducing the principal balance of the loan. As you proceed down the amortization schedule, a greater portion of each monthly payment is applied to the principal, with a decreasing percentage applied toward the interest expense. That’s because the annual interest expense decreases slowly each month as the principal balance is paid down.
The bottom line is that you are always paying the interest rate stated on the loan, whether you are making interest-only payments or amortized loan payments.
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